Did risk-based capital allocate bank credit and cause a credit crunch in the U.S.?
This paper examines the reallocation of bank credit from loans to securities in the early 1990s using data on virtually all U.S. banks from 1979 to 1992. The spectacular increase in bank and thrift failures in the 1980s raised concerns about depository institution risk and spurred interest in public policy prescriptions to reduce this risk. One of these pre-scriptions was the Basle Accord on risk-based capital, which mandates that international banks operating in the major industrialized nations hold capital in proportion to their perceived credit risks. Because capital is more expensive to raise than insured deposits, risk-based capital (RBC) may be viewed as a regulatory tax that is higher on assets in categories that are assigned higher risk weights. Therefore, it would be expected that implementation of RBC would encourage substitution out of assets in the 100% risk category, such as commercial loans, and into assets in the 0% risk category, such as Treasury securities. Thus, the allocation of credit away from commercial loans may have caused a "credit crunch," which the authors define as a significant reduction in the supply of credit available to commercial borrowers. Consistent with these expectations, U.S. banks did reduce their commercial loans and increase their holdings of Treasuries in the early 1990s. A number of alternative explanations for this change in bank behavior have been offered. The authors suggest several other hypotheses including the leverage credit crunch hypothesis reflecting banks' interest in reducing their required leverage capital ratio; the loan examination credit crunch hypothesis reflecting the more rigorous examination process which encouraged substitution into safe assets; the voluntary risk retrenchment credit crunch hypothesis reflecting management's voluntary substitution of safer assets to lower the cost of funding and reduce the risk of bankruptcy; and the macro/regional demand-side hypo-thesis reflecting the reduc
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