Unintended consequences of higher capital requirements

Unintended consequences of higher capital requirements
Arzu Uluc and Tomasz Wieladek
Bank Of England September 19  2016

Following the global financial crisis of 2007-08, financial reform introduced time-varying capital requirements to raise the resilience of the financial system. But do we really understand how this policy works and the impact it is likely to have on UK banks’ largest activity, mortgage lending? In a recent paper we investigated the UK experience of time-varying microprudential capital requirements before the financial crisis. We found that an increase in this requirement intended to make a bank more resilient actually induced it to shift into riskier mortgage lending.

Many countries around the world have introduced new macroprudential and microprudential regulations to increase the resilience of the financial system to socially costly financial crises. One instrument, which is part of the Basel III package of reforms, is a capital requirement that varies over time, and would be raised as risks in the system build up. But, to date, there is little understanding of how banks will respond to this instrument, in terms of both the volume and riskiness of mortgages offered, or the extent to which providers outside the banking system will respond. This should not be surprising, since in the past regulators in most countries imposed a constant capital requirement, by bank and over time, in accordance with the regulatory framework of Basel I. But the UK regulator before the crisis, the Financial Services Authority (FSA), adjusted banks’ and building societies’ capital requirements over time to address legal, operational and interest rate risks, which were not accounted for in Basel I.

In Uluc and Wieladek (2015), we combine this unique UK pre-crisis capital requirements data with a loan-level database, containing a large set of loan and borrower characteristics on all new mortgages issued in the UK between 2005Q2 and2007Q2. This dataset allows us to shed light on the impact of time-varying capital requirements on the mortgage market.  We first test if changes in bank-level capital requirements affect the size of mortgages offered. We also examine if the affected banks shift lending towards riskier borrowers to boost short-term profitability and grow capital. Finally, we study whether the size of loans made by locally competing banks, which were not subject to a rise in capital requirements, and non-bank finance companies, rise in response to the loan contraction by the affected banks, which would be indicative of credit substitution.

Before presenting the results of our research, let`s first look at what economic theory says. If an increase in capital requirements is binding and the Modigliani-Miller (1958) theorem fails, which implies that bank equity is privately more expensive than bank debt, then the affected bank can choose to reduce risk-weighted assets by contracting lending or to raise capital organically by increasing earnings to satisfy the new requirement. One way to achieve the latter in the short run is to lend more to riskier borrowers, who can be charged extra fees and/or higher interest rates. Under Basel I, the regulatory framework during this period, household mortgages were assigned a risk weight of 50% regardless of loan and borrower characteristics. Faced with a rise in the capital requirement, banks were therefore incentivised to reallocate lending towards more profitable high-risk borrowers to grow capital via retained earnings. In that case, raising capital requirements could have the perverse effect of making the asset side of bank balance sheets riskier via increased riskier loans. Furthermore, the effect on individual banks need not translate to an effect on aggregate loan supply, as substitution of other sources of credit may offset this effect. In the presence of credit substitution, financial policy, if aimed at affecting the loan supply, will be less effective.

The results from our research indicate that a rise in an affected bank’s capital requirement of 100 basis points, conditional on all observable borrower, loan and balance sheet characteristics, leads to a 5.4% decline in average loan amount. Our results suggest the presence of risk shifting: this loan contraction does not occur for first-time buyers and borrowers with an impaired credit history, but affects those with verified income to a greater extent. Interestingly, unaffected lenders – competing with affected lenders in the local mortgage market – expand the average size of their loans by a quantitatively similar amount. This result is consistent with the idea that locally competing banks may completely offset the loan contraction associated with higher capital requirements on affected banks. On the other hand, there is no evidence for credit substitution from non-bank finance companies.

The findings in this study are based on changes to microprudential capital requirements and are therefore subject to the Lucas Critique, since bank behaviour might change in the presence of macroprudential regulation. Nevertheless, they may offer important lessons for economic policy and theory. Our results suggest that increases in capital requirements intended to make a bank more resilient may also raise the riskiness of a bank’s asset portfolio by inducing risk shifting behaviour. Furthermore, competition in the local lending market may mute the loan contraction when higher capital requirements are imposed on only a subset of lenders. Basel III will address some of these issues. Clearly, when the change in the capital requirement is at the level of the banking system, rather than individual institutions, loan substitution of competing institutions is likely to be smaller. The reciprocity clause in Basel III would also help to stop substitution by foreign branches. And the internal-model determined risk weights may help to address risk shifting, so long as the weights vary with the degree of risk. Nevertheless, our study illustrates the adaptability of the financial system and hence the potential for unintended consequences, following the introduction of new financial regulations, which could be applicable to Basel III as well. Awareness of these issues might help both policy makers and researchers to better understand the transmission of both macroprudential and microprudential policies to the mortgage market and induce more work on this area.

~~~

Arzu Uluc works in the Bank’s Macro-financial Risks Division and Tomasz Wieladek is a Senior International Economist at Barclays.

If you want to get in touch, please email us  t bankunderground@bankofengland.co.uk. You are also welcome to leave a comment below.

Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.