| Credit channel and risk-based capital adequacy requirements (2002) | |||||||||||||||
Abstract | |||||||||||||||
| Introduction: Importance of bank lending in the propagation of exogenous shocks has been recognised in the literature. Such views are collectively called the credit view. The credit view is that a negative shock, e.g. a monetary tightening, restricts the availability of credit to borrowers, thereby affecting the real economy. The credit view consists of two different views, namely the “bank-lending view” and the “balance sheet view”. According to the “bank-lending view” banks cut back on lending in the wake of tight money because they have less money to lend, even though there are good loans to be made. On the other hand, the balance sheet view implies that banks cut back on lending in the wake of tight money because borrowers are in bad shape. Thus the two views have different implications. Nevertheless, both the views imply that a monetary tightening shifts the supply schedule of bank loans left, thereby affecting the real economy. This transmission mechanism of monetary policy is called the credit channel. The quantitative importance of the credit channel may be dependent on institutional characteristics of the financial market. If banks can substitute from deposits to less reserve-intensive forms of finance, such as certificates of deposit, commercial paper, and equity, for instance a reduction in bank reserves caused by a monetary tightening will not shift the supply schedule of bank loans. If borrowers have access to a variety of non-bank financial sources, for instance, a leftward shift of the supply schedule of bank loans, if any, will not affect the real economy. As such, it is argued in the literature that the importance of the credit channel is likely to diminish over time due to ongoing financial innovation and deregulation, e.g. Bernanke and Gertler. There may be institutional changes that make the credit channel of monetary policy more important however. An example of such institutional changes may be the introduction of the risk-based capital standards. In July, the bank supervisors of the G10 countries plus Luxembourg agreed to implement risk-based capital requirements, which took effect in 1989. This is known as the Basle Accord. Under the Accord, the Bank for International Settlements (BIS) requires bank supervisors to impose minimum risk-weighted capital-to-asset ratios of eight per cent on all internationally operating banks of their countries. The BIS gives positive weights and zero weights to risky components (e.g. commercial and industrial loans), and safe components (e.g. U.S. government securities), of banks’ assets respectively. This means that banks can raise their risk-weighted capital-to-asset ratios by substituting from loans to government bonds. If many banks shift their portfolios in this way at the same time, the aggregate supply schedule of bank loans will shift inward, and a credit crunch will ensue. The focus of this paper is similar but different to that of the U.S. literature, however. First, this paper examines how the implementation of the risk-based capital standards affects the channel through which an exogenous shock (e.g. monetary policy) has influences on bank lending. That is, the focus is on the credit channel in the presence of the risk-based capital standards. Second, this paper focuses on the case of Japan. Under the Basle Accord, allowable components of bank capital are dependent on national regulations of individual countries, which creates difference in the effects of the risk-based capital standards on the credit channel between U.S. and Japan. This paper is organised as follows. Section 2 reviews the risk-based capital standards of the BIS in the context of Japanese banks. Section 3 discusses a benchmark model for this paper. In particular, the “costly-state-verification-model (Townsend 1979) which captures asymmetric information problems pertain to financial transactions, is employed. With this model, we derive incentive-compatibility constraints for a bank to make loans. This section also examines how exogenous shocks affect these constraints and thereby bank lending. Section 4 introduces the essence of the risk-based capital standards of the BIS into the model, and shows how, in addition to the incentive compatibility constraints, a capital adequacy constraint must also be satisfied. Section 5 concludes by comparing the implications derived from the model with the results of empirical works. | |||||||||||||||
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