Banking is the most regulated among all industrial sectors of the economy. Thirty years ago Buser, Chen and Kane (1981) remarked that, "a bank has traditionally been conceived as more than just another business firm; it operates under unusual regulatory restrictions.....". Since then the regulatory environment surrounding banks has not changed much. When financial market was deregulated in the early 1980s banks were reregulated by more stringent capital regulation which restricted their asset generation capacity. Banking is now the only industry that is subjected to international capital regulation supervised through Basle Capital Accords.
Banks may be special institutions but they are primarily business organizations whose ultimate aim is to generate enough profit to satisfy a market determined ROE. Capital structure (mix of equity and debt) of any business is an endogenous variable geared towards generating a required level of sales (which is also an endogenous variable) with a certain return from which to earn the required profit to satisfy the required ROE. For banks, sales are analogous to generating banking assets; everything else is same. Regulatory intervention seeking to alter the capital structure of banks, transforms the character of some of the endogenous variables (like leverage, assets-capacity etc.) to exogenous variables. As capital regulation is administered through capital-assets ratio, a rise in the ratio lowers down the sales (banking assets) generation capacity of banks. A transition from a low capital regime (pre-regulation) to high capital regime (post- regulation) 'reduces the banks' future ability to pledge which can lead to a bank run because maturing deposits may exceed what the bank can pledge' (Diamond and Rajan, 2000). With fewer assets available banks may be forced to cross boundaries and reach for high-return-high- risk assets which has the potential of endangering the system as a whole.
In particular, the paper seeks to establish the following:
1. Bank capital regulation has reduced the rate of growth of assets of US banks substantially over the pre-regulation period. The reduced level of assets has motivated the banks to make investments in assets with higher rate of return in order to earn enough to satisfy required return on equity (ROE).
2. As higher rate of return on assets is associated with higher risk, capital regulation has ultimately resulted in increasing level of asset losses, thereby increasing the risk of the banking industry.
Unlike Saunders (2000) and Flannery and Rangan (2004) who prefer market value accounting, we have followed book value accounting as in Kopecky and VanHoose (2006). This approach appears to be more appropriate while presenting a critique of bank capital regulation which itself is based on book-value accounting. Moreover, closure decisions of bank regulators are also based on book value accounting. Definitions of variables are given in the Appendix.
The study is based on the data of US insured banks for the period, 1950-2004 as available from Historical Statistics on Banking published by Federal Deposit Insurance Corporation (http://www2.fdic.gov/hsob/hsobrpt.asp, accessed on June 26, 2011).
Prior to 1980 bank supervisors in the US did not impose specific numerical capital adequacy standards. Instead, the supervisors applied informal and subjective measures tailored to the circumstances of individual institutions. Since 1980, bank supervisors had placed much more emphasis on precisely defined numerical minimum capital standards. This was later firmed up with the passage of Institutional Lending and Supervision Act of 1983, which adopted a leverage ratio of primary capital (consisted mainly of Equity and Loan Loss Reserves), to average total assets (Besanko and Kanatas, 1996; Federal Deposit Insurance Corporation (FDIC), 2003). The first Basle capital accord, which was introduced in 1988, expanded the idea and brought in international convergence of capital standards. …