The Stabilizing Effects of Risk-Sensitive Bank Capital

Abstract

The aim of the present paper is to assess the pro-cyclical impact of risk-sensitive bank capital. We develop a theoretical model where banks may apply two capital management rules: (i) either keep a constant, time-invariant, capital to loan ratio for all loans ("flat" capital ratio), (ii) or hold distinct, time-variant, capital to loan ratios depending on the measured riskiness of the loans ("risk-based" capital ratio). Despite its inherent cyclicality we show that the risk-sensitive capital rule may work to stabilize banks' supply of credit over the business cycle when the credit market is characterised by over-investment, i.e. credit standards are loose and resources are inefficiently allocated to risky projects. In this case the decrease in the capital-to-high-quality-loan ratio in good times provides banks with more leeway to lend to high quality borrowers, limits the search for higher but riskier yields, reduces over-investment, and ultimately smoothes the credit cycle. We test the relevance of this stabilizing effect using quarterly balance sheet data from a panel of US banks over the period 2003-2007. This period, characterized by easy access to credit and-presumablyover-investment, is particularly well suited for our test. We start by partitioning our sample of banks into two groups: banks whose capital to asset ratio has been observationally counter-cyclical, and banks whose capital has been either flat or pro-cyclical over our sample. We then compare the elasticities of credit to GDP across the two groups. Although such partitioning works to biase our statistical test against finding stabilizing effects, we find that banks with counter-cyclical, risk-sensitive, capital ratios have been the least sensitive to the business cycle. This paper thus provides both theoretical support for and empirical evidence of the stabilizing effects of risk-sensitive bank capital management.

Credit Allocation, Capital Requirements and Output

“…The paper which is perhaps closest related to ours is Boissay and Kok-Sørensen (2009) who conclude that a favorable allocational effect of risk-sensitive capital requirements may attenuate procyclicality. Other papers have focused on allocational effects of capital requirements from perspectives which differ from ours (see eg Rochet, 1992;Thakor, 1996;Repullo, 2004;and Repullo and Suarez, 2004).…”

“…Secondly, if the costs from high-risk capital requirements increase more than the costs from low-risk requirements under the Basel II regime, also the number of the insufficiently competent high-risk entrepreneurs will decrease. The third effect which affects the output difference is much more subtle (see alsoBoissay and Kok-Sørensen, 2009). The decrease in the popularity of high-risk projects tends to increase the average success rate of the low-risk projects.…”

Credit Allocation, Capital Requirements and Procyclicality

“…The first of them is the favorable allocation effect that the share of high-risk projects continues to be smaller in each period under risk-based capital requirements. The second effect is the more subtle Boissay-Sørensen (2009) effect (cf. footnote 7 above).…”

“…More precisely,Boissay and Sørensen (2009) consider a model in which all investment projects are similar but the capital requirements of the entrepreneurs can nevertheless differ, because some banks use loan rating and others do not. In the model the more competent entrepreneurs choose a bank which uses a costly rating technology and the less competent entrepreneurs opt for unrated loans.…”

Macroeconomic Propagation Under Different Regulatory Regimes: Evidence From an Estimated DSGE Model For the Euro Area

“…5 See e.g. Borio and Zhu [2008], Zhu [2008], Repullo and Suarez [2009], Jokivuolle et al [2009], and Boissay and Kok Sørensen [2009]. 6 See BCBS (2009), "Strengthening the resilience of the banking sector -consultative document", December and BCBS (2010), "The Group of Governors and Heads of Supervision announces higher global minimum capital standards", September.…”