In Focus Risk
Bank-capital requirement increases, and their effects
Regulators need to be aware of the potential impact on lending of any additional capital obligations
Steven Ongena Professor of banking, University of Zurich
steven.ongena@
bf.uzh.ch
To further strengthen financial markets after the crisis, regulators have resorted to taking measures to increase capital requirements. The Basel III agreement, that is due to
be implemented in 2019, seeks to further increase the amount and quality of capital, enhance risk capture, contain leverage, improve liquidity, and limit procyclicality. Minimum capital requirements are raised
by 50%, requiring banks to increase their risk-based capital ratios. Banks can reach this goal by increasing the amount of regulatory capital they hold, or by lowering the quantity of risk-weighted assets they finance. Together with my fellow researchers Reint
Gropp, of the Halle Institute for Economic Research, and Thomas C. Mosk and Carlo Wix, of the Goethe University Frankfurt, I studied the impact of the 2011 European Banking Authority (EBA) capital exercise – which unexpectedly required certain banks to increase their regulatory-capital ratios – on banks’ balance sheets and the real economy. Based on this exercise, we forecast that the
Basel III agreement may induce banks to reduce the amount of assets they finance by lowering their credit exposure to certain firms, but that they will likely not increase their amount of regulatory capital.
Risk-based capital ratio The goal of the risk-based capital ratio is to ensure that banks hold sufficient capital available to allow them to absorb a financial loss. The ratio is obtained by dividing the amount of regulatory capital a bank owns by the amount of risk-weighted assets it finances. Regulatory capital is equal to the amount
of equity, retained earnings, and reserves a bank owns.
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reacted differently, depending on whether or not they were included in the exercise.
The reduction in levels of risk-weighted assets was carried out via reductions in corporate and retail- credit exposure
Risk-weighted assets are equal to the total
value of each asset financed by the bank multiplied by their respective risk weights. Riskier deals require banks to allocate more funds, making such deals less attractive.
The EBA capital exercise Any attempt to identify effects of regulatory changes with regard to capital requirements faces a methodological challenge of finding an external change in capital requirements. The 2011 EBA capital exercise provides a
setting which allows the authors to isolate the effect of changes in capital requirements on banks’ lending behavior. The exercise required a subset of European
banks to hold a 9% capital ratio – up from 5%. The selection rule included banks in descending order of their market share, such that 50% of each country’s banking sector was included in the exercise. Since banks differ in size within countries,
as do banking sectors across countries, banks with significantly different balance sheets were included, or excluded, from the exercise. In their paper – Bank Response To Higher
Capital Requirements: Evidence From A Quasi- Natural Experiment – the researchers take advantage of this selection process and observe how seemingly identical banks
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What does this exercise teach us? Data from nearly 200 European banks reveal that the banks included in the exercise increased their risk-based capital ratio by 2% more than the excluded banks. The amount of regulatory capital evolved
identically for both groups of banks, whilst the included banks reduced their amount of risk-weighted assets by 16% compared to the excluded banks. These results provide evidence that, when
banks face increases in capital-requirement ratios, they tend to reduce their levels of risk- weighted assets instead of raising new capital. Further analysis shows that the reduction
in levels of risk-weighted assets was carried out via reductions in corporate and retail- credit exposure. Companies that relied on the treated banks
for funding grew less, and exhibited less investment and sales growth than those that were less reliant on such banks. The exercise may have been a somewhat
blunt instrument, as the results suggest that banks did not raise their capital ratios by increasing their levels of regulatory capital, but by decreasing their exposure to corporate and retail clients. Requiring banks to increase their amount
of regulatory capital, instead of their regulatory-capital ratio, may be a more effective policy that would both strengthen the banking sector and avoid penalising business activities. CCR
Edited from an article originally written for SFI’s Practitioner Roundups.
April 2018
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