07 March 2014

ECB: Forward-looking reaction to bank regulation

This paper presents empirical evidence that banks react to regulation in a forward-looking manner. In a case study of Finnish banks 1998-2004, a reaction to Basel II is found already at the turn of the century, about seven years before de jure implementation of the regulation in 2007.

Loan market indicators are studied to uncover evidence about changes in bank behavior when new information about Basel II was released. Survey techniques are employed to uncover information from banking professionals about changes in credit policies driven by Basel II around this time. Quantitative evidence about changes in credit policies when the regulation was under preparation in the Basel committee is obtained from loan samples based on a novel econometric approach.

The three approaches yield a consistent view about changes in credit policies driven by expectations about Basel II. The study of loan market indicators reveals significant structural changes in the loan market following the first information release about Basel II: an increase in the growth rate of housing loans relative to corporate loans, and a decrease in the interest margin of housing loans. The survey of information from banking professionals yields qualitative evidence about changes in credit policies towards households around this time, based on the expectation that Basel II will decrease the capital cost of household loans. To increase the share of such loans in their portfolios, banks loosened credit policies towards household borrowers. The analysis of loan samples with the novel econometric approach corroborates these findings, and makes the changes in credit policies and credit availability of borrowers susceptible to quantitative study. The estimations indicate that the changes in credit policies were substantial contributing to an increase in credit availability of households by 20–50 percent on average.

Besides new results, the present paper also contributes to the literature a novel econometric approach to estimate borrowing constraints and the related credit policy parameters of lenders. The methodological contribution builds on the insight that, under specified conditions, stochastic frontier analysis of a loan sample yields quantitative estimates of borrowing constraints in parametric form. The novel approach to estimate borrowing constraints complements the earlier approaches in the finance literature by opening the possibility to study borrowing constraints from loan samples. It has broad applicability since suitable data of loans is widely available in household surveys and corporate balance sheets. Compared with earlier approaches, the novel approach seems particularly well suited for testing quantitative hypotheses about borrowing constraints and the related credit policies of lenders.

The estimation results contribute to our understanding about how capital regulation influences bank behavior. The most important new result is the existence of an expectations channel of regulation: banks may react to regulation strongly many years before it is implemented. The results have important policy implications for the design of bank regulation and the timing of regulatory changes. The novel approach to estimate borrowing constraints opens a wide agenda of research about credit availability and its role in economic activity.

Working paper

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