Identifying channels of credit substitution when bank capital requirements are varied[Which financial frictions? Parsing the evidence from the financial crisis]

What kinds of credit substitution, if any, occur when changes to banks’ minimum capital requirements induce them to change their willingness to supply credit? The question is of first-order importance given the emergence of ‘macro-prudential’ policy regimes in the wake of the global financial crisis, under which regulatory tools – in particular, minimum capital ratio requirements for banks – will be employed to control the supply of bank credit as part of the effort to improve the resilience of the financial system. Regulatory efforts to influence the aggregate supply of credit may be thwarted to some degree by ‘leakages’, as other credit suppliers substitute for the variation induced in the supply of credit by regulated banks. Credit substitution could occur through foreign banks operating domestic branches that are not subject to capital regulation by the domestic supervisor, or through bond and stock markets. The UK experience for the period 1998–2007 is ideally suited to address these questions, given its unique regulatory history (UK bank regulators imposed bank-specific and time-varying capital requirements on regulated banks), the substantial presence of both domestically regulated and foreign regulated banks, and the UK's deep capital markets. In this study we show that foreign-regulated branches are indeed an important source of credit substitution. Leakage by foreign regulated branches can occur either as a result of competition between branches and regulated banks that are parts of separate banking groups, or because a foreign banking group shifts loans from its UK-regulated subsidiary to its affiliated branch, which is not subject to UK capital regulation. Our results suggest the presence of both channels is important, but the responsiveness of affiliated branches is substantially stronger (roughly twice as strong). We do not find any evidence for leakages through capital markets. That result may reflect the possibility that under non-crisis conditions loan substitution through unregulated banks enjoys informational, monitoring and cost advantages over substitution via securities markets. This evidence has important policy implications: (1) because significant leakages result from interbank competition, in addition to loan transfers within affiliated entities of the same banking groups, forcing foreign banks to consolidate their operations in each country into either a foreign branch or a foreign subsidiary will not solve the leakage problem; and (2) international cooperation will be necessary to prevent regulatory arbitrage between domestically regulated banks and foreign branches.— Shekhar Aiyar, Charles W. Calomiris and Tomasz Wieladek