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The economic cost of capital: a VECM approach for estimating and testing the banking sector's response to changes in capital ratios

Sebastian De-Ramon () and Michael Straughan ()
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Sebastian De-Ramon: Bank of England, Postal: Bank of England, Threadneedle Street, London, EC2R 8AH

Authors registered in the RePEc Author Service: Sebastian de Ramon ()

No 663, Bank of England working papers from Bank of England

Abstract: The Basel III/CRD IV reforms to the banking system following the financial crisis of 2008–09 required banks to raise significantly both the quality and quantity of capital on their balance sheets. This econometric study provides evidence of both the long and short-term implications for ongoing activity in the UK economy of a change in the aggregate proportion of bank capital funding. We find that, in response to changes in their capital funding, banks change credit spreads applied to private non-financial corporate borrowers to a greater extent than for household borrowers in the short term, but equalise these changes in the longer term. The short-term impact reflects banks’ desire to adjust their capital ratios through changes to the value of their risk-weighted assets by restricting the flow of lending to higher-risk sectors to a greater extent than to lower-risk sectors. We also find that after recent regulatory reforms banks may have modified their price-setting behaviour somewhat. We develop a vector error correction model of these effects with an innovative non-standard estimation of the short-term coefficients. Using this approach, we are able to: (i) test hypotheses about the short-term and long-term responses to changes in the aggregate mix of bank capital funding; (ii) test hypotheses about the responses of the non-financial corporate and household sectors; and (iii) enhance the accuracy of the short-term dynamics and the accuracy of the macroeconomic simulations of the effect of increasing bank capital.

Keywords: Capital requirements; DSGE models; UK economy; bank competition (search for similar items in EconPapers)
JEL-codes: D22 D53 E27 G21 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-acc, nep-ban, nep-cba, nep-mac and nep-rmg
Date: 2017-06-30
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Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:0663

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