metadata: authors: 0: author: Chiuri, Maria Concetta
1: author: Ferri, Giovanni
2: author: Majnoni,
docna: 0: docna: The macroeconomic impact of bank capital
            requirements in emerging economies - past evidence to assess
            the future
docty: Policy Research Working Paper
subtopic: Administrative & Regulatory Law,Banks & Banking Reform,Financial Regulation & Supervision,Economic Growth,Financial Sector Policy
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The authors test for emerging economies,
            the hypothesis - previously verified only for the Group of
            10 (G-10) countries - that enforcing bank capital asset
            requirements, exerts a negative effect on the supply of
            credit. Their econometric analysis of data on individual
            banks, suggests three main results: 1) Enforcement of
            capital asset requirements - according to the 1998 Basel
            standard - significantly curtailed credit supply,
            particularly at less-well-capitalized banks. 2) This
            negative effect is not limited to countries enforcing
            capital asset requirements in the aftermath of a currency,
            or financial crises. 3) The adverse impact of capital
            requirements on the credit supply was somewhat smaller for
            foreign-owned banks, suggesting that opening up to foreign
            investors, may be an effective way to partly shield the
            domestic banking sector from negative shocks. Overall, by
            inducing banks to reduce their lending, enforcement of
            capital asset requirements may well have induced an
            aggregate slowdown, or contraction in credit in the emerging
            economies examined. The results have relevance for the
            ongoing debate on the impact of the revision of bank capital
            asset requirements, contemplated by the 1999 Basel proposal.
            They suggest that in several emerging economies, the phasing
            in of higher capital requirements needs to be carefully
            managed, to avoid a credit supply retrenchment, which should
            not be underestimated.
repnme: repnme: The macroeconomic impact of bank capital
            requirements in emerging economies - past evidence to assess
            the future
display_title: The macroeconomic impact of bank
            capital requirements in emerging economies - past evidence
            to assess the future
listing_relative_url: /research/2001/01/1346356/macroeconomic-impact-bank-capital-requirements-emerging-economies-past-evidence-assess-future
topicv3: Regulatory Enforcement m1326305 1935,Monetary and Financial Stability m1327169 1098,Bank Regulation and Supervision m1327225 317,Financial Sector Development m1327681 1920,Trade Guarantees m1505111 3906
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Financial Sector Practice (FSP)
no_of_pages: 34
model_extractions: POLICY RESEARCH WORKING PAPER 2605

# Summary findings

Chiuri, Ferri, and Majnoni test for emerging economies the hypothesis-previously verified only for the Group of 10 (G-10) countries-that enforcing bank capital asset requirements exerts a negative effect on the supply of credit. Their econometric analysis of data on individual banks suggests three main results:

* Enforcement of capital asset requirementsaccording to the 1988 Basel standard-significantly curtailed credit supply, particularly at less-wellcapitalized banks.

* This negative effect is not limited to countries enforcing capital asset requirements in the aftermath of a currency or financial crisis.

* The adverse impact of capital asset requirements on the credit supply was somewhat smaller for foreign-

owned banks, suggesting that opening up to foreign investors may be an effective way to partly shield the domestic banking sector from negative shocks.

Overall, by inducing banks to reduce their lending, enforcement of capital asset requirements may well have induced an aggregate slowdown or contraction in credit in the emerging economies examined.

The results have relevance for the ongoing debate on the impact of the revision of bank capital asset requirements contemplated by the 1999 Basel proposal. They suggest that in several emerging economies the phasing in of higher capital requirements needs to be carefully managed to avoid a credit supply retrenchment, which should not be underestimated.

This paper-a product of the Financial Sector Strategy and Policy Department-is part of a larger effort in the department to study the impact of financial regulation on economic development. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Elena Mekhova, room MC9-622, telephone 202-4585984, fax 202-522-2031, email address emekhovaaworldbank.org. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. Giovanni Majnoni may be contacted at gmainoni@worldbank.org. May 2001. (28 pages) _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should he cited accordingly. The findings, initerpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represen_ **_t_** _he view of the World Bank, its Executive Directors, or the countries they represent._ Produced by the Policy Research Dissemination Center
The Macroeconomic Impact of Bank Capital Requirements in Emerging Economies: Past Evidence to Assess the Future by Maria Concetta Chiuri ', Giovanni Ferri a and Giovanni Majnonil * i The World Bank; d University of Bari (Italy) May 2001 JEL classification numbers: G18, G21, G28 Keywords: bank capital asset requirements, capital crunch

* We wish to thank Hosook Hwang for valuable research assistance. Helpful comments were provided by Fabrizio Coricelli, Jerry Caprio, Patrick Honohan and Vasso Ioannidou and by semninar participants at the OECD and at the World Bank. In addition, we are grateful to the IMF for having granted us permission to access the archive of the Article IV Consultation documents.
# 1. **Introduction**

During the last decade an increasing number of emerging countries adopted stiffer rules for bank minimum capital requirements following the spirit, if not the letter, of the 1988 Capital Accord proposed by the Basel Comnmittee on Banking Supervision for "internationally active" banks of G-10 countries. As a result, the Accord, initially designed to provide a level playing field for internationally active banks, has become a model for capital regulation of national banking systems in both developed and emerging countries.

Following the early phases of implementation of the Accord in developed countries, a widespread concern emerged about the possible negative impact that higher capital requirements could exert on the level of economic activity, especially during economic downturns. The intense debate led to a number of empirical analyses, which identified several cases in which binding capital requirements led to a sudden contraction of bank lending.' On the occasion, Mr. Richard Syron, president of the Federal Reserve Bank of Boston, coined the expression "capital crunch" to characterize the simultaneous shortage of capital and the limited banks' ability to grant new loans that occurred during the 1990-91 recession in the United States.<sup>2</sup> More recently, following the widespread adoption of Basel-like minimum banks' capital requirements, similar concerns have been expressed for emerging economies. Several authors have claimed that the tightening of capital requirements - or their more - stringent enforcement contributed to the depth and length of the financial crisis of East Asian economies. Indeed, the issue seems even more relevant for emerging economies than it might have been for G-10 economies, given the larger role that banking systems usually play in the former countries.

This paper provides new evidence on the effects that the introduction of Basellike capital requirements in emerging countries had on bank lending policies. Our purpose is twofold. First, we want to assess whether the different institutional setup prevailing in emerging economies with respect to G-10 countries affects the banks' reaction to the introduction of otherwise similar capital regulations in the former countries vis-a-vis the latter ones. Second, our aim is to use any evidence of systematic effects associated with the implementation of capital requirements in emerging countries' banking systems to provide guidance both on the definition of the new Capital Accord and on its phasing-in prescriptions (Basel Committee on Banking Supervision, 1999b).

In order to offer preliminary evidence on these issues the paper extends previous - empirical analyses in several directions. In the first place, we expand previous studies - focusing on single countries to a larger set of emerging economies.<sup>3</sup> Secondly, rather than looking at individual countries in isolation, we group a relatively large number of - emerging countries which have adopted and enforced capital regulation in the last decade - and look at the statistical regularities arising from their joint analysis. Thirdly,

> ' For an exhaustive and updated survey of the literature on the impact of capital requirements on the level of economic activity, see BIS (1999).

> 2 1 Remark reported in Woo (1999), p. .

> 3 Previous empirical work on the impact of capital requirements on bank lending in developing countries includes Ferri and Kang (1999) and Ito (2000).

1
rather than relying on aggregate data, we analyze the behavior of individual banks active in each selected country, thus being better able to identify supply-driven credit restrictions. Finally, our framework encompasses both shocks to bank capital arising from external sources - such as business cycle related losses - and shocks originating - from regulatory sources such as in the case of an increase in capital ratios.

The evidence gathered in the paper points out three major results. First, the enforcement of capital adequacy requirements negatively affects the supply of bank loans over a multiyear horizon and the effect tends to be stronger for initially less capitalized banks. Second, the impact of higher capital requirements is not limited to countries implementing enforcement practices in the aftermath of financial crises. Third, the adverse impact of more stringent minimum capital regulations on their deposit taking is somewhat smaller for foreign-owned banks, suggesting that opening domestic banking to foreign ownership or to the entry of foreign institutions may be an effective way of partly shielding the domestic banking sector from negative shocks. Overall, higher capital requirements seem to exert a rather general and negative effect on bank lending in emerging economies, whether affected by crises or not.

Accordingly, our analysis suggests using caution in enforcing - more than - introducing minimum capital requirements in emerging economies, where financing channels alternative to the banking system are generally weaker. Under these circumstances, the curtailing of bank loans could cause a depletion of organizational capacity in emerging economies' corporate sectors with potential long-lasting detrimental consequences for these economies' prospects (Greenwald and Stiglitz, 1993). Adequate phasing in procedures should, therefore, be considered for those economies which may face new and higher capital requirements as a result of the revised Capital Accord. By the same token, local supervisory authorities considering the opportunity of introducing higher than the Basel suggested minimum capital ratios or enforce sounder provisioning policies, need to carefully consider these effects as well.

More generally, our analysis is consistent with the view that risk-based capital requirements can exert effective and positive discipline only in those countries securing a minimum set of preconditions -e.g. adequate accounting standards, a proper definition of regulatory capital, and sound provisioning practices. Where, instead, those preconditions are lacking and the whole burden falls on higher capital ratios, the restrictive impact on bank lending may have large negative effects on the economy.

- In the following we start surveying the considerable literature mostly referred - to developed countries empirically assessing the impact of the enforcement of the - 1988 Basel CARs (Section 2). Section 3 outlines our methodological framework - building on the seminal contribution of Peek and Rosengren (1995) to identify the impact of the enforcement of the 1988 Basel CARs in emerging economies. Specifically, - we single out crisis countries in which the enforcement likely took place under - external pressures from the others. Section 4 describes the procedure adopted to select the sample of emerging economies and exposes our testing strategy. We present the econometric results in Section 5, while Section 6 concludes.

2
# 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).

3
banking system to play its normal role in the transmission of the monetary policy stimulus would have prevented the economy from responding to sizable interest rate cuts.

According to the definition proposed by the Council of Economic Advisors (1991), a credit crunch is "a situation in which the supply of credit is restricted below the range usually identified with prevailing market interest rates and the profitability of - investment projects". Various reasons surveyed in Bernanke and Gertler (1995) and - Hubbard (1995) account for banks' desire to retrench their loan supply following a monetary tightening or some other negative shock to the economy. It is argued that the introduction of the Basel Committee capital standards, induced a credit crunch by making loans more costly to hold for banks than government securities.<sup>5</sup> Various authors, using different methodologies, have contributed to this interpretation. Some of the relevant papers have used cross-sectional bank-level data. Bernanke and Lown (1991) show that loan growth at individual banks between 1990:Q2 and 1991:Q1 was positively linked to initial capital ratios. Peek and Rosengren (1995) introduce an influential method to address the issue of identification of supply-induced effects. Namely, they argue that capital-unconstrained banks should react to negative shocks to capital by intensifying deposit taking, thus, when banks are not capitalconstrained, one should expect a negative relationship between shocks to capital and deposit taking. On the contrary, they find a positive link between shocks to capital and the dynamics of deposits in 1990. They conclude this evidence suggests that the capital constraints for banks were pervasive as the Basel Committee ratios were phased in and, indeed, show that this impact is larger for banks having lower initial capital ratios. Berger and Udell (1994) concur that the expansion of loans was lower in 1990-92 for lesscapitalized banks, but do not detect a sensitivity of loan expansion to capital ratios higher than the one observed during the recession of the early 1980s. All in all, most contributions published on the issue6 support the hypothesis that the capital crunch adversely affected loan expansion in the US at the beginning of the 1990s.

Another episode that has received attention as one in which a capital crunch was likely refers to the Scandinavian countries' banking crisis of the early 1990s. At the beginning of the 1990s Scandinavian banks were heavily exposed to the sharp economic recession and suffered significant loan losses and decreased profitability. Bank capital became scarcer not only because of the events above but also because stricter capital requirements were introduced in response by regulators in order to implement European prudential standards. Applying to the three Scandinavian countries the methodology proposed by Peek and Rosengren (1995), Minetti (1998) finds support for the hypothesis of a capital crunch for Norway and Sweden but not for Finland. In particular, for Norway - and Sweden he detects a positive relationship and not a negative one as it should have S Following the 1988 Basel Committee rules, loans to the private sector require the bank to post a minimum of 8% in qualifying capital equivalent, whereas credits on the State sector bear a zero requirement. In the US, Basel Committee capital standards were formally approved in 1989 and phased in at the end of 1990. **6** A notable exception is Sharpe (1995), who presents a survey of this literature and a critical review of its research findings. He argues that the evidence in favor of a capital crunch is far from conclusive, the only exception being the evidence for banking in New England where the support for the capital crunch is reasonably firm.

4
- been the case if banks were not capital-constrained between capital shocks and the dynamics of deposits.<sup>7</sup>

The link between bank capital standards and banks' loan supply came again under investigation in assessing the Japanese and East Asian crisis. According to many studies, in Japan the fragility of the banking system was a major culprit behind the persistent crisis - or lack of recovery - the country experienced through the 1990s. The hypothesis of a capital crunch is also frequently cited as a possible explanation for the retrenchment in lending by Japanese banks, in light of both the increasing burden of nonperforming loans (NPLs) and of the fact that Japanese authorities have paid more and more attention to Basel Committee CARs. Woo (1999) addresses the capital crunch issue on a cross-section of Japanese banks, using the methodology put forth by Peek and Rosengren (1995). Although he does not find similar results for the previous years, the evidence reported supports the capital crunch hypothesis for 1997, possibly the year in which the enforcement of capital adequacy was stiffened the most. Regarding East Asian crisis countries, it has been noted that, in response to the crisis, all of them adopted measures to strengthen bank capital adequacy enforcement. Some authors have claimed that this contributed - at least partly - to the East Asian credit crunch (Ding, Domac and Ferri, 1998; Ito and Pereira da Silva, 1999). Ferri and Kang (1999) address this issue for Korea, an interesting country to study since the decision to stiffen capital requirements was enacted by Korean regulators immediately upon the inception of the crisis. Once more, applying to Korean banks the methodology put forth by Peek and Rosengren (1995) and controlling for each bank's share of bad loans, they find a positive and significant link between shocks to capital and the expansion of deposits. They also show that those banks suffering from larger negative capital shocks experienced a more marked slow-down in the expansion of loans and increased more their lending rates. Thus, curtailing credit expansion could be the result of intensified credit rationing and/or of stiffer lending rates.

On the theoretical ground, Holmstrom and Tirole (1997) develop a model, which provides a rationale for applying looser banking norms in recessions. In a model in which agents both in the real and in the financial sector may be capital constrained, Holmstrom and Tirole reach the conclusion that intermediaries should satisfy market-determined capital adequacy ratios but these ratios should be pro-cyclical, i.e. higher during expansions and lower during recessions.8

> 7 Minetti's lack of evidence of a capital crunch for Finland is consistent with the results of Vihriiala (1997), who also concurs on this finding.

8 Some authors even question the idea that enforcing increased capital standards would provide the proper incentives for banks to reach a more efficient allocation of credit. For instance, Hellman, Murdoch and Stiglitz (1999) argue that the net worth of a bank consists of two components. On the one hand stands the easily measurable bank's paid in capital. On the other hand, the bank possesses a hardly measurable "goodwill" capital, stemming from its "informational capital" on borrowers accumulated through the effective but costly screening and monitoring of those borrowers. They argue that enforcing increased capital standards will lead banks to rely more on the paid in capital component to the detriment of the "informational capital" component. Accordingly, they show that enforcing increased capital standards may induce banks to "under-invest" in their screening and monitoring of borrowers, thus leading to a worsening - rather than an improvement - in the allocation of credit.

_5_
A comprehensive paper by the Basel Comnmittee on Banking Supervision (1999a) surveys the evidence for G-10 countries on the response of banks to the introduction and enforcement of the 1988 CARs. The paper's main findings are that "there is some evidence that bank capital pressures during cyclical downturns in the US and Japan may have limited bank lending in those periods and contributed to the economic weakness in some macroeconomic sectors". However, the report argues that for G-10 countries these effects "may well have reflected both regulatory and market pressures on banks to maintain ratios at least as high as minimum."<sup>9</sup> In a recent analysis, the Basel Committee on Banking Supervision (2000) has argued that - other things being equal - risksensitive capital requirements tend to increase the pro-cyclical nature of capital ratios and this, therefore, may exert an impact on the macroeconomic cycle. The analysis goes on to note that although the empirical evidence for developed countries - as already mentioned - is mixed, the relevance of the impact is likely to be highly dependent on historical and institutional factors and, more specifically, on the presence of an important bank credit channel in the economy.

Besides the possible impact of the introduction of bank CARs outlined above, there is one additional issue of specific relevance to emerging economies. Specifically, we contemplate the hypothesis that the impact of this regulatory restriction could be smaller if the ownership of the domestic bank is in a Western country.'" There are various reasons why we could _ex ante_ expect this to be the case. First, a significant entry of foreign banks may not only improve the efficiency of the recipient domestic banking market (e.g. Claessens, Demirgug-Kunt, and Huizinga, 1998; Clarke, Cull, D'Amato, and1 Molinari, 1999), but also stimulate sounder banking practices and, thus, render the domestic banking system more resilient to negative shocks. Second, foreign banks can perform a "stabilizing" role in emerging economies: to the extent that the local domestic market is not the bulk of their business, it is unlikely that a local negative shock will precipitate a systemic crisis for foreign banks." Accordingly, in the face of a major snock, a large share of foreign banks might partially offset "lending channel" detrimental effects" vis-a-vis a situation in which only national banks lend in the domestic market.'<sup>3</sup> Third, a significant presence of foreign banks might reduce direct 9 Basel Committee on Banking Supervision (1999a), p. 2.

'° We exclude Japanese ownership because the Japanese crisis largely coincided with the period of observation - the 1990s - thus making it a possible further source of instability rather than a stabilizing factor (Peek and Rosengren, 1997).

11 Demirgu,c-Kunt, Levine, and Min (1998) have explored the link between foreign bank entry and occurrence of currency/financial crises in emerging economies. They find that increased foreign bank presence lowers the probability of systemic banking crises. However, we must distinguish between foreign banking in emerging economies carried out in the retail domestic market and international banking in emerging economies of the wholesale type. Whereas the former may generally act as a "stabilizing" factor, the latter may be a "de-stabilizing" factor: e.g. Peek and Rosengren (1998) argue that Japanese banks' curtailed wholesale international lending to South-East Asia contributed to the crisis.

**12** Obviously, this role of foreign banks in offsetting domestic lending channel effects should not be exaggerated. To the extent that foreign banks tend to lend mostly to the top tier of domestic borrowers, when the shock hits, it will be impossible for them to reach out to smaller businesses with which they didn't have previous relations.

**'3** An additional reason according to which the presence of foreign banks may be stabilizing applies to countries that, having adopted a currency board, are impaired at providing lending of last resort to illiquid

6
capital flights when the shock occurs: depositors who perceive the heightened risk of domestic banks can flee to foreign banks in the domestic market rather than fleeing abroad. Moreover, if the banking crisis and the currency crisis are compounded, foreign banks are the most convenient way to "dollarize" domestic deposits.'<sup>4</sup> Fourth, to the extent that domestic monetary/financial authorities have accepted a significant presence of foreign banks, they have "tied their hands" in the sense that it is much more difficult for them to distort the allocation of credit or extract regulatory rents from the banking system (Kane, 1998; 1999). In turn, a large presence of foreign banks is a potent reassuring signal.

# 3. **Testing hypotheses and methodology**

In choosing our econometric approach we were aware of the well-known problem of identifying supply-driven contractions in intermediation. As we underscored above, in fact, such contractions may also stem from demand determninants. Accordingly, our results would be hardly interpretable if our approach didn't pay enough attention to the identification issue. In view of this, the methodology we follow in our econometric analysis is the one proposed by Peek and Rosengren (1995). The Peek and Rosengren framework can be easily generalized in order to model the effect that changes in capital regulation might have caused on deposits and loans of banks operating in emerging economies. In particular, capital shortages in the banks included in our sample may have derived from two sources: the first stems from loan losses, which forced banks to write down capital; the second is due to changes in regulation which raised banks' capital ratio.

In order to derive the implications of the two sources of shocks it is useful to refer to the following simplified version of the banks' balance sheet: _D + (RK + EK) _ D+TK = L + B_ **_(1)_** where D = Deposits, _RK =_ Regulatory Capital, _EK =_ Excess Capital, _TK=_ Total Capital, _L_ = Loans, and B = Bonds.

We also assume that capital regulation is defined by the leverage ratio: and that supply determined loans can be expressed as From equations (1) and (2) we obtain the following expression for deposits: _D=L+B-(RK+EK) =RK/k-RK-EK+B_ which by total differentiation becomes: banks (Caprio, Dooley, Leipziger, and Walsh, 1996). In such a situation, at least theoretically, foreign banks could obtain liquidity from their mother country's central bank.

> 14 Some hold that dollarization - the extreme form of currency substitution - would help defuse the problem of sudden stops and reversal in capital inflows which so often precipitate the twin crises (Calvo, and Reinhart, 1999). In fact, it is argued, explicit dollarization would avoid in emerging economies the build-up of currency mismatches, which trigger financial sector crises when capital inflows come to a sudden stop.

7
_dD = ((llk)-1)dRK_ + _(RK)d(1lk) - dEK + dB_ _(4)_ _(5)_ As a matter of completeness, we further assume that banks do not wish to change their bond holdings _(dB =_ 0). Then we can also totally differentiate the expression (3) for loans and have:

# _dL = (/k)dRK + RKd(U/k)_

Both expressions (4) and (5) are discussed within three distinct scenarios:

1. the crisis case, when a negative shock to total capital affects bank lending and liabilities (i.e. _ATK<O);_

2. the regulatory restriction case, when a change in regulation raises the fixed minimum capital requirement (i.e. _Ak>O);_ 3. the case of crisis with regulatory restriction, when the regulatory restriction takes place during a financial crisis and the previous two impacts need to be considered simultaneously.

# **3.1 The crisis** case

It is easy to see from (4) that if the bank is capital constrained _(dEK_ = 0 and _dTK_ = _dRK),_ the impact of a decrease in capital (and in regulatory capital) determines an effect of equal sign (reduction) in deposits. Alternatively, if the bank is not capital constrained _(dRK = -dEK_ and _dTK =_ 0) the impact will be of opposite sign. This is the case considered by Peek and Rosengren that we shall label as the "crisis case".

Following Peek and Rosengren we have that:

|_1.1_|_4TK <_0|X|_ADI/TK >_0 if the bank is capital constrained.|
|---|---|---|---|
|_1.2_|_ATK_<0||_ADIATK_< 0 if the bank is not capital constrained.|
|_1.3_|_ATK <0_|_=>_|_AIJTK_<br>> 0 if the bank is capital constrained.|
|_1.4_|_ATK <0_|_=O_|_ALIATK_= 0 if the bank is not capital constrained.|

A direct implementation of these results (see Peek and Rosengren, 1995) is testing whether there is a positive correlation between a change in capital _(dTK)_ and in deposits (and/or loans).

# **3.2 The case of regulatory change**

Let's now consider the "regulatory case". Capital shortages may derive from an increase in capital ratio (here the leverage ratio k). If effective, this exogenous increase will cause a reduction in deposits of the constrained banks (since _dEK = 0)._ The impact on the unconstrained bank instead will be null, since there will only be a substitution of excess capital with regulatory capital _dEK = -RKx(dk1k).'_<sup>_5_</sup>

> **15** This expression can be derived substituting the relation, **dRK** = -dEK , which holds for unconstrained banks, in equation 4.

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_=_ Therefore in this second case we have that an increase in the capital ratio _(k KIL)_ has a clear-cut impact on deposits and loans whenever the bank is capital constrained:

- _2.1 dk >_ 0 X _dD_ < 0 if the bank is capital constrained.

- _2.2 dk >_ 0 > _dD_ = 0 if the bank is not capital constrained.

- _2.3 dk >_ 0 w _dL <_ 0 if the bank is capital constrained. _2.4 dk >_ 0 _dL_ = 0 if the bank is not capital constrained.

Note though that an increase in the capital ratio _(dk >_ 0) does not imply a predefined variation of total capital _TK._ Still, where banks are capital constrained and have limited asset alternative to loans, the presence of an idiosyncratic negative shock to capital should lead to a positive correlation between changes in capital and deposits (loans). In addition, the correlation becomes stronger with the increase of the leverage ratio (k).'<sup>6</sup>

# **3.3 The case of crisis with regulatory restriction**

We are now ready to consider the third case in which capital shortage may derive both from losses and from the introduction of a more restrictive capital regulation. If the bank is capital constrained _(dEK =_ 0) we shall have a cumulative effect driven by the capital reduction due to losses (lower deposits) and by a higher capital ratio (lower deposits). The impact on deposits of the negative shock on capital, foreseen by Peek and Rosengren, would therefore be reinforced. If the bank is not capital constrained then the cumulative effect should be similar to that foreseen by Peek and Rosengren. In fact the increase in regulatory capital would be absorbed by a compensating reduction in excess capital _(dEK = dRK)_ with no effects on deposits (eq. 2.2) while the negative shock to total capital would again be transmitted with a negative sign to deposits (eq. 1.2).

Looking at the loan side we can easily see that the increase in capital ratio _(k)_ (eq. 2.3) and the decrease in total capital _(TK)_ (eq. 1.3) will have a negative impact for capital constrained banks. The sum of the two effects in the "crisis" plus "regulatory tightening" is likely to have a magnified effect.

- _3.1 dTK_ <0 and _dk>>_ 0 _dD_ <0 if the bank is capital constrained.

- _3.2 dTK_ < 0 and _dk >_ 0 X _dD_ > 0 if the bank is not (enough) capital constrained."

- _3.3 dTK_ < 0 and _dk >0 > dL_ < 0 if the bank is capital constrained.

- _3.4 ATK_ < 0 and _dk >_ 0 _=* dL_ = 0 if the bank is not (enough) capital constrained.

Therefore, when a regulatory restriction is enforced during a financial crisis, it is less likely that we find a negative correlation between changes in capital and changes in

> 16 From equation (4) we can observe that for a capital constrained banks (i.e. when _dTK=dRK) dD/dTK>O if dTKI7K < (I(4-k))4d(kYk)._

> 7 Note that _dD>O_ iff _dEK>-RKx (dk)._

9
deposits (loans). This would only materialize for banks not (enough) capital constrained, either being well capitalized or undergoing smaller negative capital shocks.

# **4. Sample selection and testing strategy**

We have just shown the impact of a regulatory change under the latter two scenarios and have seen that a regulatory restriction can only reinforce the effect of a crisis on deposits and lending. In turn, this might have as well a detrimental effect on the supply of credit if exercised in a stable economy. The next step is to test those theoretical hypotheses on a sample of banks operating in emerging economies. Although in principle interesting, we disregard the first hypothesis, i.e. the crisis case, given the sufficient evidence already provided in the literature.

In particular, we need to identify those emerging economies in which capital requirements were not only subject to increase, but the increase was also enforced. It is a matter of fact that national regulators had a certain leeway in the effective enforcement of bank CARs. As a result, enforcement didn't always follow the introduction of the 1988 Basel CARs. This was the case especially in countries where the supervisory authority lacked the necessary strength and independence.

In order to identify the emerging economies where bank CARs were effectively enforced, we made an extensive survey of the collection of the IMF Article IV Consultation documents, considering all the reports from the last decade for a large selection of emerging economies. These documents offered us an independent and well informed assessment of whether and when enforcement had followed the introduction of the 1988 Basel CARs.

In these documents we looked for a number of indicators of a more rigorous stance on the part of bank supervisory authorities. Among them, we considered: i) a more severe approach to provisioning practices (e.g. the introduction of more restrictive criteria in the definition of non-performing loans or more stringent provisioning requirements); ii) changes in the bankruptcy regulation; iii) the implementation of bank restructuring programs and/or reorganization of bank supervisory agencies.

On the basis of these indicators we detected 16 countries in which the introduction or the revision of capital requirements was accompanied by measures of more effective supervision. For each of them we have also identified the year in which these measures were taken. This group includes 10 countries in which the regulatory change happened in conjunction with an exchange rate and/or financial crisis (Argentina, Brazil, Hungary, Korea, Malaysia, Mexico, Paraguay, Thailand, Turkey, and Venezuela)'<sup>8</sup> and other 5 non-crisis countries (Chile, Costa Rica, India, Poland, and Slovenia). A sixth non-crisis country (Morocco) had to be eliminated due to the lack of data on bank loans and deposits associated to different accounting procedures of Islamic banking. We also contemplated the possibility of different degrees of enforcement, identifying a subset of

> _18_ We identified crisis countries according to the two lists provided in Detragiache and Demirguc,-Kunt (1998) and Kaminsky and Reinhart (1999). Hungary was added to such a list, since it did undergo a crisis even though it was not highlighted by the two referred studies, which did not consider transition economies. Furthermnore, we did not include India among crisis countries since its banking crisis occurred a few years before India enforced Basel CARs.

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10 countries for which the evidence of enforcement is more convincing. In this latter group the crisis countries were 8 and the non-crisis 2. A more detailed description of the change in legislation occurred in each country and the year of enforcement is contained in Table 1 (for crisis countries), in Table 2 (for non-crisis countries), and in Table 3 (for countries that were considered but not included due to lack of evidence).

On the basis of the 15 selected countries we then verified the number of banks for which we have (from Bankscope) the balance sheet/profit and loss accounts in the years which precede and follow the enforcement date, as required for the empirical analysis. In the 15 countries previously listed we were able to select 572 banks (426 for crisis countries and 146 for non-crisis countries). Table 4 contains the sample composition by country, including also additional information on: (i) the percentage of banks with foreign ownership in Western countries; (ii) the percentage of banks that were undercapitalized in the pre-enforcement year; and (iii) the percentage of banks suffering an asset reduction either at year t or at year (t+l) or at year (t+2). The largest percentage of banks included in the sample are Brazilian and Indian, the smallest those of Venezuela and Slovenia. India is also the country with the lowest foreign presence in the banking sector (only 4%). Since Indian banks account for almost half of non-crisis countries' banks this helps explain why Western ownership is on average larger in crisis than in non-crisis countries. Venezuela had the largest percentage both of undercapitalized banks and of banks suffering an asset reduction either in the year of enforcement or in the following two years. On average, the percentage of banks experiencing an asset reduction with the enforcement is almost twice as large in crisis than in non-crisis countries.

The specific international composition of our sample might well affect the empirical results, although we will control for this problem as accurately as possible. Still, it is not an easy task to disentangle the effect of the enforcement of CARs in emerging economies, especially for those economies contemporaneously experiencing a financial crisis. In Section 3 we pointed out a transmission mechanism caused by a financial tightening and/or a regulatory shock, originating from a contraction in assets and especially affecting capital constrained banks. In Table 4 column 3 we make an attempt to evaluate the potentially capital constrained banks in our sample; we do this by computing the percentage of banks with CARs lower than the sample median by country, at the year preceding the enforcement. This proxy is the best we could find, given the limited information available on CARs regulation by country, especially before the enforcement. An alternative and indirect measure is provided in the last column of Table 4, reporting the percentage of banks with a drop in assets occurring the years immediately following the enforcement. As expected, such percentage is higher in crisis countries, whereas the share of undercapitalized banks is analogous between non-crisis and crisis countries.

Table 5 (for crisis countries) and Table 6 (for non crisis countries) provide an overview of the trend in the most important variables for our study: they report by country the percentage change in assets, equities, loans and deposits occurring the year before the enforcement, the year of enforcement and over the two years after the enforcement. Furthermore, the two tables also show the evolution of the equity/asset ratio. Data in the tables were computed on a restricted sample excluding Western owned

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banks; however, the values presented in each column are not strictly comparable, due to missing observations.

At a first glance, the capital asset ratio in all countries does not seem on average to have raised following the change in regulation. There are a few exceptions, as Argentina, Paraguay or Turkey. Moreover, in countries like Venezuela, Thailand, Malaysia, Korea or Brazil, where crises were deeper, we found on average a substantial drop in assets, loans and/or equity. In general, there is no clear-cut evidence that equity increased (at an accelerated pace) with the regulatory restriction in most countries. In some countries the data show that (the rate of growth of) loans declined even significantly.

Table 6, concerning non-crisis countries, shows a less clear trend. During the change in regulation two countries out of five, namely Poland and Slovenia, reported a drop in the average level of equity, or of deposits and loans.

Nevertheless, the informational content of these descriptive statistics should not be overstated. Indeed, because of the international and intertemporal composition of our sample the descriptive statistics used so far are not informative enough and one needs to move to the empirical estimation in order to control for potential heterogeneity. Our testing procedure is based on the construction of an international panel whose observations are centered on the year of enforcement. The panel we managed to assemble is an unbalanced one since: (i) there are some missing observations across time, and (ii) the available time length varies by country. The construction of a panel is justified by the fact that the announcement of the change in regulation might have occurred at any time during the year (for instance in Venezuela and Brazil it was in June, in Paraguay in December). In general, we expect not to be able to capture the enforcement effect in the same year. It might instead be spread also over the following years.

In order to test for the effect on deposits and loans of a shock to CARs, we use the Peek and Rosengren (1995) approach, but with some adjustment specifically tailored to our case. We do take into account explicitly the international and inter-temporal dimensions of our sample, by means of panel analysis and by including control variables for year and macro-economic effects. We estimate the two following regressions: In (6) and (7) the variables _ATK,_ **_AD, AL_** are normalized by the beginning of period assets. The effect of a change in total capital on **_AD_** or AL is captured by the 12
estimates of the a2 and b2 parameters. The a2 parameter, which defines the relationship between changes of bank deposits and changes of bank capital, reveals the presence (if positive) of a capital crunch. As shown in Section 3.3, such an impact is expected to decrease with the level of banks' initial leverage ratio (capital over total assets), since higher capital requirements should have a stronger impact on undercapitalized banks. This effect is identified by a3 and b3 parameters, provided that potential demand side shocks are controlled for by the logarithm of total assets (Log(A)), and country/time varying effects are captured by the vector of macro variables X. Vector X includes real GDP growth, the local exchange rate as currency units per US dollar and the local nominal interest rate.<sup>19</sup> The vector DyTincludes year dummies, having as reference category the year preceding the enforcement. Both regressions include a full set of bank fixed effects **_Pb_** and normal i.i.d. random errors, **_ED ,EL_** respectively.

This methodology can be applied straightforwardly to banks in crisis countries. Indeed, in crisis countries banks normally suffer macro negative shocks to their capital. Our expectation is that not only _AUL/A_ will be positively related to the change in banks' capital endowment, but also _AD/A_ will exhibit the same feature. Should we obtain this result, we will be able to claim that the capital constraints associated with the enforcement of the CARs did shrink bank intermediation, thus further reducing the supply of credit. Such a result should be reinforced where the negative impact of a crisis on bank capital has been strengthened by a more severe enforcement discipline. Typically we would expect the effect of the change in capital to be smaller for banks which have higher initial leverage ratios (i.e. Capital/Total assets). Correspondingly, we expect the estimates of the a3 and b3 coefficients to be negative, proving that the effect of the change in capital decreases when the ratio of capital over total assets increases.

Due to the panel structure of regressions (6) and (7), we cannot expect to catch the specific effects associated to undercapitalized banks or banks owned by foreign Western investors by means of specific dummies. For this reason we have integrated our panel estimations with cross section regressions, where banks' fixed effects have been replaced by the control variables _Dlow_ and _Djb._ The first variable regards undercapitalized banks suffering a drop in total assets (here the dummy _Dlow_ = 1)2 which represent 35% of the crisis-sample banks (Table 4). The second variable concerns banks that are owned by foreign Western investors (here the dummy Djb = 1), which represent one fourth of our sample (Table 4). For the reasons outlined above, these banks may cope better with the regulatory restriction.

The methodology embedded in equation (6) and (7) does not deliver equally clear results for non-crisis countries. There is, in fact, no guarantee that negative capital shocks will prevail for banks in countries that are enforcing CARs during a non-crisis period. Any attempt to select banks exposed to negative capital shocks falls into a small sample problem, given that the non crisis sample includes 146 banks, only 37.5% of which has

> 19 Source: International Financial Statistics by the IMF.

> 2 0 The dummy _Diow_ takes the value 1 if the bank has a capital asset ratio lower than the country median the year before the enforcement, 0 otherwise.

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experienced asset contractions concurrent with regulatory changes.<sup>2</sup> ' Following the discussion in Section 3.2, that suggests that the impact of the regulatory change should be more easily identifiable for undercapitalized banks, we have chosen to evaluate the effect of changes in bank capital on deposits and loans for banks with low initial capital. Indeed, the sub-sample of low capitalized banks selects banks supposedly forced to reduce their assets to meet their CAR obligations. Therefore, we have dropped the variable related to the level of initial capitalization from equations (6) and (7) to obtain equations (8) and (9), which represent the specification chosen for the non-crisis countries case. A positive correlation between changes in deposits and loans and changes in capital should be expected for capital constrained banks that experience an idiosyncratic negative capital shock.

Finally, it is worth stating that both sets of equations (6)-(7) and (8)-(9) are reduced forms of the systems exposed in Section 3. In our reduced forms, the impact on deposits and loans of a change in CAR regulations will be indirectly estimated only through the effect of the change in total capital.

# **5. The empirical analysis: Main results**

# **5.1 Testing the crisis with regulatory change hypothesis**

The empirical estimates of equations (6) and (7) for banks in crisis countries are reported in Table 7. The results are obtained by means of panel analysis, controlling for bank fixed effects and for country trends in both the financial and the real sector.

The effects of changes in capital on both the change in deposits and the change in loans are strong and consistent with the theory. As predicted by the theoretical analysis of the crisis case with regulatory enforcement, changes in deposits and in loans are positively affected by changes in capital. The a2 parameter in the deposit regression is positive and strongly significant. This result has also been checked for robustness by repeating the estimation over the sub-sample of banks that have experienced a drop in total assets either in the year of the enforcement or within the following two years, in

> 21 Were it feasible to regress equations (6) and (7) above separately for the two classes of banks, we would expect that a2 and _b2_ be insignificant for unconstrained banks but significant - and positive - for constrained banks. Alternatively, we would expect that a2 and _b2_ be significant for both classes but their size be smaller for unconstrained than for constrained banks.

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order to verify that the estimated coefficients are not driven by positive changes of both capital and deposits.<sup>2 2</sup> Both deposits and loans grow at a higher pace for larger banks (the positive and significant effect of log(A)). This seems consistent with the Too Big To Fail hypothesis, according to which, conscious that the risk of closure during the crisis is lower for larger institutions, depositors move their deposits to larger banks. Note that in both regressions the time dummies, having as reference category the year prior to the enforcement, are all negative but insignificant. This result suggests that the negative impact of the regulatory change is most virulent at first and then decays. However, to the extent that its impact continues (and the cross-section results below support this), it spans also to the year following the enforcement and it seems to have a systemic nature. As regards our economic fundamental controls, only the growth in GDP shows significant positive effects in the deposit equation.

To check for the robustness of our results, in addition to the panel, we report in Tables 8 and 9 the cross-section OLS estimates of equations (6) and (7) restricted to the year of the enforcement and the year thereafter. As already mentioned, the cross-section - regressions allow us to identify two further potential effects namely, the differential impacts for initially less capitalized banks and for banks under foreign (Western) - ownership that could not be addressed in the panel with bank level fixed effects. The evidence found is consistent with previous results. In the deposit equation, the effect of the slow down in capital accumulation is still strongly significant in the years t and _t+1._ Both deposits and loans grow less at initially less capitalized banks - _dlow_ = 1 - but the difference is not significant at the usual levels, probably due to the concurrent effect of the variable expressing bank capital in levels. As regards foreign owned banks, their deposits and loans generally grow above average and the difference is significant at the 1% level at time t+l. Thus, we detect some evidence that foreign owned banks were less exposed to the negative effects of a capital crunch..

# 5.2 Testing **the regulatory change hypothesis**

The theoretical analysis discussed in Section 3 found that even when exerted in a stable economy, the enforcement of capital asset requirements can curtail credit supply, particularly if less-well capitalized banks are the main source of financial intermediation. Thus, in spite of the small sample problems, we restricted our tests to undercapitalized banks. In so doing, our sample drops from the original 146 to 63 non-crisis countries' banks. Furthermore, differently from the crisis countries' panel, the non-crisis countries' panel has been focused on t and t+1. For crisis countries, in fact, it is likely that the 22 For robustness, we have repeated our estimations over two sub-samples. First, the sub-sample of the (some 700) crisis countries' banks experiencing a drop in total asset either in the year of enforcement or within the following two years. Second, the sub-sample of banks located in those crisis countries where the supporting evidence of the regulatory enforcement was particularly strong.. In both cases the results were very similar to those in Table 7. They have not been reported in order to limit the number of tables but are available from the authors upon request.

23 Bongini, Claessens, and Ferri (2000) find evidence of Too Big To Fail policies pursued by national authorities in East Asian crisis countries.

24 We need however to state a caveat. We cannot exclude that our result is driven by simultaneous business - - cycle effects possibly not adequately controlled by the macro variables included or simply by - differences in the sample composition due to the unbalanced nature of our panel.

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- perception of mounting financial sector weaknesses and/or balance of payments' problems (Kaminsky and Reinhart, 1999) - will generate anticipation of stricter regulation enforcement. Such presumption does not hold for non-crisis countries. Accordingly, our panel for non-crisis countries has 126 observations. As above, we estimate it via the fixed effect method.<sup>2 5</sup>

The empirical results of the panel analysis are contained in Table 10.26 Compared with the results of the crisis case, we find similar or even neater evidence. Both changes in deposits and loans are positively correlated with changes in capital and the estimated coefficients are even bigger than the ones in Table 7. For these countries the results of the loan equation are also likely to be more relevant. While in crisis countries the positive correlation between capital and loans can be affected by the concurrent cleaning of banking books that often takes places simultaneously with the enforcement of solvency regulation, this is less likely to be the case in non crisis countries. Even for non-crisis countries, larger banks fare better in terms of deposit and loan growth. Also in this case, GDP growth is the economiic fundamental variable with the largest impact on the dynamics of deposits and loans. The evidence for non-crisis countries seems therefore to confirm what we found for crisis countries and to provide more robust evidence of the relationship between capital and bank loans.

# **6. Conclusions**

This paper has provided new evidence on the effects that a stricter enforcement of minimum capital discipline can have on bank intermediation in less developed financial systems. In this respect, we have not limited our attention to the simple revision of capital ratios but have also considered those measures - e.g. improving accounting standards, adopting rigorous provisioning practices and more binding bankruptcy laws - which make capital requirement more sensitive to the change in the quality of banks' portfolios. - Our paper offers a clear support to the general presumption that the "capital crunch" the credit crunch associated to a stricter enforcement of bank capital regulation - is more pervasive in those countries where the credit channel is more important - i.e. where alternatives to bank credit are less developed.

Notwithstanding the general recognition that capital regulation may have different macroeconomic effects according to the divers institutional and developmental features of each economy, still we observe that bank capital regulation has not yet clearly addressed the distinct needs of less developed economies. More specifically, the proposal of a new Capital Accord set out by the Basel Committee in its recent Consultative paper is still largely focused on problems faced by more developed banking systems.

This paper contributes to the ongoing discussion on the new Capital Accord, stressing the fact that economies, which mostly rely on bank credit, may have to devote

> 25 It goes without saying that, for non-crisis countries, the possible differential effects for foreign banks is disregarded, since they were mostly well-capitalized.

> 26 To perform a robustness check we estimated equations (8) and (9) also for the sub-sample of banks experiencing a drop in total asset either in the year of enforcement or within the following two years. We do not report these results (that are available upon request) as they turned out to be very similar to the ones reported below for initially low capitalized banks.

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particular attention to the process of enforcement of a stricter bank capital discipline. The presence of different institutional constraints need not be read as an alibi for not modernizing capital regulation. It should instead motivate a timely revision of these constraints, on the part of the domestic authorities, and more differentiated regulatory options on the part of the international authorities setting regulatory standards.

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