The Procyclical Effects of Bank Capital Regulation

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday January 14, 2013 at 8:58 am
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Editor’s Note: The following post comes to us from Rafael Repullo, Professor of Economics at CEMFI, Madrid, Spain; and Javier Suarez, Professor of Finance at CEMFI, Madrid, Spain.

The basic argument about the procyclical effects of bank capital requirements is well-known. In recessions, losses erode banks’ capital, while risk-based capital requirements, such as those in Basel II, become higher. If banks cannot quickly raise sufficient new capital, their lending capacity falls and a credit crunch may follow. Yet, correcting the potential contractionary effect on credit supply by relaxing capital requirements in bad times may increase bank failure probabilities precisely when, because of high loan defaults, they are largest. Given the conflicting goals at stake, some observers think that procyclicality is a necessary evil, whereas others think that procyclicality should be explicitly corrected. Basel III is a compromise between these two views. It reinforces the quality and quantity of the minimum capital required to banks, but also establishes that part of the increased requirements be in terms of mandatory buffers—a capital preservation buffer and a countercyclical buffer—that are intended to be built up in good times and released in bad times.

In our paper, The Procyclical Effects of Bank Capital Regulation, forthcoming in the Review of Financial Studies, we develop a model that captures the key trade-offs in the debate. The model is constructed to highlight the primary microprudential role of capital requirements (containing banks’ risk of failure and, thus, deposit insurance payouts and other social costs due to bank failures) as well as their potential procyclical effect on the supply of bank credit.

Bank borrowers in the model are overlapping generations of entrepreneurs who demand loans for two consecutive periods. Consistent with the view that relationship banking makes banks privately informed about their borrowers, we assume that borrowers become dependent on the banks with whom they first start a lending relationship, and banks with ongoing relationships have no access to the equity market. These assumptions capture the lock-in effects caused by the potential lemons problem faced by banks when a borrower switches from another bank and the implications of these informational asymmetries for the market for seasoned equity offerings. Furthermore, they provide a microfoundation for the connection between the capital shortages experienced by some banks and the credit rationing of some potential borrowers.

Differently from many papers in the literature, the model allows banks in their first lending period to raise more capital than needed to just satisfy the capital requirement. This addresses the concerns about the limitations of analyses based on static models that predict that capital requirements are always binding and, in particular, about the fact that voluntary capital buffers might partly mitigate the procyclical effects of capital requirements.

For simplicity, the model formalizes the market for loans to newly born entrepreneurs as perfectly competitive and free from capital constraints. Also, it captures the business cycle as a Markov process with two states, expansion and recession, which affect the probability of default of all loans (lower in expansions than in recessions). The model is calibrated with U.S. data for the period prior to the financial crisis that started in 2007, and is used to compare a laissez-faire regime with no capital requirements, Basel I, Basel II, and the regime in which capital requirements maximize a social welfare function that incorporates a social cost of bank failure.

One key finding of the paper is that the equilibrium buffers, in spite of being quite sizeable (of up to 3.8% in the expansion state under Basel II), are not sufficient to neutralize the effects of the arrival of a recession on the supply of credit to bank-dependent borrowers (which falls by 12.6% on average in the baseline Basel II scenario). Moreover, despite Basel II inducing banks to hold larger buffers during expansions (in order to prepare for the rise in capital requirements when entering a recession), the cyclical swings in the supply of credit (in the form of credit rationing suffered by the borrowers dependent on capital constrained banks) are more pronounced under the risk-based requirements of Basel II than under the flat requirement of Basel I.

However, bank failure probabilities are also related to the state of the business cycle and risk-based requirements, such as those of Basel II are more effective in bringing them down during recessions, when they are larger. This means that the welfare comparison between the two Basel regimes, as well as the design of socially optimal capital requirements, involves nontrivial trade-offs. In fact, the paper shows that Basel II dominates Basel I in welfare terms, except for very low values of the social cost of bank failure. It also shows that the optimal capital requirements are lower and more cyclically varying than the requirements of Basel II if the social cost of bank failure is low, and they are higher and less cyclically varying if it is large.

Conditional on assessing that the social cost of bank failure is large (as the recent crisis appears to confirm), Basel III may be considered a move in the right direction: The new capital conservation and countercyclical buffers would assume the role of making the effective capital requirements faced by banks less sensitive to the cycle (in particular, less prone to produce credit rationing at the arrival of recessions) than the Basel II requirements.

Our analysis also uncovers the limits of the one-size-fits-all principle. Economies with larger social costs of bank failure (e.g., with a banking sector whose size implies a larger systemic threat) should face larger but less cyclically varying capital requirements than economies at the other side of the spectrum.

The full paper is available for download here.

 

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