Implications of bank regulation for loan supply and bank stability: a dynamic perspective

Abstract

Research Question Banks finance their loans and other assets with a combination of external finance in form of deposits and external equity as well as internal finance by gaining internal funds. Whereas the two types of external finance typically generate a trade-off between bank stability and loan supply due to different costs, we are interested in the impact of internal finance. Like external equity, internal funds improve the stability of banks, but unlike equity they are the outcome of a bank's past decisions on loan supply and capital structure. These decisions thus not only determine a bank's current stability, it also predetermines the future availability of internal funds, the future costs of external finance with deposits and external equity and a bank's vulnerability to future risks. Vice versa, expected future difficulties with respect to funding might affect a bank's lending and capital structure decision today. This paper sets out to understand the role of internal funds in this intertemporal link and the influence of bank regulation on the dynamics of loan supply and bank stability. Contribution In a theoretical partial equilibrium model, we study the decisions of a forward-looking bank over time with respect to its investment and capital structure. Taking the advantages of regulatory intervention as given, our approach is to identify the conditions under which different regulatory instruments can achieve bank stability and to assess the costs of doing so in terms of loan supply. We analyze the effects of risk-weighted capital-to-asset ratios and liquidity coverage ratios as well as regulatory margin calls, which is a theoretical proposal by Hart and Zingales (2011). Results Credit risk and financial frictions that cause debt to be cheaper than equity create an intratemporal and intertemporal trade-off between the stability of a bank and the efficiency of its loan supply. Internal funds may overcome this trade-off, but their availability is restricted. In this model framework, all regulatory instruments may increase bank stability for certain credit risks, but have distinctively different effects on loan supply. According to our model, risk-weighted capital-to-asset ratios may increase the volatility in loan supply. Liquidity coverage ratios may increase the volatility in loan supply as well, but in contrast to risk-weighted capital-to-asset ratios they never impose an additional restriction on loan supply of an already stable bank. Regulatory margin calls will also never change the loan supply if the bank chooses a safe capital structure. However, for high credit risks, it stops credit intermediation.