# 2. **The impact of CARs on bank behavior: previous contributions and open issues.**

It is a well-known tenet that capital adequacy rules have an impact on bank behavior.<sup>4</sup> Specifically, the literature has focused on two aspects. First, it is believed that the introduction of capital adequacy rules will normally strengthen bank capital and, thus, improve the resilience of banks to negative shocks. The second main affected area is banks' risk taking. If, as it happens, capital adequacy rules establish higher standards for loans to the private sector than for credits vis-a-vis the public sector (e.g. Treasury securities), introducing these rules, might cause a shift in banks' balance sheets from the former to the latter assets.

Put in other words, the first question is whether banks fulfill the CARs by increasing capital (the numerator) or by reducing risk-weighted assets (the denominator). The second question, instead, asks whether the stiffening of capital adequacy can lead to a contraction in banks' supply of loans. Although the two issues are indeed related to each other - i.e. the contraction in the loan supply can be the most effective way of reducing risk-weighted assets - they have been addressed using different methodologies.

The two questions just outlined appear even more relevant for emerging economies. Regarding the first, in fact, banks might be more likely forced to reduce riskweighted assets when their ability to raise capital is impaired by shallow domestic capital markets, i.e. the typical situation in emerging economies. Regarding the second, bank lending represents a larger share in the corporate sector's external finance in emerging economies, thus making these economies more prone to suffer from the ensuing restriction in bank lending.

Regarding the first question, some authors provide evidence that banks change the composition of their assets away from high risk-weighted assets when capital requirements are binding for them. Studies on this issue have mostly focused on US banks: e.g. Dahl and Shrieves (1990), Aggarwal and Jacques (1997), and Jacques and Nigro (1997) all offer evidence for US banks only. Some other contributions have tried to assess whether negative shocks to capital induced Japanese banks to restrict lending. Considering that a large part of Japanese banks' Tier 2 capital consists of unrealized capital gains on equity investments, Kim and Moreno (1994) - on aggregate data - and Ito and Sasaki (1998) - on individual bank data - provide evidence that negative shocks to capital stemming from stock market plunges lead to significant declines in lending. Peek and Rosengren (1997) show that negative shocks to capital resulting from declines in the Tokyo stock market translate into curtailing loans in the US by Japanese banks and subsidiaries.

The second issue - whether the stiffening of capital adequacy can lead to a - contraction in banks' supply of loans has been debated at length in trying to explain the early 1990s US recession. By historical standard such recession was rather mild and yet recovery was extremely slow. Various authors have suggested that the reason for such extremely tardy recovery has to be found in the capital crunch, a particular type of credit crunch - i.e. a retrenchment in banks' loan supply - precipitated by the inception in the US of the Basel Committee capital adequacy standards. The consequent failure of the 4 For general discussion, see Dewatripont and Tirole (1994); Freixas and Rochet (1997).

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