PrefBlog

Assiduous Readers will remember that I have long complained about the dearth of research on the ill-effects of Canada’s bank capitalization requirements. Various OSFI puff-pieces (e.g., a speech by Mark White; an essay by Carol Ann Northcott & Graydon Paulin of the Bank of Canada and Mark White; a speech by Jule Dickson later clarified for the sub-moronic) have given unreserved praise to the high capitalization required by OSFI. I have long wondered what the through-the-cycle costs of having all this excess (by world standards) capital tied up in banks might be – ain’t NUTHIN’ free! The high levels of bank capitalization certainly helped through the crisis (although not, probably, as much as secure retail funding) but what did that cost us and is it worth that cost?

I don’t know the answer – I’m just annoyed that Canadians are not asking the question.

Into the breach steps the UK Financial Stability Authority, which has just published a paper by their staff members William Francis and Matthew Osborne titled Bank regulation, capital and credit supply: Measuring the impact of Prudential Standards:

The existence of a “bank capital channel”, where shocks to a bank’s capital affect the level and composition of its assets, implies that changes in bank capital regulation have implications for macroeconomic outcomes, since profit-maximising banks may respond by altering credit supply or making other changes to their asset mix. The existence of such a channel requires (i) that banks do not have excess capital with which to insulate credit supply from regulatory changes, (ii) raising capital is costly for banks, and (iii) firms and consumers in the economy are to some extent dependent on banks for credit. This study investigates evidence on the existence of a bank capital channel in the UK lending market. We estimate a long-run internal target risk-weighted capital ratio for each bank in the UK which is found to be a function of the capital requirements set for individual banks by the FSA and the Bank of England as the previous supervisor (Although within the FSA’s regulatory capital framework the FSA’s view of the capital that an individual bank should hold is given to the firm through individual capital guidance, for reasons of simplicity/consistency this paper refers throughout to “capital requirements”). We further find that in the period 1996-2007, banks with surpluses (deficits) of capital relative to this target tend to have higher (lower) growth in credit and other on- and off-balance sheet asset measures, and lower (higher) growth in regulatory capital and tier 1 capital. These findings have important implications for the assessment of changes to the design and calibration of capital requirements, since while tighter standards may produce significant benefits such as greater financial stability and a lower probability of crisis events, our results suggest that they may also have costs in terms of reduced loan supply. We find that a single percentage point increase in 2002 would have reduced lending by 1.2% and total risk weighted assets by 2.4% after four years. We also simulate the impact of a countercyclical capital requirement imposing three one-point rises in capital requirements in 1997, 2001 and 2003. By the end of 2007, these might have reduced the stock of lending by 5.2% and total risk-weighted assets by 10.2%.

Unfortunately for the direct translation of this paper’s conclusions to the Canadian experience, the paper focusses on shocks to bank capital requirements, which may be different from the steady-state effects of a constantly high requirement. For all that, however, the reasoning seems applicable in general terms:

Moreover, a large body of theoretical and empirical literature suggests that, contrary to the predictions of the Modigliani-Miller theorems (Modigliani and Miller (1958)), maintaining a higher capital ratio is costly for a bank and, consequently, a shortfall relative to the desired capital ratio may result in a downward shift in loan supply (Van den Heuvel (2004); Gambacorta and Mistrulli (2004)).
…
A secondary aim of our paper is to use evidence of systematic association between changes in banks’ balance sheets and banks’ surplus or deficit relative to desired capital levels during economic upturns to develop measures that may assist policymakers in calibrating capital requirements, including proposals for counter-cyclical capital requirements, which are explicitly designed to address the build-up of risk during a credit boom.

Not surprisingly, there is an effect:

Our results show that regulatory capital requirements are positively associated with banks’ targeted capital ratios. We further show that the gap between actual and targeted capital ratios is positively associated with banks’ loan supply (suggesting that loan supply falls as actual capital falls below targeted levels), suggesting that banks amend their supply schedule (for example by raising the cost of borrowing or rationing credit supply at a given price) or take action to raise capital levels (for example, restricting dividends in order to retain profits or raising new equity or debt capital). Taken together, these results indicate that capital requirements affect credit supply, confirming the linkage found by previous researchers and demonstrating a ‘credit view’ channel through which prudential regulation affects economic output. We also find significant and positive relationships with growth in the size of banks’ balance sheets and total risk-weighted assets, and significant and negative relationships with growth in capital.

The effect of increasing regulatory requirements on Italian banks has been examined:

One notable study that addresses the problem of a lack of heterogeneity of capital requirements and assesses the impact on bank lending is Gambacorta and Mistrulli (2004). The authors explicitly examine the effects of the introduction of capital requirements higher than the Basel 8% solvency standard on lending volumes of Italian banks. They find that the imposition of higher requirements reduced lending by around 20% after two years. The results are consistent with the idea that, in the face of rising capital requirements, banks may find it less costly to adjust loans than capital as the risk-based capital requirement becomes increasingly more binding. Frictions in the market for bank capital make adjusting (raising) capital in response to higher regulatory requirements, in this case, expensive, so the result of the trade-off may be a reduction in lending. This result is consistent with the idea of a ‘bank capital channel’.

As noted, the paper’s emphasis is on the effect of shocks, not upon the constant effects of higher capital requirements, and the author’s conclusions reflect this bias:

Our simple theoretical model clarifies the link between capital requirements and lending and shows how, in the presence of capital adjustment costs, the “bank capital channel” implies that higher capital requirements lower a bank’s optimal loan growth. That effect, however, depends on the level of excess capitalization, with better capitalized banks (i.e., those with more capital above regulatory thresholds) experiencing less pronounced impacts on their lending. These predictions depend on departures from the Modigliani-Miller propositions and, in particular, increasing marginal costs of capital adjustment.

A full examination of the Canadian experience would include an accounting for the effects on loans of steady-state capital ratios and – perhaps equally importantly – some accounting of the crowding-out effects on risk-capital of other firms of requiring so much equity in banks. Don’t look for any pearls of wisdom from OSFI, though; perhaps the Bank of Canada might do it.

The Bank of England has announced the release of the 2009 Q3 issue of the Bank of England Quarterly Bulletin with the usual top-notch research. This quarter’s articles are:

• Foreword
• Markets and operations
• Global imbalances and the financial crisis
• Household saving
• Interpreting recent movements in sterling
• What can be said about the rise and fall in oil prices?
• Bank of England Systemic Risk Survey
• Monetary Policy Roundtable

The article on Global imbalances seeks to challenge Taylor’s assertion that there was no global saving glut by focussing on gross, not net numbers:

An important factor was the adoption of managed exchange rate policies by some EAEs [East Asian Economies],(2) whereby a particular level of their currency was targeted, usually against the US dollar. This policy was prompted, in part, by the aim of spurring economic development through exports, thereby addressing extensive rural underemployment.(3)(4) The desire to accumulate foreign exchange reserves as insurance against a repeat of the 1997–98 Asian currency crises was an additional motivation.(5) Another factor may have been the slow pace of financial development in many EAEs which meant that there was a dearth of domestic investment opportunities (see Caballero et al (2008)). This may have necessitated savings being channelled to the deeper and more liquid financial markets in western economies.
…
Bernanke (2005) has argued that the low and falling savings rates in deficit countries which accompanied the credit boom, were principally the outcome of an endogenous process by which the excess savings of the surplus countries — the ‘global
savings glut’ — were recycled.

Meanwhile, banks were exposing themselves to liquidity risk:

An associated innovation was that banks changed their funding models. In particular, banks sold the new types of securities to
end-investors via the so-called ‘shadow banking system’, encompassing structured investment vehicles (SIVs) and conduits, which provided a framework for lending and borrowing without accepting deposits. This was termed the ‘originate to distribute’ model: aiming to spread the risks associated with securitised assets off their balance sheets, banks sold them to SIVs, which then aimed to sell them on to end-investors.(1) At the same time, banks increasingly relied on wholesale funding markets, including in selling the securitised assets, see the October 2008 Financial Stability Report. The magenta bars in Chart 8 show that the share of funding by UK banks derived from securitisations increased between 2000 and 2008.(2)

The authors repeatedly emphasize this point:

The funding structure of financial institutions, with its reliance on wholesale markets and the use of securitised assets (Chart 8), was a related vulnerability. In particular, this funding model relied on the continued functioning of those markets. This funding often came from foreign investors and this, together with banks’ increased lending overseas and the growth of the shadow banking system, generated the further vulnerability of increased and complex cross-border linkages between both financial institutions and between countries more generally. Such complex international linkages potentially give rise to unappreciated, but potent, interconnections between firms in the global financial system.

The article on oil prices makes a claim of regulatory significance:

The price of oil rose steadily between the middle of 2003 and the end of 2007, rose further and more rapidly until mid-2008 and fell sharply until the end of that year. Commentators agree that a significant part of the increase in the oil price over that period was due to rapid demand growth from emerging markets, but there are substantial differences of view about the relative importance of other factors, and limited work thus far in explaining the large fall in oil prices in the second half of 2008. The purpose of this article is to analyse the main explanations for the rise and fall in oil prices in the five years until the end of 2008. It argues that shocks to oil demand and supply, coupled with the institutional factors of the oil market, are qualitatively consistent with the direction of price movements, although the magnitude of the rise and subsequent fall during 2008 is more difficult to justify. The available empirical evidence suggests that financial flows into oil markets have not been an important factor over the period as a whole. Nonetheless, one cannot rule out the possibility that some part of the sharp rise and fall in the oil price in 2008 might have had some of the characteristics of an asset price bubble.