31 January 2019

ECB working paper: A dynamic model of bank behaviour under multiple regulatory constraints

This paper develops a structural model of bank behaviour that provides a microeconomic foundation for the observed fluctuations in bank asset and liability structures and for the response to changes in regulatory capital and liquidity requirements or economic shocks.

When deciding on asset and liability structures, bank managers trade off the ability of generating higher expected returns on equity (e.g. associated with higher leverage) against higher risks of breaching regulatory requirements or having to raise fresh equity. The estimated parameters of the structural model suggest that banks hold voluntary capital and liquidity buffers for precautionary motives, to insure against solvency and liquidity shocks that could push ratios below or close to regulatory requirements.

The model suggests that banks’ preferred mode of adjusting to higher capital requirements is to retain earnings, in line with evidence from the recent financial crisis (see Cohen 2013). Moreover, while banks tend to reduce loans in the short run, the additional accumulated earnings allow them to support lending at higher levels than before in the medium to long-run. This is an important finding of their model, as it reconciles empirical evidence on a negative short-run impact of higher capital requirements on lending, and positive long-run effects of higher capital ratios on loan supply.

Authors further show that also changes in liquidity requirements can have sizable real effects, depending in particular on their interaction with capital requirements. Following an increase in liquidity requirements banks react by holding a larger amount of liquid assets. Ceteris paribus, increasing the amount of assets decreases capital ratios, so that further adjustments in the supply of loans are necessary if banks wish to maintain constant voluntary capital buffers. Their results show that these adjustments can involve a permanent reduction in lending, in particular for banks that are initially more constrained by the liquidity ratio. This finding points to potential unintended effects arising from the interaction of multiple regulatory constraints which deserve to be studied further.

A clear lesson from the model is that supervisors need to have a good understanding of initial balance sheet conditions when deciding about the calibration of possible policy measures. The overall impact of the measures, and in particular the short-term lending reaction (which is often used as a proxy for the potential cost of policy measures) is likely to depend on how binding the constraints are prior to the policy change. This points to the importance of tailoring regulatory measures to individual financial institutions that may be characterised by different balance sheet structures. Future research should focus on investigating the importance of additional sources of heterogeneity among banks that may affect the response to policy changes.

Working paper

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