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Bank Capital Regulation: Theory, Empirics, and Policy

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Abstract

Minimum equity ratio requirements promote bank stability, but compliance must be measured credibly and requirements must be commensurate with risk. A mix of higher book equity requirements, a carefully designed contingent capital requirement, cash reserve requirements, and other measures, would address prudential objectives better than book equity requirements alone. Basel III’s ill-defined liquidity ratios, book capital ratios, and internal models of risk must be replaced by a system of credible, incentive-robust rules that combine valid concepts with objective, market-based information into a simplified and credible regulatory process. Raising minimum capital requirements will not be socially costless; bank profitability, share prices, and loan supply are likely to suffer. But avoiding the dramatic consequences of banking crises would more than repay those costs.

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Notes

  1. For example, our discussion of macroprudential regulation does not discuss the potential tradeoffs involved between the use of capital requirements or loan-to-value ratios as regulatory tools, nor do we provide a detailed analysis of the history of capital requirements in banking, the evolution of the Basel capital standards and their deficiencies, or a discussion of the many alternative approaches to capital standards undertaken in other contexts (for example, innovative approaches to risk-based capital regulation undertaken in Chile in the 1980s or in Argentina in the 1990s).

  2. Frequently, in theoretical models of banking, equity’s role in incentivizing good behavior is confined to “inside”equity, owned by the manager/owner of the bank, which is combined with outside debt to finance the bank, as in Calomiris and Kahn (1991), Holmstrom and Tirole (1997, 1998), and Calomiris, Heider, and Hoerova (2014). The latter article conjectures that a combination of outside equity, inside equity, and outside debt works similarly in environments where corporate governance of outside equity holders provides them with adequate discipline over management.

  3. For a brief list of the relevant literature, see Calomiris and Haber (2014, pp. 461–2).

  4. Adverse-selection problems are also reflected in the much higher underwriting costs paid by companies to issue equity rather than debt, which reflect attempts by issuers to overcome asymmetric information problems during “road shows” in which their investment bankers meet with institutional investors to explain the issuers’ motives for raising capital and attempt to allay any concerns they may have about the prospects of the issuer (see Calomiris and Tsoutsoura, 2010).

  5. Recognizing their own informational disadvantage and managers’ incentives to issue overpriced securities (or at least to avoid issuing undervalued ones), investors usually respond to announcements of new equity offerings by reducing the value of the shares. As a general rule, the larger an issuer’s growth opportunities as a percentage of total value (as represented by its price to book ratio), the less negative the market reaction to the announcement of an equity offering (Jung, Kim, and Stulz, 1996). But in cases where mature companies with limited (if any) profitable opportunities announce they are raising equity, the market reaction is likely to be severely negative.

  6. Holmstrom and Tirole (1997) and Calomiris, Heider, and Hoerova (2014) discuss the incentive consequences of inadequate capital in banks where managers and ownership are aligned. Kashyap, Rajan, and Stein (2008) consider the case of misaligned incentives. The recognition that there may be significant conflicts of interest between managers and shareholders at large banks, and thus significant costs from requiring excessive equity ratios, does not imply that managers always act contrary to the interests of shareholders, or that shareholders are unable to exert any influence over managerial decisions. Laeven and Levine (2009) and Cheng, Hong, and Scheinkman (2013) find evidence suggesting that blockholders in large banks are sometimes able to encourage risk taking (see also Claessens, Djankov, Fan, and Lang, 2002). Firms may be able to reduce the cost of raising outside equity by adopting corporate governance reforms, but doing so is not costless (see Calomiris and Carlson, 2014, who analyze the corporate governance practices of national banks in the 1890s).

  7. A simple example illustrates why this is so. Assume that a banking system with initial size of 100 grows at the rate of 3 percent per year. Assume that banks earn 1.2 percent of assets per year in interest and fees net of noninterest expenses, and pay 1 percent to insured depositors. If banks were required to maintain a 10 percent equity ratio, after their first year of operation they would be able to pay interest of 90 cents and retain 30 cents to meet the 3 percent growth in required equity. Abstracting from any future loan losses, the banks in this system would never have to go to the public market to raise new equity. If this same banking system were required to meet a 15 percent equity requirement, it would pay 85 cents in interest in the first year, and not have enough in retained earnings (35 cents) to grow its equity in the first year by the required 45 cents (3 percent of 15). Thus, in the system with a 15 percent equity requirement banks need to raise external equity of 10 cents in the first year, and higher amounts in every following year. We note, however, that while the cost of raising new equity is ongoing under the higher capital ratio requirement, as the minimum required ratio becomes higher the dilution cost per dollar of capital raised in the market likely declines. Signaling costs should be increasing in risk, and so, if higher equity ratios reduce the riskiness of equity, signaling costs of new offerings will also be reduced.

  8. Of course, this conclusion is model-dependent; it is possible to envisage a set of circumstances in which a rise in minimum capital requirements causes banks with debt overhang to become more constrained and lend less. If the regulator were able to require banks to raise more equity, low-risk loans that otherwise would not have been made would now be undertaken. At the same time, high-risk loans that were made before might be reduced, so the effect on total loan supply is unclear. Furthermore, an increase in lending is especially likely if a bank suffering from a debt overhang is required to meet an increased equity ratio at least in part through an increase in the required amount of equity. Otherwise, a higher required equity ratio might lead to the opposite behavior (a reduction in low-risk lending) by a bank with a debt overhang problem.

  9. The literature is vast. Two particularly influential studies are Demirguc-Kunt and Detragiache (2002), and Barth, Caprio, and Levine (2006).

  10. For a detailed discussion of Admati and Hellwig (2013) see Calomiris (2013). For a similarly mistaken view of the neutrality of bank capital structure choices, see the bold proposal for 100 percent equity banking by Kotlikoff (2011).

  11. Although much of the discussion about bank funding focuses on debt vs. equity, it is important to note that, both theoretically and empirically, there are important aspects to the structure of debt finance in banking, especially deposit vs. nondeposit funding. A greater reliance on core deposits relative to other debts tends to be associated with lower default risk of the bank, either because core deposits entail less liquidity risk than other short-term debts (such as brokered deposits), or because a bank’s ability to attract core deposits is itself an indication of lower default risk. For empirical evidence, see Ratnovski and Huang (2009), Calomiris and Mason (2003a), and Calomiris and Carlson (2014).

  12. For a review of capital structure theory in banking, see Thakor (2014). For a recent example of a theory of optimal bank capital structure in which different banks choose different interior optima as their capital structures, see Mehran and Thakor (2011).

  13. These data were taken from Rose and Wieladek (2014), which provide a more detailed description of the dependent variables.

  14. Note that by construction, a bank would only be in breach of the implied leverage requirement if it were in breach of the risk-based capital requirement ratio.

  15. Note that our sample of Banks consists of both U.K.-owned banks and foreign subsidiaries. As documented in Aiyar, Calomiris, and Wieladek (2014a), foreign subsidiaries were subject to, on average, a higher capital requirement than U.K.-owned banks. This raises a question whether our findings might be due to the inclusion of this second group of banks. The results on the regulatory and actual capital ratio are robust to estimating our regressions for the sample of U.K.-owned banks only. But in regressions reported only for this subsample of banks these variables lose statistical significance when bank size is included as an additional variable. This should not be surprising, as the two variables are correlated in the cross-section because larger banks were likely to have been perceived as better diversified and hence safer, which allowed regulators to justify a smaller capital requirement.

  16. For a review of the determinants of underwriting costs, see Calomiris and Raff (1995), Calomiris (2002), and Calomiris and Tsoutsoura (2010).

  17. See Table 6 of Cornett and Tehranian (1994).

  18. For reviews of the literature, see VanHoose (2008) and Aiyar, Calomiris, and Wieladek (2014a).

  19. Interestingly, however, the average magnitudes of loan-supply responses in Brun, Fraisse, and Thesmar (2014)–which studies the French case of an across-the-board change–is similar to the loan-supply responses found in the U.K. studies of bank-specific capital requirement changes.

  20. There is substantial evidence from numerous academic studies of many countries that a reliance on uninsured short-term debt enhances risk management and reduces the probability of banking crises, including Martinez-Peria and Schmukler (2001), Calomiris and Powell (2001), Calomiris and Wilson (2004), Barth, Caprio, and Levine (2006), Bertray, Demirguc-Kunt, and Huizinga (2013), Calomiris and Carlson (2014). Debt discipline operated to some extent even in the recent crisis, despite the insurance of many bank debts. Had it not been for the contractions of uninsured short-term bank debts in 2007–09—that is, the dramatic declines in interbank loans, asset-backed commercial paper, and repos—regulators would not have acted as quickly to force banks to shore up their positions. That example illustrates that debt market discipline is not just about crisis prevention, it is also about crisis resolution.

  21. For reviews of that literature, see Calomiris (2011a) and Calomiris and Haber (2014, Chapter 14).

  22. Regulators may also be concerned about contagion effects from loss recognition. That concern, however, presumes that markets are unaware of unrecognized losses. Data on market valuation of banks during the recent crisis (Calomiris and Herring, 2013) suggest that market values of equity ratios reflected bank condition better than regulatory values.

  23. Calomiris (2011b) advocates reforms to the use of securities ratings in bank risk measurement that would improve the accuracy of ratings by giving rating agencies an incentive to avoid understatements of security risk.

  24. Just to be doubly sure, regulation could limit CoCo holders to qualified institutional investors (insurance companies, hedge funds, pension funds, mutual funds) and prohibit institutional investors from shorting the stocks of the megabanks that are required to issue CoCos.

  25. Depositing the assets at the central bank prevents window dressing by banks, who might otherwise hold cash only once per quarter on accounting report dates.

  26. For a somewhat similar argument about the advantages of combining cash asset requirements alongside capital requirements to encourage better risk management, see Acharya, Mehran, and Thakor (2010).

  27. Our discussion focuses on the use of capital requirement changes as a macroprudential tool. Other macroprudential tools—such as changes in maximum permissible loan-to-value ratios—provide an alternative means of influencing loan supply, and one that may not suffer from the same degree of imprecision in the estimation of its effects.

  28. On the other hand, some might argue that having an explicit framework for reducing capital requirements during recessions, which makes a form of “forbearance” explicit might make the relaxation of capital requirements more accountable and controllable, and thus make excessive and destabilizing forbearance less likely. This is a difficult question for economic theory to address as it revolves around practical questions relating to the political economy of prudential regulation and supervision.

  29. Bernanke and Gertler (1995), Kashyap and Stein (1995, 2000), Gourinchas, Valdes, and Landerretche (2001), Dell’Ariccia and Marquez (2006), Dell’Ariccia, Igan, and Laeven (2008), Mendoza and Terrones (2008), DeNicolo and others (2010), Bekaert, Hoerova, and Lo Duca (2013), Dell’Ariccia, Laeven, and Suarez (2014), Jiménez and others (2014), Aiyar, Calomiris, and Wieladek (2015). These papers show that there are various channels through which monetary policy operates, and various indicators of the effects of monetary policy, including the tolerance for greater risk in equity, bond, and banking markets, the reduced pricing of risk, and the expanded supply of credit, especially by smaller banks who are more dependent on depository debt funding.

  30. This is, of course, not the only potential rule one could follow. For example, a rule that would impose bank-specific limits in high-credit growth states might be superior because it would be able to reward banks that behave prudently by assuring them that they would not be punished with higher capital requirements as the result of the behavior of other banks.

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*Shekhar Aiyar is Deputy Division Chief in the European Department of the International Monetary Fund. Charles W. Calomiris is Henry Kaufman Professor of Financial Institutions at Columbia Business School and a Research Associate of the National Bureau of Economic Research. Tomasz Wieladek is Programme Manager, responsible for research on the interaction of monetary and macroprudential policy, in the Research Hub at the Bank of England. The authors thank Luc Laeven, Lev Ratnovski, Pierre-Olivier Gourinchas, Galina Hale, Katheryn Russ, and two anonymous referees for helpful comments on an earlier draft.

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Aiyar, S., Calomiris, C. & Wieladek, T. Bank Capital Regulation: Theory, Empirics, and Policy. IMF Econ Rev 63, 955–983 (2015). https://doi.org/10.1057/imfer.2015.18

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  • DOI: https://doi.org/10.1057/imfer.2015.18

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