Risk-sensitive capital requirements and pro-cyclicality in lending

Abstract

Risk-sensitive capital requirements aim at enforcing appropriate minimum amounts of capital to absorb losses resulting from credit defaults and other risk sources. These requirements are considered to be important as they are supposed to strengthen financial stability. Nevertheless, practitioners and scholars have worried about negative side effects arising from capital-based regulation such as the reinforcement of cyclicality in lending. These concerns are based upon the notion that regulatory rules, which become tighter in downturns, restrict the bank's total lending. As a consequence, valuable projects are not financed during recessions, which may enhance the cyclical downturns. A situation commonly known as credit crunch arises. In this thesis, we address the question of if and how bank capital regulation may enhance cyclical patterns in lending. We analyze the sensitivity of the lending volume to changes of fundamental economic variables, called shocks, under a Value-at-Risk approach, under approaches with fixed risk weights, and under a laissez-faire economy. We endogenize the bank's risk-allocation and size decision. In particular, the deposit volume and the deposit interest rate are based on decisions made by the household and the bank. The deposit interest rate and the deposit volume reflect the bank's risk-taking and the regulatory constraints. Our results concerning pro-cyclicality lead to the conclusion that the effect of a given shock should be distinguished according to the type of the shock. Regulation effectively constrains bank lending after realized losses. Thus, equity shocks lead to pro-cyclical effects on lending. This observation is in line with common fears. The effects of expectation shocks, that is the effects of changes of distribution parameters or of borrowers' productivity, are dampened by regulation. More precisely, regulation effectively constrains bank lending when expectations turn more favorable. Thus, regulation may hamper economic recovery. In this respect, regulation is identified as non-pro-cyclical. We can observe counter-cyclical effects through regulation on the level of single loan volumes. These insights can be found regardless of the degree of risk sensitivity of the respective capital adequacy rule. Furthermore, a bank may grant higher loan volumes to less risky firms under risk-sensitive capital requirements than it would do under fixed requirements or under a laissez-faire regime. Including two periods shows that total loan volumes react to expectation shocks as in the one-period setting when the very period is considered at whose beginning the shock occurred. Likewise, the expected or average reaction of total loan volumes in the second period to the shifts thus implied in the bank's equity are in the same order of magnitude as in the one-period model. There is by no means an acceleration of sensitivities as such. Furthermore, this work emphasizes that enhanced risk-taking may occur under capital regulation without any interplay with other regulatory measures, such as deposit insurance schemes. Rather, the degree of risk-taking can be directly aligned with the sort of capital rules considered. A flat capital requirement always induces the bank to take more risk than under any other regime considered. The reduction in size is always compensated by taking more risk since this is the only possibility to raise the bank's expected final wealth. However, as capital requirements become risk-sensitive, our models yield mixed results. If loan repayments are normally distributed, the Value-at-Risk approach generally has no impact on risk-taking compared to the laissez-faire equilibrium