Academic journal article Atlantic Economic Journal

Bank Capital Regulation, Economic Stability, and Monetary Policy: What Does the Academic Literature Tell Us?

Academic journal article Atlantic Economic Journal

Bank Capital Regulation, Economic Stability, and Monetary Policy: What Does the Academic Literature Tell Us?

Article excerpt

Introduction

Since 1988, under terms of the Basel Accord (now known as Basel I), national bank regulators have imposed bank capital regulations, both in the form of a traditional leverage requirement and 'risk-based' requirements relating measures of bank capital to a 'risk-weighted' measure of total assets. In light of concerns that banks had developed arbitrage techniques that undermined the intent of the Basel risk adjustments, considerable regulatory effort is under way across more than 100 nations to develop the so-called Basel II system. This new international bank regulatory framework is to be based on three 'pillars': risk-based capital requirements, discretionary supervisory discipline, and market discipline. Capital regulation is clearly the central pillar, however, with small banks facing a much more complex, risk-based capital-requirement system than under the Basel I system and large banks required to implement an even more sophisticated, internal-ratings-based (IRB) system for capital tabulation. The Basel II system is slated to go into effect gradually with a target completion date of 2011.

Considerable research, reviewed by Santos (2001), Stolz (2002), and VanHoose (2007), has been devoted to examining the effects of minimum bank capital requirements on bank balance-sheet choices, portfolio risks, and safety and soundness. Analyses of the implications of capital requirements at the level of an individual bank or the banking system typically treat the rest of the economy as exogenous. Nevertheless, as noted by Bliss and Kaufman (2003), because bank capital regulation impinges on balance-sheet responses of the banking system as a whole, capital requirements potentially can affect the broader economy. Furthermore, to the extent that bank capital regulation affects the channels through which monetary and real shocks influence equilibrium output and prices, the structure of capital requirements can alter the monetary policy transmission mechanism. Indeed, bank regulators conceivably could find themselves in conflict with monetary authorities. Virtually all studies of the microeconomic effects of bank capital regulation generate the following common conclusions:

1. Short-run effects of binding risk-based capital requirements are reductions in individual bank lending and, in analyses that include consideration of endogenous loan-market adjustments, increases in equilibrium loan rates.

2. Longer-ran effects of risk-based capital regulation lead to increases in bank capital, both absolutely and relative to bank lending.

Taken together, the widespread agreement about these two sets of conclusions indicates that risk-based capital requirements have the potential to achieve one off-expressed objective: increasing the relative size of the 'capital cushion' protecting depositors and deposit insurers from losses in the event of isolated or widespread bank failures. During a short-run interval in which adjusting equity may prove costly, however, most of the adjustment to a regulatory capital tightening may occur via reductions in lending. Hence, it is possible that regulatory tightening of capital requirements could transmit short-term external shocks to aggregate credit and hence to the economy. In the longer term, simultaneous adjustments of bank equity and loans could alter the linkages from monetary policy instruments to the money stock, total credit, and economic activity. Thus, bank capital regulation has potential short-run and long-run monetary policy implications.

What has the literature to date revealed about how bank capital requirements may impinge on interest rates, aggregate bank credit, output and prices, and monetary policy effectiveness? This paper surveys research on three issues. The first issue, discussed in "Does Toughening Capital Requirements Boost Bank Capital Ratios and Create Credit Shocks'?," is the possibility that the toughening of regulatory capital standards can create a macroeconomic shock in the form of a 'credit crunch. …

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