Did Risk-Based Capital Allocate Bank Credit and Cause a 'Credit Crunch' in the United States?

By Berger, Allen N.; Udell, Gregory F. | Journal of Money, Credit & Banking, August 1994 | Go to article overview

Did Risk-Based Capital Allocate Bank Credit and Cause a 'Credit Crunch' in the United States?


Berger, Allen N., Udell, Gregory F., Journal of Money, Credit & Banking


The spectacular increase in bank and thrift failures in the 1980s raised concerns about depository institution risk and spurred interest in public policy prescriptions to reduce this risk. One of these prescriptions was the Basle Accord on risk-based capital, which mandates that international banks operating in the major industrialized nations hold capital in proportion to their perceived credit risks. All assets and off-balance sheet activities are assigned risk weights between 0 percent and 100 percent according to their perceived credit risks, and banks must hold capital of at least certain percentages against total risk-weighted assets and off-balance sheet items. U.S. regulatory authorities went further and required that all domestic banks and savings and loans, as well as all bank holding companies above a certain size abide by similar guidelines. These guidelines went into partial effect in 1990 and into full effect in 1992. U.S. regulators also added a non-risk-based leverage requirement in 1990, mandating that banks hold capital of at least a certain percentage against unweighted on-balance sheet assets, with the percentage depending upon the bank's examination rating and some discretion of the regulator.

Because capital is more expensive to raise than insured deposits, risk-based capital (RBC) may be viewed as a regulatory tax that is higher on assets in categories that are assigned higher risk weights. Therefore, it would be expected that implementation of RBC would encourage substitution out of assets in the 100 percent risk category, such as commercial loans, and into assets in the 0 percent risk category, such as Treasury securities. The allocation of credit away from commercial loans could potentially cause a significant reduction in macroeconomic activity, given that many commercial borrowers cannot easily obtain substitute sources of funding in public markets. Thus, risk-based capital may have caused a "credit crunch," which we define as a significant reduction in the supply of credit available to commercial borrowers.

This aggregate credit reallocation or credit crunch effect is expected to be stronger (1) the greater the number of banks that were below the risk-based capital standards prior to RBC implementation, and (2) the greater the proportion of aggregate assets held by these capital-deficient banks. On both counts, the evidence would predict a relatively strong credit allocation effect from RBC. The replacement of the flat-rate capital standards of the 1980s with RBC increased by more than one-fifth the numberks of banks below the regulatory capital minima. More important for the aggregate effect, RBC requirements were more often binding for the very largest banks, so that banks representing more than one-fourth of total U.S. assets did not meet the RBC standards as of December 1989 (see Avery and Berger 1991). These banks were faced with the prospects of raising their ratios of capital to risk-weighted assets to meet the RBC standards either by raising expensive capital or by reducing risk-weighted assets through substituting out of assets with high risk weights, such as commercial loans.

Consistent with these expectations, U.S. banks did reduce their commercial loans and increase their holdings of Treasuries in the early 1990s. According to some observers, RBC played a major role in this aggregate financial reallocation, and was responsible for a credit crunch. That is, they assert that RBC caused a leftward shift in the supply function for bank credit in which significant numbers of borrowers who otherwise would have been funded were denied credit or priced out of the market. We refer to this as the PBC credit crunch hypothesis (see Breeden and Isaac 1992; Wojnilower 1992; Haubrich and Wachtel 1993; Thakor 1993).

However, a number of alternative explanations for this change in bank behavior have been offered. According to some observers, implementation of the leverage requirement by U. …

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