Academic journal article Federal Reserve Bank of St. Louis Review

The Basel Accord and Financial Intermediation: The Impact of Policy

Academic journal article Federal Reserve Bank of St. Louis Review

The Basel Accord and Financial Intermediation: The Impact of Policy

Article excerpt

1 INTRODUCTION

How can a central bank influence the availability of credit through the business cycle? Banks limit the loans they offer because (1) the loans may not provide a sufficient return; (2) the loans are too risky; (3) interest margins are too low; (4) there are regulatory constraints; and (5) there is a lack of funds. The literature on financial intermediation traditionally has neglected the last two points, especially the lack of funds. With this article, we take better account of the funding of banks and how it interacts with the two policy tools available to the central bank: monetary policy through the adjustment of some interest rates and regulatory policy through the variation of capital requirements.

We find that monetary policy matters most in terms of expectations. Indeed, the fact that the central bank commits to act in certain, possibly rare, situations is more important than the action itself. Households have a saving pattern that is more favorable to aggregate credit creation in all periods if they know that banks will still be able to lend in recessions. The key here is that the central bank is predictable.

In addition, we find that adjusting capital requirements through a business cycle can be a powerful tool, but not in the usual way: In a recession, capital requirements should tighten. Again, expectations matter, and knowing that equity returns are assured even in recessions can make households more willing to put equity into banks in all periods of the business cycle. This additional funding compared with a policy of constant capital requirements more than offsets the loan reduction during the actual requirement tightening.

We obtain these results through simulations of a model economy with heterogeneous households facing unemployment, retirement, and death risks. They save for precautionary reasons and for retirement. In addition, their assets may be used to qualify for loans from the banking sector, in which case they manage as entrepreneurs a risky project that may lead to bankruptcy. Household savings are invested in bank deposits and bank equity. Banks provide loans to households and buy government bonds. As mentioned, the central bank sets capital requirements and the policy interest rate, in this case the return on government bonds.

When banks need to reduce their loan portfolio, the displaced entrepreneurs also become new equity holders, thereby acting as "automatic stabilizers." However, banks typically cut loans as a consequence of their loan portfolio becoming too risky, and households may then want to hold less equity in banks that are more risky. Whether banks have to tighten credit a good deal or not depends strongly on the distribution of assets across households and on household equity decisions. The policy tools of the central bank then become crucial in reassuring households in bad times and in encouraging them to invest in bank equity at all times.

One would first think that loosening those requirements in a trough would expand the loan mass. It appears that, on the contrary, tighter capital requirements increase the demand for bank equity and thus facilitate the financing of banks sufficiently to offset the reduction of allowable loans for a given amount of equity. Again, this highlights the importance of household saving decisions for the supply of bank capital. This result is particularly important in light of Basel Accords II and III and their more flexible regulations, which essentially tighten the equity requirements when the economy passes through a rough patch, as highlighted, for example, by Catarineu-Rabell, Jackson, and Tsomocos (2005).

Cyclically of capital requirements was previously thought to have a negative impact on credit. For example, Kashyap and Stein (2004) argue that Basel Accord II exacerbates business cycle fluctuations by requiring banks to hold more capital during downturns. Higher costs of raising capital in downturns force banks to further contract lending, which causes a credit crunch. …

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