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over the effectiveness of the regulation. We’ll discuss the relationship in full detail in the following chapters.
The rest of this paper is organized as follow. Section 2 we will review some of the related literature regarding the capital requirement, or prudent regulation. Section 3 presents the form of our model. Section 4 characterizes the equilibrium of the model when there is a minimum capital requirement. Section 5 we discuss the welfare issue, and finally in Session 6 we come to the conclusion.
2. Literature Review
There are two topics in our model, the financial contagion phenomenon in the banking systems, and the government regulation of capital requirement. Regarding the first issue, we first review the article of Allen and Gale in 19984 and 20005, with the later one as the main source of our model. In Allen and Gale 1998, they summarized two traditional views of the bank panics. One is that they are “random events” and unrelated to the real economy. This kind of view treats the bank panics as the result of sell-fulfilling properties of the depositors. If everyone believes that a banking panic is about to occur, it is optimal for each individual to try to withdraw his funds simultaneously, which made the bank runs to happen. An alternative to the random view is that banking panics are a natural phenomenon of the business cycle. An economic downturn will reduce the value of bank assets, raising the possibility that banks are unable to meet their commitments and pushing the depositors to withdraw their funds. This attempt will precipitate the crisis.
4 Allen Franklin, Gale Douglas. “Optimal Financial Crises”, Journal of Finance, 1998, vol. LIII, no. 4
5 Allen Franklin, Gale Douglas. “Financial Contagion”, Journal of Political Economy, 2000, vol. 108 no.1
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Allen and Gale based on the random view and developed a model in the article in 2000 to explain how the regional bank panics to spread to other regions, which we called it as the “contagion”. In this model, they treat the misallocation and incompleteness in the financial sector and as the causes of economic fluctuations, and trying to provide some microeconomic foundations for financial contagion. The most important feature in this model is about the interbank deposit linkage among the banking system. The model assumes that there exist four different regions and the respective representative depositors and banks. Each representative bank holds interregional claims on other banks to provide insurance against liquidity preference shocks. When there is no aggregate uncertainty, the first-best allocation of risk sharing can be achieved. However, this arrangement is financially fragile; therefore a small participators, and financial linkage within the financial institutions such as the credit relationship of the commercial banking, which is also the center of this article. They present a model of an economy with multiple banks where the probability of failure of individual banks, and of systemic crises, is uniquely determined. The cross holding of deposits motivated by imperfectly correlated regional liquidity shocks enable banks to hedge regional liquidity shocks but also lead to contagious effects conditional on the failure of a financial institution. The conclusions of their article are that (1) there exist
6 Amil Dasgupta, “Financial Contagion through Capital Connections: A Model of the Origin and Spread of Bank Panics”, 2004, Journal of the European Economic Association, 2(6), pages 1049-1084.
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a specific direction of the contagion, which provides a rationale for localized financial panics; (2) there exists an optimal level of interbank deposit holdings in the presence of contagion risk, based on the probability of bank failure; (3) they demonstrate that the intensity of contagion is increasing in the size of regionally aggregate liquidity shocks..
Viral V. Acharya and Tanju Yorulmazer (2006)7 put their emphasis on the bank herding phenomenon, that is, banks choose to lend to similar industries, which maintain a high level of inter-bank correlation and erode the profit margins of the banks because of the high intensity of competitions, causing the inefficiency. They conclude that profit-maximizing bank owners have an incentive to herd so as to minimize the information spillover from bad news about other banks on their borrowing costs and in turn on their future profits. Here, the ex ante expectation of the poor performances by the competitive banks play as a signal of the deteriorating of the “common factor” that affects the economy as a whole, pushing the banks to herd to avoid losses from higher borrowing cost if the bank failed. This paper illustrates how the information-based model works in the herding and contagion issue.
Next we turned to the second issue: the bank capital requirement. The effectiveness of capital requirement has been discussed and studied for quite a long time since the introduction of the Basel Accord in 1988. The Basel Committee published an article8 to review the impact of the Basel Accord after 10 years of the initial introduction. They indicated that the main objective of the framework is to strengthen the soundness and stability of the international banking system by encouraging international banking organizations to boost their capital positions. The
7 Viral V. Acharya and Tanju Yorulmazer, “Information Contagion and Bank Herding”, 2006, Journal of Money, Credit and Banking, 40(1), page 215-231.
8 Patricia Jackon, “Capital Requirement and the Bank Behavior: The Impact of the Basel Accord”, 1999, Bank of International Settlement, Switzerland.
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regulation. (1) Whether the adoption of fixed minimum capital requirements led some banks to maintain higher capital ratios. (2) Do banks adjust their capital ratios to meet the requirements by increasing capital or reducing risk-weighted assets? (3) What is the impact of capital requirements on risk-taking? (4) Have banks artificially boosted their capital ratios by engaging in capital arbitrage9 and creating some side effects such as credit crunches? (5) Did the introduction of minimum capital requirements for banks harm their competitiveness and reduce competitive inequalities between banks?Regarding issue (1) and (2), the historical data in 1988-1996 showed that the risk-weighted assets of major banks in the G-10 actually rose from 9.3% to 11.2%, while the way the banks choose to achieve is vary according to the stage of the business cycle and the bank’s own financial situation. Research suggests that banks are likely to cut back lending to meet the capital requirements when it would be too costly to raise new capital. However, for issue (3) and (4), though some theoretical papers have suggested that capital requirements applied may induce banks to substitute towards the riskier assets, engage in the arbitrage activities by securitizations and even tighten their lending in the economic downturn, no significant empirical evidence support such views. Finally, the competitiveness and inequality issues are more difficult to study than the previous ones. The article mentioned that the response from the equity market may be a potential source, but it still needs more extensive study.
Sangkyun Park (1994)10 recognizes two main factors that cause the capital requirement to affect the weighted average cost of capital and hence the investment
9 According to C. Bajlum and P. Tind Larsen (2007), capital structure arbitrage refers to trading strategies that take advantage of the relative mispricing across different security classes traded on the same capital structure.
10 Sangkyun Park, “The Bank Capital Requirement and Information Asymmetry”, 1994, Federal Reserve Bank of St. Louis
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information asymmetry between managers and the stock market. For a bank enjoying a low cost of debt (deposits), an increased proportion of equity financing raises the weighted average cost of capital. When the stock market underestimates the value of a bank due to information asymmetry, equity financing is expensive. This paper finds that banks constrained by the tightened capital requirement grew slower in 1991 and that information asymmetry as well as underpriced deposits played a role in explaining the slower growth. Empirical results support that both factors contributed to the slow growth of risk-weighted assets after the tightening of the capital requirement, and it suggests that to mitigate the negative effect of asymmetric information by implementing the capital requirement in a flexible manner.Hellmann, Murdock and Stiglitz (2000)11 specified two different effects of the capital requirement in their article, the capital at risk effect, and the franchise value effect. It is well-known that an increase in bank competition that erodes the present value of the banks’ future rents (their franchise or charter value) reduces their incentives to behave prudently. The standard regulatory response has been to tighten capital requirements: higher capital implies higher losses for the banks’ shareholders in case of default, and hence lower incentives for risk-taking. However, in addition to this “capital at risk effect”, there is a ”franchise value effect” that goes in the opposite direction. Specifically, it claims that higher capital requirements reduce the banks’
franchise values, and hence the payoffs associated with prudent investment, so their overall effect is ambiguous. HMS argued that by adding the deposit rate control to the existing regulation, any Pareto-efficient outcome can be achieved since it facilitates prudent investment by increasing franchise values, and this method dominates the
11 Hellman, Murdock and Stiglitz, “Liberalization, Moral Hazard in Banking, and Prudential
Regulation: Are Capital Requirements Enough?”, 2000, The American Economic Review, 90(1), page 147 - 65.
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traditional capital requirement regulation.
Few papers discuss the issue of the social welfare after the introduction of the capital requirement, and Skander J. Van den Heuvel (2007)12 is the latest one which tries to measure welfare cost of such regulation. The main contributions of this paper are to build a framework to analyze the social cost of capital requirements, to derive a simple formula for its magnitude and to use that formula to measure the welfare cost of such requirements. This paper argues that capital adequacy regulation can come with an important cost because it reduces the ability of banks to create liquidity by accepting deposits. Based on the U.S. data and estimation, the welfare cost of the current effective capital requirement is equivalent to a permanent loss in consumption of 0.1 to 0.2 percent (1% in another estimation), which is fairly large and beyond the benefit in reducing the cost of moral hazard problems. All of these suggest that the current capital requirements are too high. Therefore, to deal with such tradeoff between maintaining a relative low capital requirement and having an acceptable probability of bank failure, to designing a more risk-sensitive system seems to be the trend in practice. However, it concludes that the stated goal of keeping capital ratios at about the same level for the average bank is clearly not justified.
12 Van den Heuvel, Skander J, 2008. "The welfare cost of bank capital requirements," Journal of Monetary Economics, Elsevier, vol. 55(2), pages 298-320
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國立 政 治 大 學