Prudential Regulation and the “Credit Crunch”: Evidence from Japan

Abstract

The underlying causes of sharp declines in bank lending during recessions in large developed economies, as exemplified by the U.S. in the early 1990s and Japan in the late 1990s, are still being debated due to the lack of any convincing identification strategy of the supply side capital-lending relationship from lending demand. Using within bank share of real estate lending in the late 1980s as an instrumental variable for bank capital, we find that Japanese banks cut back on their lending in response to a large loss of bank capital in fiscal year 1997. Copyright 2007 The Ohio State University.

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“…Watanabe (2007) or Berrospide and Edge (2010) highlight the difficulties inherent in estimating target capital levels.…”

“…Focusing on that later development, Woo (2003) and Watanabe (2007) found that Japanese banks significantly reduced their lending in response to a large increase in bank capital requirements resulting from the reinforcement of the prudential policy guidelines by the Japanese regulator. Watanabe's results suggest a very large role was played by the contraction of capital in business lending: had capital not been squeezed, business lending to sound industries (which indeed fell, depending on the industry, between 3 and 5 % points) would actually have increased.…”

“…In addition, some studies, like Watanabe (2007) or Berrospide and Edge (2010) attempt to measure banks' capital surplus, i.e. the difference between the observed and the desired capital ratios.…”

“…Our identification strategy builds on the approach used by Watanabe (2007), who also examines the link between bank's capital and loan growth in the second half of the 1990s. Watanabe uses the individual bank's share of lending to the real estate industry in 1989 as an instrument for that bank's capital to asset ratio in the late 1990s, as we do.…”

“…We then use an instrumental variable procedure along with industry-year and firm-year fixed effects to address the simultaneity between lending and capital. Our instrument is based on Watanabe (2007) and relies on bank-specific exposure to real estate development as of 1995. The underlying idea is that, unlike banks that enter the real estate development industry during a housing boom, banks with a traditionally high exposure to real estate development are likely to better know the industry than the rest, but possibly due to relationship lending, they are more likely to be exposed to the ups and downs of real estate prices.…”