How bank regulators should set capital requirements

Alex Verkhivker | Mar 16, 2017

Sections Accounting

Central bankers, regulators, and market participants have spent several years hammering out banking requirements meant to prevent another financial crisis. A central component of the rules overhaul: higher capital requirements. The idea is that if banks hold more capital relative to risky assets such as loans, they should be better able to withstand economic downturns and even bank runs.

But US President Donald Trump has expressed concern that new capital rules could present obstacles to lending. And some research suggests stricter capital requirements should be implemented with caution. They could prompt banks to inefficiently underinvest in loans to corporate and other clients, according to the University of Houston’s Tong Lu, Chicago Booth’s Haresh Sapra, and Georgia State University’s Ajay Subramanian.

The researchers seek to model a regulatory policy that balances the risks of setting capital requirements too high against the consequences of setting them too low, and to assess the important role accounting standards play in the implementation of such capital requirements.

Overly strict capital requirements could heighten inefficiencies by making banks reluctant to write loans.

The two most widely used accounting measures include fair-value accounting, which values securities at their current market prices, and historical-cost accounting, which values them at their origination values. To analyze how regulation affects banks’ decisions to alter their loan portfolios, the researchers first examine a benchmark environment for an unregulated bank. They then model the decisions of a regulated bank to originate loans and to subsequently alter the riskiness of the loan portfolio, and determine how a bank regulator ultimately derives the level at which to set the capital liquidity ratio.

The model reveals that a bank regulator optimally imposes capital requirements that value banks’ balance sheets at current market prices, necessitating the use of fair-value accounting standards. “The interaction between the use of fair-value accounting and regulatory intervention is more subtle,” write Lu, Sapra, and Subramanian. “Although the regulator does indeed rely on fair-value accounting to impose an interim capital requirement when agency conflicts are severe, it could be suboptimal for the regulator to impose a very strict interim capital requirement that shuts down asset substitution.”

This suboptimality arises because the decision to originate loans and the decision to subsequently increase a loan portfolio’s riskiness, by substituting low risk loans for high risk ones, are inherently linked. Therefore, overly strict capital requirements, meant to alleviate the distortions that arise from banks making risky loans, could heighten inefficiencies by making banks reluctant to write loans. Proposals for very stringent capital requirements based on fair-value accounting that entirely prevent asset substitution should be implemented with caution, the researchers write.

To balance the trade-off between asset substitution and underinvestment, the model reveals, an optimal regulatory policy should feature some degree of forbearance by the regulator. The banking regulator can judiciously allow banks to engage in asset substitution that, in turn, induces banks to invest in higher quality loans. By taking into account the tension between asset substitution and underinvestment, bank regulators will ensure that capital requirements are efficiently set.