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Bank Capital Regulation and Credit Supply
Bank Capital Regulation and Credit Supply
a r t i c l e
i n f o
Article history:
Received 8 July 2008
Accepted 16 August 2010
Available online 20 August 2010
JEL classication:
G21
E44
a b s t r a c t
Banks can meet the need to increase their capital ratio either by issuing new equity or by reducing loans.
It is generally known that banks prefer to reduce assets due to the high cost of equity. With a simple
banking model we show that, if incumbent shareholders are to benet, banks may prefer to reduce loans,
even though they can recapitalize by issuing new equity without any cost. The result holds when banks
hold relatively small amounts of long-term loans, or when the economy is in downturn.
2010 Elsevier B.V. All rights reserved.
Keywords:
Capital adequacy ratio
Credit supply
Recapitalization
1. Introduction
Capital-based regulation has become a major issue in the banking industry after subprime mortgage problems led to the American nancial crisis of 2007. Losses on mortgages and other
mortgage-related securities dramatically reduced the capital base
of many banks. To maintain the minimum capital adequacy ratio,
capital-constrained banks began collecting outstanding loans or
became reluctant to approve new lending. This effort by banks to
raise the capital ratio by loan contraction is alleged to have contributed to the worldwide nancial crisis.
Capital-constrained banks can recover the capital ratio either by
reducing assets or by increasing equity capital. It has been shown,
theoretically and empirically, that banks reduce lending more often than they recapitalize. In a survey of the impact of the Basel Accord, Jackson et al. (1999) argue that banks are likely to cut back
lending when either economic conditions are poor or raising new
capital is costly. Because the bank capital constraint is more likely
to be binding during economic downturns, recapitalization would
not be easy and the bank may meet the capital ratio by reducing
lending. When capital regulation was newly introduced in late
1980s, many American banks reduced their credit supply to meet
the capital requirement. For this reason, Bernanke and Lown
q
This research was partially supported by the Development Fund of the College
of Business Administration, Pukyong National University.
Corresponding author. Tel.: +82 51 629 5760; fax: +82 51 629 5754.
E-mail addresses: jshyun@business.kaist.ac.kr (J.-S. Hyun), bkrhee@pknu.ac.kr
(B.-K. Rhee).
0378-4266/$ - see front matter 2010 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankn.2010.08.018
(1991) and Peek and Rosengren (1995) refer to the credit crunch
that occurred in New England in the early 1990s as a capital
crunch. According to King (2001) and Brana and Lahet (2006),
when Japanese international banks were under capital constraint
in the mid-1990s, they withdrew from East Asian countries, contributing to the outbreak of the Asian nancial crisis in 1997.
Theoretical discussions regarding the preference of banks to reduce loans are focused on the cost related to the issuing of new
capital. Issuing new equity requires a great deal of preparatory
work and is associated with various costs in terms of time and effort. In this sense, Peura and Keppo (2006) assume a time delay on
implementation as well as costs of a xed proportion to the size of
the capital issuance. As suggested in Myers and Majluf (1984),
asymmetric information and information dilution are the costs of
raising equity capital. The signaling effect is another cost that managers may want to avoid. Therefore, the pecking order theory suggests that equity is usually the last method to be used to raise
funds.
This paper is an attempt to suggest another motivation to explain why banks prefer to cut lending rather than recapitalize in
order to raise capital ratios. One effect of recapitalization is the
dilution of controlling rights. In a commentary on the global nancial crisis, Onado (2008) argues that the reluctance of banks to
recapitalize is due not only to the cost of the operation but also
to the fact that it could signicantly dilute existing shareholder value. This dilution effect is not often discussed in banking area, especially in relation to capital regulation. This paper tries to
theoretically analyze the effect of the dilution on a banks decisions
about how to meet its capital requirement.
324
J.-S. Hyun, B.-K. Rhee / Journal of Banking & Finance 35 (2011) 323330
that the behavior of large investors who pursue their own interests
may not be compatible with the interest of small shareholders. Controlling shareholders non-dilution motives for debt nancing as
mentioned in Du and Dai (2005) is also evidence of decision making
in favor of existing equity holders.
In this context, it is assumed that a banks managerial decisions are made to maximize the wealth of incumbent shareholders. Under this assumption, issuing new equity to the public
means a linear loss of shares in proportion with an increase in
capital ratio. Meanwhile, loan reduction may yield less than a
proportionate decrease of shareholder prot if the bank cuts
the riskiest outstanding loans. A banks loan decisions are made
after considering various types of information about borrowing
rms. However, the central part of the selection procedure is to
assess the credit-worthiness of borrowers. Libby (1979) argues
that the main task of loan ofcers of commercial banks is to
judge the customers ability to pay their obligations. From interviews with bank executives, Nutt (1989) concludes that in loan
decision making, the repayment prospect is the single most
important factor. To be consistent with these ndings, we
assume that the bank cuts the lowest credit assets among those
with the same net present value (NPV) when it reduces the
loans.
In relation to capital regulation and loan contraction, banks
tend to cut relatively high-risk weighted assets when they need
to reduce loans to recover from a weakened capital position as
has been seen in some Asian countries. Using post-Basel period
data, Montgomery (2005) shows that relatively poorly capitalized
Japanese international banks cut back on relatively high-risk
weighted assets. With data from 11 developing countries, Hussain
and Hassan (2006) suggest that the portfolio risk of banks has
dropped during the ve years following the adoption of capital
requirement regulations.
Based on these assumptions, we show that capital-constrained
banks prefer loan reduction over the issuance of new equity.
However, the recapitalization is not uniformly dominated by loan
reduction. From a relationship banking point of view, banks have
multiple interactions with the same customer. Loan reduction
may trigger a subsequent default of outstanding loans, causing
a nonlinear effect on prot loss. This paper shows that banks prefer asset reduction to equity issuance when the new capital regulation is not a dramatic increase of capital adequacy ratio. This
result is meaningful because, in contrast with previous articles
dealing with the same issue, we do not impose any cost on issuing equity.
This paper is organized as follows. In Section 2, the model is
presented. In Section 3, resource allocation under capital regulation is discussed. Section 4 describes the effects of increased bank
capital ratio and Section 5 discusses the interactive effect of NPV
and credit risk of assets. Section 6 concludes with policy
implications.
2. Model
2.1. Agents
We consider a simple banking model with three periods dened
as 0, 1 and 2. A representative bank faces an innite number of
rms. As in Gorton and Winton (1995), there exists a continuum
of entrepreneurs/rms with total mass 1. Each entrepreneur/rm
can be matched with an element in [0, 1] [0, 1].
At t = 0, each entrepreneur builds a rm, which costs B0. He or
she borrows B0 from the bank as a long-term loan. The entrepreneur pays interest at the end of period 1, but pays both principal
and interest at t = 2. After the rms are developed, each entrepre-
J.-S. Hyun, B.-K. Rhee / Journal of Banking & Finance 35 (2011) 323330
yt x
325
market opens up so that the bank may sell new shares to the
public.
2.2. Optimal behavior
The behavior of rms is simple. To operate a rm, the entrepreneur applies to the bank for a short-term loan of B1 in each period.
If a rm fails to nance B1, it cannot commence production but
must instead wait for the next period. Those rms that borrow
B1 commence production, and their level of output is randomly
determined by the probability as in Eq. (1).
Firms with output level y can service their debt. Because it is assumed that the output level y is large enough to pay interest, those
rms realize a positive prot of y (rlB0 + (1 + rl)B1), which is then
consumed by entrepreneurs. Firms with zero output inform the
bank that they cannot pay interest. However, even though they
produced nothing in period 1, they retain the factory and wait
for the next period.
At the end of period 2, a rm pays the principal of its long-term
loan (B0). The scrap value of each rm is assumed to be B0. For this
reason, the bank does not need to establish a loan loss reserve for
long-term debt.
There may be some possibility of false reporting by a rm. Even
though the realized output of a rm is y, it may report to the bank
that its output was zero. The rm has an incentive to do so because,
due to the serial independence of the probability distribution, the
default in period 1 does not affect the banks lending decision in
period 2. Here, myopia for rms and the honest reporting of production are assumed.
The banks behavior is as follows: at t = 0, with 1 unit of deposit
and capital K, the bank faces total demand B0 for long-term loans.4
Because the bank does not, at this point, have any information about
the entrepreneurs seeking loans, the bank approves loans to all
rms.5 If the reserve requirement is q, the banks remaining resources (1 q + K B0) are invested in government bonds.
During the period 0, the bank collects information about each
entrepreneurs effort level (x), which is then used as a credit rating
for the respective rm. It is assumed that the bank knows the effort
level of each entrepreneur. Even after realization of the rst-period
output level, the bank applies the same credit rating to each rm
because, given the effort level, the output is determined by idiosyncratic shock.
At the beginning of period 1, the bank faces a demand for shortterm loans from all rms. The bank must therefore reallocate resources of 1 q + K B0 between government bonds and shortterm loans. In contrast to the long-term loan decision at t = 0, the
bank now has information regarding each rm, which is the credit
rating x. Expected prot from an additional short-term loan to a
rm with rating x is /(x)rl(B0 + B1) (1 /(x))B1, where /(x) is
the probability of positive output as in Eq. (1). Because the banker
is assumed to be risk-neutral, he or she will simply maximize the
expected prot by lending to all rms that give expected prots
higher than that of government bonds. That is, the bank will approve loans to all rms with credit rating greater than x1 such that
/x1 r l B0 B1 1 /x1 B1 r f B1 :
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J.-S. Hyun, B.-K. Rhee / Journal of Banking & Finance 35 (2011) 323330
rating is due to the assumption that the amount of the loan is uniform across rms. Later in Section 5, this assumption is relaxed to
analyze the effect of the positive relationship.
Because no operating costs for the bank are assumed, the deposit rate and the risk-free rate are equal. In addition, they can be assumed to be zero without a loss of generality, i.e., rd = rf = 0. For
notational simplicity, r is used to denote the lending rate, which
is the only nonzero interest rate. A reserve requirement rate (q)
is also assumed to be equal to zero.
Because there are rms equivalent to [0, 1] [0, 1], they can be
represented by a square, as shown in Fig. 1. The indices for the horizontal axis are also used to denote a rms credit rating. When the
bank approves the short-term loan to all rms whose credit ratings
are greater than x, rms that belong to area U and G will commence production. As can be seen from the gure, there is a continuum of rms with the same credit rating. By the law of large
numbers, the proportion of rms with positive output, ex post,
among the rms with credit rating x is equal to the probability
1 A + Ax. Therefore, those rms in area G realize positive output
whereas the remaining rms (U) have zero output.
The prot of the bank is
Z 1
rB0 B1 ds
B1 ds dz
x
0
1AAz
2 A1 x
A
rB0 B1 1 x2 B1 :
1 x
2
2
px
Z
1AAz
The rst term is the interest received from rms with output y,
and the second term is the loss from those with zero output. When
the prot is positive, it is consumed by the banker.6
i B0 0;
0
ii
k
Ab 1 x2 1 rb 1
B0
; where b :
<
k 2rb 1b Ab2 1 rb 1
B1
J.-S. Hyun, B.-K. Rhee / Journal of Banking & Finance 35 (2011) 323330
327
(ii) @Q
> 0,
@A
(iii) @Q
< 0,
@r
rA1r
(iv) if x < 12 < 2rA1r
; @Q
< 0 for b < b0 where b0 is dened in
@b
Appendix A.2, and it is a positive value greater than 1 x.
(i)
@Q
@x
< 0,
328
J.-S. Hyun, B.-K. Rhee / Journal of Banking & Finance 35 (2011) 323330
amounts of the loans are different, the NPVs of loans depend not
only on the credit rating but also on the amount of the loan. In this
way, we can include in the model both high NPV assets with low
credit ratings and low NPV assets with high credit ratings.
The model can be solved in a similar way except that the bank
has to decide the level of the lowest credit rating to approve the
loan for each loan level Bi1 , i = 1, 2, . . . , n. If we denote the lowest
credit.rating
by xi for any i i, the capital ratio is calculated by
h
P
1
k K B0 n ni1 1 xi Bi1 .
Because there are an innite number of rms for each credit rating and loan level, the law of large numbers is still applicable. Then
the bank prot becomes the sum of prot from each level of shortterm loan, and is written as,
n
1X
2 A1 xi
A
rB0 Bi1 1 xi 2 Bi1 :
1 xi
n i1
2
2
For the increase of minimum capital ratio, the bank has to cut loans
with low NPVs when they meet the new capital regulation by
decreasing the amount of assets. Among the loans given to rms
applying for the same amount, those given to low credit rms have
low NPVs, and they are the rst ones to be cut off. Therefore, results
similar to those derived in the previous section may hold for each
loan level. However, a disproportionate decrease of bank prot in
loan reduction case is not easily shown due to the existence of multiple levels of loans.
The comparison of prots from the two ways of increasing the
capital ratio cannot be done analytically. A numerical calibration
is used for this purpose. Normalizing the level of long-term loan
(B0) to unity, three different levels of short-term loans are assumed.
A third of the rms apply for 0.5 of working capital, another third of
rms apply for 1.0, and the nal third apply for 2.0. For interest rate
r, 0.04 is used. It is matched with the interest margin of the banks
because r is the lending rate when the deposit rate is 0. Parameter
A is not easily determined. It is regarded as a macroeconomic condition, governing the overall default probabilities of rms. When
A is 0.05, the ratio of non-performing loans (NPL) is around 2% for
x between 0.01 and 0.2. For the same range of x, the NPL ratio rises
to 2.53.5% as we increase the value of A to 0.06 and to 0.07. Three
different values (0.05, 0.06, 0.07) are used for parameter A. The level
of bank capital (K) is set to 0.17 so that the bank meets the initial
capital regulation (k = 0.08) when A is 0.06.
Fig. 3 shows the pattern of change in prots as the minimum
capital ratio increases. The numbers in the horizontal axis denote
the ratio of capital regulations, i.e., k0 /k in Eq. (4). We simulate
the result for k0 /k from 1.0 to 1.3. Solid lines represent the prots
earned when the bank meets the new regulation by issuing equity,
and the dotted lines represent those prots earned by loan reductions. Normalizing the amount of long-term loans to one, the bank
prot is around 5% of the loan. Because a larger A means a higher
p'(loan)
p'(equity)
0.055
A=0.05
0.050
0.045
0.040
A=0.06
A=0.07
0.035
0.030
0.025
1
1.05
1.1
1.15
1.2
329
J.-S. Hyun, B.-K. Rhee / Journal of Banking & Finance 35 (2011) 323330
@Q
3
2Ab 1 xfr2 A1 x 1b r1 xr 2
@b
2
2Ar 2Ab 2r1 x r r2 1 x
A1 x2r 2 2r 1 b r1 r1 xg
2Ab 1 xgb
3
where x0 is the lowest level of credit among those rms able to nance their working capital when the bank reduces the amount of
loans. The rst term is the capital ratio when the bank issues new
equity and the last the ratio when the bank reduces the amount
of loans. The share of the incumbent shareholders becomes K/
(K + d) when the bank issues new equity. If the condition
k K=B0 1 xB1 is applied, it becomes
0
K
k b1x
;
K d k0 b 1 x
where b is the ratio of long-term debt (B0) to short-term debt (B1).
The prot of the bank under new regulation can be denoted by
p0L or p0E , depending on whether the bank reduces its loans or issues
new equity. Accordingly, the following two prot equations are
obtained.
2 A1 x0
A
rB0 B1 1 x0 2 B1 ;
2
2
k
2 A1 x
rB0 B1
px 0 1 x
2
k
A
b 1 x0
:
1 x2 B1
2
b1x
p0L px0 1 x0
p0E
2b 1 x
x0 xf2rb 1b
p0L p0E
B1
A1 rb 1bb2 x0 x 1 x0 1 xcg:
0
2b 1 x
p0L p0E
B1
0 n
o
k
2
2 2
2rb 1bk Ab k 1 rb 1
k
Ag2 1 rb 1:
If the right-hand side of the equation is positive, it is sufcient for p0L
to be greater than p0E . If g is plugged back into the above equation,
inequality (4) is obtained. h
A.2. Proof of Theorem 2
It is easy to see the rst three claims in Theorem 2 by differentiating Q with respect to each parameter and simplifying as
follows:
Ab1x1r1b
(i)
@Q
@x
(ii)
@Q
@A
(iii)
@Q
@r
2Ab 1 xC 3 b C 2 b C 1 b C 0
K d
K
0
k
;
B0 1 xB1
B0 1 x0B1
2rb1bb1x2 1r1b
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