Credit Channel and Risk-Based Capital Adequacy - CiteSeer

37 Pages·2002·0.26 MB·English

THE AUSTRALIAN NATIONAL UNIVERSITY

WORKING PAPERS IN ECONOMICS AND ECONOMETRICS

Credit Channel and Risk-Based Capital Adequacy Requirements

Tomoya Suzuki

School of Economics
Faculty of Economics and Commerce
Australian National University
Canberra, ACT, 0200, Australia

Working Paper No. 422

September 2002

ISBN: 086831 422 6

Acknowledgement:
This paper is based on one of the chapters in my PhD thesis at the Australian National
University. I would like to thank Dr Graeme Wells and Dr Paul Lau for their comments and
suggestions. Also appreciated are the comments from the participants of the seminar at the
Australian National University. Any remaining errors are the sole responsibility of the author.
(cid:1) Introduction
Importance of bank lending in the propagation of exogenous shocks has been recog(cid:1)
(cid:1)
nised in the literature(cid:2) Such views are collectively called the (cid:3)credit view(cid:4)(cid:2) The
credit view is that a negative shock (cid:5)e(cid:2)g(cid:2) a monetary tightening(cid:6) restricts the avail(cid:1)
ability of credit to borrowers(cid:7) thereby a(cid:8)ecting the real economy(cid:2) The credit view
consists of two di(cid:8)erent views(cid:7) namely the (cid:3)bank(cid:1)lending view(cid:4) and the (cid:3)balance
sheet view(cid:4)(cid:2) According to the bank(cid:1)lending view(cid:7) banks cut back on lending in the
wake of tight money(cid:7) because they have less money to lend(cid:7) even though there are
good loans to be made(cid:2) On the other hand(cid:7) the balance sheet view implies that
banks cut back on lending in the wake of tight money because borrowers are in
bad shape(cid:2) Thus(cid:7) the two views have di(cid:8)erent implications(cid:2) Nevertheless(cid:7) both the
views imply that a monetary tightening shifts the supply schedule of bank loans
left(cid:7) thereby a(cid:8)ecting the real economy(cid:2) This transmission mechanism of monetary
policy is called the credit channel(cid:2)
The quantitative importance of the credit channel may be dependent on institu(cid:1)
tional characteristics of the (cid:9)nancial market(cid:2) If banks can substitute from deposits
to less reserve(cid:1)intensiveforms of (cid:9)nance (cid:5)such as certi(cid:9)cates of deposit(cid:7) commercial
paper(cid:7) and equity(cid:6)(cid:7) for instance(cid:7) a reduction in bank reserves caused by a monetary
tightening will not shift the supply schedule of bank loans(cid:2) If borrowers have access
to a variety of non(cid:1)bank (cid:9)nancial sources(cid:7) for instance(cid:7) a leftwardshift of the supply
(cid:1)
There is a large literature on the credit view(cid:1) See(cid:2) for instance(cid:2) Walsh (cid:3)(cid:4)(cid:5)(cid:5)(cid:6) Ch (cid:7)(cid:8) for a
literature survey(cid:1)
(cid:10)
(cid:2)
schedule of bank loans(cid:7) if any(cid:7) will not a(cid:8)ect the real economy(cid:2) As such(cid:7) it is ar(cid:1)
gued in the literature that the importance of the credit channel is likelyto diminish
over time due to ongoing (cid:9)nancial innovation and deregulation (cid:5)e(cid:2)g(cid:2) Bernanke and
Gertler (cid:10)(cid:11)(cid:11)(cid:12)(cid:6)(cid:2)
There may be institutional changes that make the credit channel of monetary
policy more important(cid:7) however(cid:2) An example of such institutional changes may be
the introduction of the risk(cid:1)based capital standards(cid:2) In July (cid:10)(cid:11)(cid:13)(cid:13)(cid:7) the bank super(cid:1)
visors of the G(cid:10)(cid:14) countries plus Luxembourg agreed to implementrisk(cid:1)based capital
requirements(cid:7) which took e(cid:8)ect in (cid:10)(cid:11)(cid:13)(cid:11)(cid:2) This is known as the Basle Accord(cid:2) Under
the Accord(cid:7) the Bank for International Settlements (cid:5)BIS(cid:6) requires bank supervisors
to impose minimumrisk(cid:1)weighted capital(cid:1)to(cid:1)asset ratios of eight per cent on all in(cid:1)
(cid:3)
ternationallyoperating banks of theircountries(cid:2) TheBISgivespositiveweightsand
zero weights to risky components (cid:5)e(cid:2)g(cid:2) commercial and industrial loans(cid:6) and safe
components (cid:5)e(cid:2)g(cid:2) U(cid:2)S(cid:2) government securities(cid:6) of banks(cid:15) assets(cid:7) respectively(cid:2) This
meansthat banks can raisetheirrisk(cid:1)weightedcapital(cid:1)to(cid:1)asset ratios bysubstituting
from loans to government bonds(cid:2) If many banks shift their portfolios in this way at
(cid:2)
See Kashyap and Stein (cid:3)(cid:4)(cid:5)(cid:5)(cid:9)(cid:8) for further discussion on the institutionalcharacteristics of the
(cid:10)nancial marketthat make the credit channel less important(cid:1)
(cid:3)
The BIS proposed to revise the Basle Accord of (cid:4)(cid:5)(cid:6)(cid:6) on its consultative paper on (cid:11)A New
Capital Adequacy Framework(cid:12) issued in June (cid:4)(cid:5)(cid:5)(cid:5)(cid:1) This paper focuses on the Accord of (cid:4)(cid:5)(cid:6)(cid:5)(cid:2)
however(cid:1) Santos(cid:3)(cid:13)(cid:14)(cid:14)(cid:4)(cid:8)providesabriefhistoryofcapitalregulationsincetheBasleAccordof(cid:4)(cid:5)(cid:6)(cid:5)(cid:1)
See(cid:2) for instance(cid:2) Altmanand Saunders (cid:3)(cid:13)(cid:14)(cid:14)(cid:4)(cid:8)for further discussion onthe BIS(cid:15)s new proposal of
(cid:4)(cid:5)(cid:5)(cid:5)(cid:1)
(cid:16)
the same time(cid:7) the aggregate supply schedule of bank loans will shift inward(cid:7) and a
credit crunch will ensue(cid:2)
In the U(cid:2)S(cid:2)(cid:7) for instance(cid:7) the implementation of the risk(cid:1)based capital standards
coincided in timing with the slowdown in bank lending(cid:2) Banks representing more
than one(cid:1)fourth of total U(cid:2)S(cid:2) assets did not meet the risk(cid:1)based capital standards of
the BIS as of December (cid:10)(cid:11)(cid:13)(cid:11) (cid:5)see Avery and Berger (cid:10)(cid:11)(cid:11)(cid:10)(cid:6)(cid:2) These coincident events
ledeconomiststotestingahypothesisthat theimplementationoftherisk(cid:1)basedcap(cid:1)
(cid:4)
ital standards caused a credit crunch(cid:2) This means that the U(cid:2)S(cid:2) literature regards
the implementation of the risk(cid:1)based capital standards(cid:7) per se(cid:7) as an exogenous
shock(cid:7) and examines its one(cid:1)time impacts on bank lending(cid:2)
The focus of this paper is similar but di(cid:8)erent to that of the U(cid:2)S(cid:2) literature(cid:7)
however(cid:2) First(cid:7) this paper examines how the implementation of the risk(cid:1)based capi(cid:1)
tal standards a(cid:8)ects the channel through which an exogenous shock (cid:5)e(cid:2)g(cid:2) monetary
policy(cid:6) has in(cid:17)uences on bank lending(cid:2) That is(cid:7) the focus is on the credit channel in
the presence of the risk(cid:1)based capital standards(cid:2) Second(cid:7) this paper focuses on the
case of Japan(cid:2) Under the Basle Accord(cid:7) allowable components of bank capital are
dependent on national regulations of individual countries(cid:7) which creates di(cid:8)erence
in the e(cid:8)ects of the risk(cid:1)based capital standards on the credit channel between U(cid:2)S(cid:2)
(cid:4)
There isarelativelylargeempiricalliteratureonthe linkagebetween theBasleAccordandthe
U(cid:1)S(cid:1) credit crunch(cid:1) See(cid:2) for instance(cid:2) Bernanke and Lown (cid:3)(cid:4)(cid:5)(cid:5)(cid:4)(cid:8)(cid:2) Haubrich and Wachtel (cid:3)(cid:4)(cid:5)(cid:5)(cid:16)(cid:8)(cid:2)
Brian Hall (cid:3)(cid:4)(cid:5)(cid:5)(cid:16)(cid:8)(cid:2) Peek and Rosengren (cid:3)(cid:4)(cid:5)(cid:5)(cid:17)(cid:8)(cid:2) Berger and Udell (cid:3)(cid:4)(cid:5)(cid:5)(cid:9)(cid:8)(cid:2) and Brinkmann and
Horvitz (cid:3)(cid:4)(cid:5)(cid:5)(cid:17)(cid:8)(cid:1)
(cid:18)
and Japan(cid:2)
A notable di(cid:8)erence in banking structures between U(cid:2)S(cid:2) and Japan is that
(cid:5)
Japanese banks hold corporate equities(cid:2) They hold the stocks of their regular
customers as part of long(cid:1)term relationship(cid:7) and hence these stocks are not traded
for pro(cid:9)t(cid:2) Due to the long(cid:1)run growth of stock prices during the post(cid:1)war period(cid:7)
latent capital gains from the stock holdings were substantial to the Japanese banks
in the latter half of (cid:10)(cid:11)(cid:13)(cid:14)s(cid:2) Under the Accord(cid:7) the banks are allowed to count a
certain proportion of latent capital gains from stock holdings toward capital(cid:7) which
makes the risk(cid:1)weighted capital(cid:1)to(cid:1)asset ratios for the Japanese banks vulnerable to
(cid:17)uctuations in stock prices(cid:2) If stock prices fall substantially(cid:7) latent capital losses
from stock holdings will lower the risk(cid:1)based capital(cid:1)to(cid:1)asset ratios of the Japanese
banks(cid:2) In extreme cases(cid:7) the banks may choose to reduce their assets (cid:5)with positive
risk weights(cid:6) by cutting back on lending in order to meet the capital standards of
the BIS(cid:2) Thus(cid:7) an exogenous shock that have in(cid:17)uences on stock prices can a(cid:8)ect
lending activities of the Japanese banks under the Basle Accord(cid:2) The following
sections aim to formalise this idea(cid:2)
This paper is organised as follows(cid:2) Section (cid:16) reviews the risk(cid:1)based capital stan(cid:1)
dards of the BIS in the context of Japanese banks(cid:2) Section (cid:18) discusses a benchmark
modelfor this paper(cid:2) In particular(cid:7) the (cid:3)costly(cid:1)state(cid:1)veri(cid:9)cation(cid:4) model (cid:5)Townsend
(cid:10)(cid:11)(cid:19)(cid:11)(cid:6)(cid:7) whichcapturesasymmetricinformationproblemspertainto(cid:9)nancialtransac(cid:1)
(cid:5)
See(cid:2) for instance(cid:2) Aoki(cid:2) Patrick(cid:2) and Sheard (cid:3)(cid:4)(cid:5)(cid:5)(cid:9)(cid:8)(cid:2) Hoshi and Patrick (cid:3)(cid:13)(cid:14)(cid:14)(cid:14)(cid:8)(cid:2) and references
therein for further discussion on the Japanese banking system(cid:1)
(cid:20)
(cid:6)
tions(cid:7) is employed(cid:2) With this model(cid:7) we derive incentive(cid:1)compatibility constraints
for a bank to make loans(cid:2) This section also examines how exogenous shocks a(cid:8)ect
these constraints and thereby bank lending(cid:2) Section (cid:20) introduces the essence of the
risk(cid:1)based capital standards of the BIS into the model(cid:7) and shows how(cid:7) in addition
to the incentive compatibility constraints(cid:7) a capital adequacy constraint must also
be satis(cid:9)ed(cid:2) Section (cid:12) concludes by comparing the implications derived from the
model with the results of empirical works(cid:2)
(cid:2) Summary of Risk(cid:3)Based Capital Standards
Regulators have imposed high capital standards on banks in an attempt to protect
depositors against bank failures(cid:2) Prior to the Basle Accord(cid:7) however(cid:7) bank capital
standards were stricter in some countries (cid:5)e(cid:2)g(cid:2) the U(cid:2)S(cid:2)(cid:6) than in other countries
(cid:5)e(cid:2)g(cid:2) Japan(cid:6)(cid:2) As international banking activities increased due to the globalisation
of (cid:9)nance(cid:7) the regulatory discrepancy became a source of competitive inequality
among internationalbanks(cid:2) Foreign banks(cid:7) Japanese banks inparticular(cid:7) are argued
to have increased their shares in the holdings of U(cid:2)S(cid:2) (cid:9)nancial assets by taking
advantage of lax capital regulations applied to them(cid:2) While the U(cid:2)S(cid:2) regulators
of banks were eager to tighten capital requirements in response to the S(cid:21)L crisis(cid:7)
implementation of stricter capital standards was believed to put the U(cid:2)S(cid:2) banks at
(cid:6)
More speci(cid:10)cally(cid:2) this paper analyses the impact of the risk(cid:18)based capital standards on the
creditchannelwithinaframeworkofthecostly(cid:18)state(cid:18)veri(cid:10)cationmodelsimpli(cid:10)edbyRomer(cid:3)(cid:4)(cid:5)(cid:5)(cid:19)(cid:8)(cid:1)
(cid:12)
a greater disadvantage in competition with the foreign banks(cid:2) This dilemmaled the
U(cid:2)S(cid:2) regulators to forging the consensus among the bank supervisors of developed
countries that international convergence of bank capital regulations is required(cid:2) In
(cid:10)(cid:11)(cid:13)(cid:19)(cid:7) theBasleCommitteeoftheBankforInternationalSettlements(cid:5)BIS(cid:6)published
guidelines for harmonizing the capital adequacy requirements in the international
banking market(cid:2) Following the guideline(cid:7) the bank supervisors of the Group of (cid:10)(cid:14)
countries and Luxembourg arrived at the agreement(cid:7) which is the Basle Accord(cid:7)
that all international banks should be subject to the same minimum level of the
(cid:7)
capital(cid:1)to(cid:1)asset ratios(cid:2)
As the adequate level of capital for an individual bank depends on the riski(cid:1)
ness of its portfolio(cid:7) the capital standards under the Basle Accord is risk(cid:1)adjusted(cid:2)
Banks(cid:15) assets are classi(cid:9)ed and assigned weights (cid:5)(cid:14)(cid:7) (cid:10)(cid:14)(cid:7) (cid:16)(cid:14)(cid:7) (cid:12)(cid:14)(cid:7) and (cid:10)(cid:14)(cid:14) percent(cid:6)
depending on their risks(cid:2) As summarised in Table (cid:10)(cid:7) a heavier weight is assigned to
a riskier asset(cid:2) For instance(cid:7) holdings of government bonds and commercial loans
to the non(cid:1)bank private sector are included in (cid:14)(cid:22) risk category and (cid:10)(cid:14)(cid:14)(cid:22) risk cat(cid:1)
egory(cid:7) respectively(cid:2) Due to the risk weights(cid:7) a portfolio shift can clearly a(cid:8)ect the
denominator even when the total value of assets is held constant(cid:2) Thus(cid:7) a bank may
have an incentive to substitute from risky assets to safe assets(cid:7) at least temporarily(cid:7)
if it needs to meet the risk(cid:1)based capital standards(cid:2)
In the calculation of the numerator of the capital(cid:1)to(cid:1)asset ratio(cid:7) two types of
capitalarede(cid:9)ned(cid:7) namelyTier(cid:10) (cid:5)Core(cid:6)and Tier(cid:16) (cid:5)Supplementary(cid:6)capital(cid:2) Under
(cid:7)
See Kapstein (cid:3)(cid:4)(cid:5)(cid:6)(cid:5)(cid:8) for a more detailed history of forgingthe Basle Accord(cid:1)
(cid:23)
Table (cid:10)(cid:24) Major Items of Risk(cid:1)Based Assets
(cid:14)(cid:22) risk category
(cid:1) Cash
(cid:1) Claims fully guaranteed by OECD governments
(cid:1) Fixed interest securities issued by OECD governments with a residual
maturity of up to (cid:10) year
(cid:16)(cid:14)(cid:22) risk category
(cid:1) Claims on multilateral development banks(cid:7) and claims fully guaranteed by
these institutions
(cid:12)(cid:14)(cid:22) risk category
(cid:1) Loans fully secured by mortgage on residential property
(cid:10)(cid:14)(cid:14)(cid:22) risk category
(cid:1) Claims on the non(cid:1)bank private sector
Source(cid:24) Maximilian J(cid:2) B(cid:2) Hall (cid:5)(cid:10)(cid:11)(cid:11)(cid:18)(cid:6)
the Basle Accord(cid:7) an international bank is required to meet a capital standard(cid:24)
Tier (cid:10) (cid:25) Tier (cid:16) (cid:2) Deductible components
(cid:3) (cid:14)(cid:1)(cid:14)(cid:13)(cid:1) (cid:5)(cid:10)(cid:6)
wiAi
P
whereAi and wi denote the value of the bank(cid:15)s ith asset and its weight(cid:7)respectively(cid:2)
Tier (cid:10) capital is common to all the signatory countries(cid:7) which essentially consists of
stockholders(cid:15) equity(cid:2) On the other hand(cid:7) allowable components of Tier (cid:16) capital are
dependent on banking structures of individual countries (cid:5)see Table (cid:16)(cid:6)(cid:2) In contrast
to the U(cid:2)S(cid:2) and U(cid:2)K(cid:2) banks(cid:7) Japanese and West(cid:1)German banks were allowed to
hold corporate equities under the national regulations(cid:2) Major Japanese banks(cid:7) for
instance(cid:7) commonly held equities of their regular borrowers as part of long(cid:1)term
relationships(cid:7) and these stocks were not traded for capital gains(cid:2) Due to the steady
(cid:19)
riseofstock pricesduringthe post(cid:1)war period inJapan(cid:7) latentcapitalgains fromthe
long(cid:1)term holdings of stocks were substantial as of the late (cid:10)(cid:11)(cid:13)(cid:14)s(cid:2) The regulators of
GermanyandJapan successfullynegotiatedwiththoseofU(cid:2)K(cid:2)and U(cid:2)S(cid:2)forinclusion
of latent capital gains from stock holdings in bank capital(cid:2) The Basle framework
allows banks to count (cid:20)(cid:12)(cid:22) of latent capital gains from holdings of corporate equities
(cid:8)
toward Tier (cid:16) capital(cid:2)
Equation (cid:5)(cid:10)(cid:6) shows that the capital(cid:1)to(cid:1)asset ratio for a Japanese bank is vulner(cid:1)
able to a change in stock prices(cid:2) Suppose that stock prices sharply fall(cid:2) The fall of
stock prices will reduce Tier (cid:16) capital of the numerator without a(cid:8)ecting any other
component(cid:2) At the same time(cid:7) it will be di(cid:26)cult for a bank to issue new equities(cid:2)
The upshot will be contraction of bank loans(cid:7) as Japanese banks will have to curtail
risky assets (cid:5)i(cid:2)e(cid:2)(cid:7) commercial and industrial loans(cid:6) with positive weights in the cal(cid:1)
culation of the risk(cid:1)weighted capital(cid:1)to(cid:1)asset ratio in an attempt to meetthe capital
standards of the BIS(cid:2)In other words(cid:7) any exogenous shock that can negativelya(cid:8)ect
stock prices may have impacts on the real economy of Japan by shifting the supply
schedule of bank loans inward(cid:2) In this way(cid:7) the capital regulations of the BIS may
(cid:8)
Wagster (cid:3)(cid:4)(cid:5)(cid:5)(cid:19)(cid:8)estimatesthe risk(cid:18)weighted capital(cid:18)to(cid:18)assetratios for(cid:4)(cid:14)Japanese banks(cid:2)(cid:10)nd(cid:18)
ing that the ratios with and without latent capital gains were(cid:2) on average(cid:2) (cid:4)(cid:13)(cid:1)(cid:16)(cid:17)(cid:20) and (cid:13)(cid:1)(cid:4)(cid:4)(cid:20) as
of (cid:4)(cid:5)(cid:6)(cid:7)(cid:2) respectively(cid:1) As such(cid:2) it was crucial for Japanese banks and their regulators to obtain a
permission(cid:2)fromregulators of the other countries(cid:2) to include latent capital gains fromstock hold(cid:18)
ings into capital(cid:1) See Kapstein (cid:3)(cid:4)(cid:5)(cid:6)(cid:5)(cid:8) for the negotiation between the signatory countries on the
de(cid:10)nitionofbankcapital(cid:1) SeealsoMaximilianHall(cid:3)(cid:4)(cid:5)(cid:5)(cid:16)(cid:8)forcross(cid:18)country di(cid:21)erence inallowable
components of Tier (cid:13) capital(cid:1)
(cid:13)
Table (cid:16)(cid:24) Allowable Components of Capital for Banks of U(cid:2)S(cid:2)(cid:7) U(cid:2)K(cid:2)(cid:7) and Japan
Type of Capital Countires
Tier (cid:10) Capital
(cid:10)(cid:2) Common shareholders(cid:15) equity All
(cid:16)(cid:2) Disclosed reserves All
(cid:18)(cid:2) Some form of preferred stock U(cid:2)S(cid:2)
Tier (cid:16) Capital
(cid:10)(cid:2) Undisclosed reserves that have been charged against income Japan
(cid:16)(cid:2) Revaluation Reserves
(cid:1) Formal revaluation carried to the balance sheet U(cid:2)K(cid:2)
(cid:1) Market values of securities not already re(cid:17)ected on the Japan
balance sheet (cid:5)(cid:20)(cid:12) percent(cid:6)
(cid:18)(cid:2) Hybrid debt(cid:1)capital instruments(cid:24)
(cid:1) perpetual debt U(cid:2)K(cid:2)
(cid:1) mandatory convertible debt U(cid:2)S(cid:2)
Source(cid:24) Wagster (cid:5)(cid:10)(cid:11)(cid:11)(cid:23)(cid:6)
strengthen the creditchannel(cid:2) The following twosections aimto formalisethecredit
channel for Japan in the presence of the risk(cid:1)based capital standards(cid:2) Section (cid:18) sets
up a benchmark model of the credit channel without the BIS(cid:15)s capital standards(cid:2)
From the model(cid:7) two incentive compatibility constraints are derived(cid:7) under which
(cid:5)(cid:10)(cid:6) a (cid:9)rm borrows from a bank(cid:7) and (cid:5)(cid:16)(cid:6) a bank makes loans to a (cid:9)rm(cid:2) The sec(cid:1)
tionexamineshow exogenous shocks a(cid:8)ect theseincentive(cid:1)compatibilityconstraints(cid:2)
Section (cid:20) expands the model by introducing the risk(cid:1)based capital standards(cid:2) The
objective is to examine how the capital standards a(cid:8)ect the credit channel(cid:2)
(cid:11)