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On the Behaviour and Determinants of Risk-Based Capital Ratios: Revisiting the Evidence from UK Banking Institutions

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  • William Francis

    (Financial Services Authority)

  • Matthew Osborne

    () (Financial Services Authority)

Abstract

Using bank-level panel data from the United Kingdom, this paper investigates the factors that influence banking institutions' choice of risk-based capital ratios. Special focus is placed on evaluating whether and how institutions respond to changes in regulatory capital requirements and if these responses vary across the economic cycle. This issue is of particular interest to policymakers that rely on capital regulation in conjunction with other supervisory tools to affect bank behaviours and maintain market confidence and financial stability more broadly. The paper also explores the extent to which UK banks’ capital management practices were procyclical under Basel I. Understanding whether such practices existed under this less risk-sensitive (and potentially, less procyclical) regulatory capital regime is a useful first step towards determining if banks, in their capital management practices, consider swings in economic conditions on their capital positions and lending capacities, which may, in turn, impact on the severity and duration of such economic cycles. We find a statistically significant association between banks' risk-based capital ratios and individual capital requirements set by regulators in the UK. We also find that the rate at which banks respond to changing capital requirements depends significantly on certain characteristics of the bank (e.g., size, exposure to market discipline, nearness to regulatory threshold) as well as the direction of the economic cycle. We find a (marginally statistically significant) negative association between capital ratios and the economic cycle, but no association when we focus only on the largest banks in the UK, suggesting that systemically important banks tend to maintain risk-based capital ratios over the cycle (although we note that this finding is based on a sample period which does not contain a significant downturn). Further, we note a positive association between capital ratios and capital quality, suggesting that reliance on capital with relatively higher adjustment costs (e.g., tier 1 capital) may raise the profile of that consideration in capital management practices and lead cost-minimizing banks to maintain higher total risk-based capital ratios overall. Finally, we find a positive marginal effect of market discipline on total risk-based capital ratios held by UK banks. We interpret this result as suggesting that banks mitigate expected market reactions (e.g., on their funding costs or ability to access certain capital markets activities) to their business decisions by holding higher capital ratios.

Suggested Citation

  • William Francis & Matthew Osborne, 2009. "On the Behaviour and Determinants of Risk-Based Capital Ratios: Revisiting the Evidence from UK Banking Institutions," Occasional Papers 31, Financial Services Authority.
  • Handle: RePEc:fsa:occpap:31
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    Citations

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    Cited by:

    1. de-Ramon, Sebastian J A & Francis, William & Harris, Qun, 2016. "Bank capital requirements and balance sheet management practices: has the relationship changed after the crisis?," Bank of England working papers 635, Bank of England.
    2. Lin, Karen Lai Kai & Konishi, Masaru, 2013. "Capital requirements, bank behavior and fair value accounting: Evidence from Japanese commercial banks," Working Paper Series G-1-6, Center for Financial Research, Graduate School of Commerce and Management, Hitotsubashi University.
    3. de Ramon, Sebastian & Francis, William & Milonas, Kristoffer, 2017. "An overview of the UK banking sector since the Basel Accord: insights from a new regulatory database," Bank of England working papers 652, Bank of England.
    4. Emanuel Kopp & Christian Ragacs & Stefan W. Schmitz, 2010. "The Economic Impact of Measures Aimed at Strengthening Bank Resilience – Estimates for Austria," Financial Stability Report, Oesterreichische Nationalbank (Austrian Central Bank), issue 20, pages 86-114.
    5. repec:eee:jbfina:v:87:y:2018:i:c:p:87-101 is not listed on IDEAS
    6. Maria Abascal & Luis Carranza Ugarte & Mayte Ledo & Arnoldo Lopez Marmolejo, 2011. "Impact of Financial Regulation on Emerging Countries," Working Papers 1108, BBVA Bank, Economic Research Department.
    7. Song, Joonhyuk & Ryu, Doojin, 2016. "Credit cycle and balancing the capital gap: Evidence from Korea," Economic Systems, Elsevier, vol. 40(4), pages 595-611.
    8. Ana Kundid Novokmet, 2015. "Cyclicality of bank capital buffers in South-Eastern Europe: endogenous and exogenous aspects," Financial Theory and Practice, Institute of Public Finance, vol. 39(2), pages 139-169.
    9. Balázs Égert & Douglas Sutherland, 2014. "The Nature of Financial and Real Business Cycles: The Great Moderation and Banking Sector Pro-Cyclicality," Scottish Journal of Political Economy, Scottish Economic Society, vol. 61(1), pages 98-117, February.
    10. R. Glenn Hubbard, 2013. "Financial regulatory reform: a progress report," Review, Federal Reserve Bank of St. Louis, issue May, pages 181-198.
    11. repec:ipf:finteo:v:39:y:2015:i:3:p:139-169 is not listed on IDEAS
    12. Peter Andrews, 2011. "Economic Evidence and Financial Regulation," Chapters,in: The Financial Crisis and the Regulation of Finance, chapter 4 Edward Elgar Publishing.
    13. Meraj Allahrakha & Benjamin Munyan, 2016. "Do Higher Capital Standards Always Reduce Bank Risk? The Impact of the Basel Leverage Ratio on the U.S. Triparty Repo Market," Working Papers 16-11, Office of Financial Research, US Department of the Treasury.
    14. Dinc, Yusuf, 2017. "Comparative empirical analysis on the effect of mortgage loan on capital adequacy ratio," MPRA Paper 86451, University Library of Munich, Germany, revised 25 May 2017.
    15. Hamada, Miki, 2017. "Bank capital and bank lending in the Indonesian banking sector," IDE Discussion Papers 662, Institute of Developing Economies, Japan External Trade Organization(JETRO).
    16. de-Ramon, Sebastián & Iscenko, Zanna & Osborne, Matthew & Straughan, Michael & Andrews, Peter, 2012. "Measuring the impact of prudential policy on the macroeconomy: A practical application to Basel III and other responses to the financial crisis," MPRA Paper 69423, University Library of Munich, Germany.
    17. Francis, William, 2014. "UK deposit-taker responses to the financial crisis: what are the lessons?," Bank of England working papers 501, Bank of England.

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    Keywords

    bank; capital; financial regulation; prudential policy;

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