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Capital Regulation and Banks' Financial Decisions

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  • Haibin Zhu

    (Monetary and Economic Department, Bank for International Settlements)

Abstract

This paper develops a stochastic dynamic model to examine the impact of capital regulation on banks’ financial decisions. In equilibrium, lending decisions, capital buffer, and the probability of bank failure are endogenously determined. Compared to a flat-rate capital rule, a risk-sensitive capital standard causes the capital requirement to be much higher for small (and riskier) banks and much lower for large (and less risky) banks. Nevertheless, changes in actual capital holdings are less pronounced due to the offsetting effect of capital buffers. Moreover, the nonbinding capital constraint in equilibrium implies that banks adopt an active portfolio strategy, and hence the countercyclical movement of risk-based capital requirements does not necessarily lead to a reinforcement of the credit cycle. In fact, the results from the calibrated model show that the impact on cyclical lending behavior differs substantially across banks. Lastly, the analysis suggests that the adoption of a more risk-sensitive capital regime can be welfare improving from a regulator’s perspective, in that it causes less distortion in loan decisions and achieves a better balance between safety and efficiency.

Suggested Citation

  • Haibin Zhu, 2008. "Capital Regulation and Banks' Financial Decisions," International Journal of Central Banking, International Journal of Central Banking, vol. 4(1), pages 165-211, March.
  • Handle: RePEc:ijc:ijcjou:y:2008:q:1:a:5
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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