Bank Capital, Capital Regulation and Lending

The report evaluates bank loan supply in a straightforward value maximizing partial equilibrium framework. The main focus is on the function of bank capital, capital regulation and the pricing of bank liabilities. The design is built in order to resemble the problem of the Finnish native banks in the late 1980s and the early 1990s, especially pertaining to capital regulation that changed subtantially in those times. While equity capital is presumed exogenous, the financial institution may select the amount of subordinated debt which also counts as regulatory capital. The model signifies that bank qualities matter for loan supply, when the bank is punished for bank failure (capital insufficiency relative to a regulatory requirement)…

If this penalty is positive, fair or excessive pricing (lemons premium) of bank liabilities makes bank lending rely positively on bank capital but underpricing produces a negative relationship. An adverse relationship might also emerge if the bank anticipates “perverse” bank support policies ie that capital insufficiency will probably be rewarded with transfers from the authorities. Hence both a credit crunch because of insufficient capital and “excessive” risky lending because of moral hazard can obtain in one model, based on the circumstances. The exact nature of capital regulation makes no difference, provided a failure to meet the requirement is adequately penalized. The model implies that the mutually exclusive hypotheses of credit crunch / excessive lending caused by moral hazard could be tested not merely by analyzing the connection between bank lending on one side and bank equity and bank costs alternatively, but additionally by analyzing the connection of subordinated debt with bank lending and the capital ratio…

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Source: Research Discussion Papers, Bank of Finland

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