Essays on bank capital and balance sheet adjustment in the UK and US, and implications for regulatory policy

The financial crisis prompted widespread interest in developing a better understanding of how market and regulatory driven capital targets affect bank behaviour. Such considerations are important to assessing the effects of shocks to banks' capital ratios on their supply of financial intermediation services to the real economy, whether those shocks originate in higher regulatory capital requirements, unexpected losses, or demands from investors or counterparties. In particular, my research is relevant to the effects of changes in capital requirements or the imposition of explicitly counter-cyclical capital requirements, as proposed by the Basel III agreement. In this thesis, I describe three related research chapters focusing on how banks' actual capital ratios and long-run capital ratio targets affect bank behaviour. The first chapter uses a unique, comprehensive database of regulatory capital requirements on all UK banks to examine their effects on capital, lending and balance sheet management behaviour in the pre-crisis period 1996-2007. We find that capital requirements that include firm-specific, time-varying add-ons set by supervisors affect banks‘ desired capital ratios and that resulting adjustments to capital and lending depend on the gap between actual and target ratios. We use these results to measure the effects of a capital regime that includes features similar to those embedded in the UK framework. Our results suggest that countercyclical capital requirements may be less effective in slowing credit activity when banks can readily satisfy them with lower-quality (lower-costing) capital elements versus higher-quality common equity. Finally, we apply a simple version of our model to a small sample of large banks in the crisis period 2007-2011 and find that balance sheet adjustments to achieve target tier 1 capital ratios focused on risk-weighted assets, and changes in tier 1 and total capital played a reduced role compared to the pre-crisis period. Given the size of the UK banking sector and the global nature of many of the largest institutions in the UK banking sector, the results have implications for the ongoing debate surrounding the design and calibration of international capital standards. The second chapter assesses the relation between bank capital ratios and lending rates for the 8 largest UK banks over the period 1998-2011. The methods differ from previous literature in that they employ a dynamic error correction specification and a unique regulatory database to disentangle long- and short-run effects. There is no long-run link in pre-crisis boom times, but a strongly negative association is revealed during the stressed conditions of 2007-11 when well-capitalised banks may have benefited from lower funding costs. Higher capital ratios also have positive short-run effects on lending rates which are sizeable during crisis times. These results imply that countercyclical variations in bank capital requirements, as envisaged by Basel III, need to be very substantial to offset the procyclical reduction in the supply of bank lending during a crisis. In the third chapter the focus moves to the United States to examine the effect of capital ratios on profitability spanning several economic cycles going back to the late 1970s. Theory suggests that this relationship is likely to be time-varying and heterogeneous across banks, depending on banks‘ actual capital ratios and how these relate to their optimal (i.e., profit-maximising) capital ratios. We employ a flexible empirical framework that allows substantial heterogeneity across banks and over time. We find that the relationship is negative for most banks in most years, but turns less negative or positive under distressed market conditions. Banks with surplus capital relative to their long-run targets have strong incentives to reduce capital ratios in all periods. Similar to the second research chapter, these results have the policy implication that counter-cyclical reductions in capital requirements during busts may not be effective since, in such conditions, banks have incentives to raise capital ratios.