Capital regulation and banks' financial decisions

Haibin Zhu

No 232, BIS Working Papers from Bank for International Settlements

Abstract: This paper develops a stochastic dynamic model to examine the impact of capital regulation on banks' financial decisions. In equilibrium, lending decisions, capital buffer and the probability of bank failure are endogenously determined. Compared to a flat-rate capital rule, a risk-sensitive capital standard causes the capital requirement to be much higher for small (and riskier) banks and much lower for large (and less risky) banks. Nevertheless, changes in actual capital holdings are less pronounced due to the offsetting effect of capital buffers. Moreover, the non-binding capital constraint in equilibrium implies that banks adopt an active portfolio strategy and hence the counter-cyclical movement of risk-based capital requirements does not necessarily lead to a reinforcement of the credit cycle. In fact, the results from the calibrated model show that the impact on cyclical lending behavior differs substantially across banks. Lastly, the analysis suggests that the adoption of a more risk-sensitive capital regime can be welfare-improving from a regulator's perspective, in that it causes less distortion in loan decisions and achieves a better balance between safety and efficiency.

Keywords: Capital requirement; economic capital; regulatory capital; actual capital holding; procyclicality effect; dynamic programming; prudential regulation (search for similar items in EconPapers)
Pages: 46 pages
Date: 2007-07
New Economics Papers: this item is included in nep-ban, nep-dge, nep-mac, nep-reg and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (9)

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