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Bank Capital Regulation and Soft Budget Constraints

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  • Kenji Tsuji

Abstract

This paper presents a model of soft budget constraints on firms where refinancing of poor projects is ex post inefficient when viewed in isolation, and analyzes how bank capital regulation affects the softness of firms’ budget constraints. A firm is said to have a soft budget constraint if a bank allows the firm to continue to operate even when continuation is ex post inefficient. It is shown that bank capital regulation may induce soft budget constraints on firms because banks have an incentive to roll over loans made to poor firms in order to comply with the regulation. It is also shown that soft budget constraints are more likely to arise when the regulation is less strict, that is, when banks’ minimum required capital ratios are lower. This paper also demonstrates that soft budget constraints may be more likely to arise under Basel III, that bank capital regulation may increase the probability of bank failures by inducing the soft budget constraint problem, and that the bank capital regulation of Basel I was one of the causes of soft budget constraints in the post-bubble period of Japan. Copyright The Author(s), licensee International Atlantic Economic Society 2015

Suggested Citation

  • Kenji Tsuji, 2015. "Bank Capital Regulation and Soft Budget Constraints," International Advances in Economic Research, Springer;International Atlantic Economic Society, vol. 21(1), pages 33-40, March.
    • Handle: RePEc:kap:iaecre:v:21:y:2015:i:1:p:33-40:10.1007/s11294-014-9504-x
    DOI: 10.1007/s11294-014-9504-x
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    More about this item

    Keywords

    Bank capital regulation; Soft budget constraints; Credit crunch; Basel III; G20; G30;
    All these keywords.

    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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