Does Macropru Leak? Evidence from a UK Policy Experiment

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday September 13, 2012 at 10:34 am
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Editor’s Note: The following post comes to us from Shekhar Aiyar, Senior Economist at the International Monetary Fund; Charles Calomiris, Henry Kaufman Professor of Financial Institutions at the Columbia University Graduate School of Business; and Tomasz Wieladek, MPC Adviser, External MPC Unit, Bank of England.

How can governments limit excessive and unstable credit growth? Should they raise capital requirements for banks? In our recent NBER working paper, Does Macropru Leak? Evidence from a UK Policy Experiment, we address these questions using evidence from a policy experiment in the UK. The minimum capital ratio requirements that national regulatory authorities impose on banks have two sets of objectives: (i) so-called ‘micro-prudential’ motives, to ensure the safety and soundness of individual banks; and (ii) ‘macro-prudential’ goals, especially to influence the aggregate supply of credit. Micro-prudential regulation has a long pedigree, but the focus on macro-prudential regulation has increased sharply in the wake of the global financial crisis. This sharpened focus underlies recent changes in the international regulatory regime for banks. Basel III, as the new regime is called, establishes a “countercyclical capital buffer”, under which national regulators would vary banks’ required capital-to-risk-weighted assets ratio over time, thereby helping smooth the credit cycle. For variation in minimum capital requirements to be effective in regulating the aggregate supply of credit, three conditions must be satisfied:

  • Capital must be a relatively costly form of financing compared to debt (implying a violation of the Miller-Modigliani neutrality proposition).
  • Capital requirements must be high enough to induce banks to rely more on capital than they would absent the requirements (that is, the requirements must bind).
  • Substitute sources of credit — or ”leakages” — from lenders that are not under the control of the macro-prudential regulator must be unable to offset fully any changes in credit supply by the groups of banks under the control of the macro-prudential regulatory authority.

Despite the centrality of these propositions to the macro-prudential enterprise, supporting empirical evidence is scant. We attempt to gather such evidence in a recent paper (Aiyar et al. 2012). We examine the experience of banks in the UK, which provides an ideal testing ground for these propositions for two reasons:

  • First, under the UK’s policy regime in the 1990s and early 2000s, the Financial Services Authority (FSA) set time-varying minimum capital requirements — so-called trigger ratios — at the level of individual banks. Variation across banks and over time in minimum capital ratio requirements was substantial, and this permits us to investigate the extent to which capital requirement changes affected the lending supply of regulated banks.
  • Second, these varying trigger ratios were set for all banks under the FSA’s jurisdiction — i.e. for all UK-owned banks and all subsidiaries of foreign banks operating in the UK — but there were also other banks operating in the UK (branches of foreign-based banks) that were not subject to UK capital regulation. Foreign branches were typically subject to the international standard minimum requirement of 8% of risk-weighted assets, while UK-based banks and foreign subsidiaries operating in the UK were subject to requirements in excess of that 8% minimum. The minimum capital ratio requirements in excess of 8% were intended to fill gaps in the early Basel I regime. Specifically, the higher ratios were an attempt to take into account operational risk and interest rate risk differences across banks.

Foreign branches, therefore, were a potential source of ”leakages,” in the sense that foreign branches could offset through changes in their supply of loans any variation in the supply of loans from regulated banks that was induced by changes in minimum capital ratio requirements. The empirical questions examined in our study divide into two parts. First, we examine whether changes in capital ratio requirements affected the supply of lending by banks subject to those requirements. Second, we examine whether the lending behavior of foreign branches offset the variation in total loan supply by UK-regulated banks.

Our study uses quarterly data on minimum capital requirements for all FSA-regulated banks and foreign branches operating in the UK between 1998 and 2007. Over that period, the variation in minimum capital requirements as a percentage of risk-weighted assets for UK-regulated banks ranged from a minimum of 8% to a maximum of 23%. Although the FSA’s mandate during our sample period was explicitly micro-prudential, the aggregate outcome of its bank-by-bank decisions was in fact countercyclical, just as one might expect in a future macro-prudential regime (that is, capital ratios rose during rapid growth phases of the business cycle, and fell during slower-growth phases).In the first part of our study, changes in bank lending to the real economy by UK-regulated banks are regressed on several lags of changes in the trigger ratio (i.e. the minimum required ratio of capital-to-risk-weighted assets). Control variables include GDP growth, inflation, and a number of bank-specific balance sheet characteristics. Several different strategies are employed to control for demand shocks, and to ensure that the effects of capital requirement changes are not capturing other sources of variation in loan supply, such as changes in non-performing loans. We find a large, statistically significant, and robust impact of changes in minimum capital requirements on bank lending. A rise in the trigger ratio of 100 basis points is estimated to induce a cumulative reduction in the growth rate of bank lending of between 6.5% and 7.5%.

Next, we investigate the leakage associated with foreign branch lending. We find that when capital requirements are tightened on FSA-regulated banks, this confers a relative cost advantage on the foreign branches operating in the UK, which raise their lending supply in response to the contraction of lending by competing, UK-regulated banks. The change in lending by foreign branches is regressed on several lags of the change in lending by a “reference group” of regulated banks. For each foreign branch, the reference group of regulated banks comprises banks that specialize in lending to the same sectors of the economy as the branch; thus the reference group captures the relevant set of competitor banks. A technique called instrumental variables is used to ensure that the changes in lending examined are restricted to those caused by changes in regulatory capital requirements. We find that foreign branches, on average,increase lending supply by about 3% in response to a 1% decline in lending by their reference group of regulated banks.

The high coefficient on branches’ responses to changes in UK-regulated banks’ lending reflects the smaller aggregate size of lending by foreign branches. Accounting for that difference implies an estimated leakage effect of about 30%. That is, for any given change in minimum capital requirements across the regulated banking system, leakages through foreign branches reduce the aggregate credit supply response of the banking system by almost one-third. The fact that the offset is only partial implies that, on balance, changes in capital requirements can have a substantial impact on aggregate credit supply by UK-resident banks. Of course, foreign branches are only one potential source of leakage (others include capital markets and cross-border lending), but it is likely to be the most important one.

Our study has important implications for macro-prudential capital regulation.

  • First, we find that increases in capital requirements have large effects on bank lending supply. This implies that — at least in the UK over our sample period — capital was a relatively costly source of finance, and minimum capital ratio requirements were binding constraints.
  • We also find that foreign banks respond to regulation-induced changes in regulated banks’ lending by partially offsetting the changes in regulated banks’ lending supply.

These results confirm that coordination of macro-prudential regulation across regulators — for example, to ensure that all banks operating in the UK are subject to similar variation in their minimum capital ratios — would increase the effectiveness of such measures in regulating aggregate credit supply.

The full paper is available for download here.

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