This paper develops a model of endogenous bank funding-market conditions. A bank can attract more outside funding if it has more equity or offers the prospect of higher future profits. Banks consider equity costly and thus fund loans in part with outside funding. When bank loan losses reduce equity, then banks first increase outside funding. Where losses continue, bank funding conditions tighten and banks are forced to reduce outside funding. In such an event, banks are forced to decrease lending sharply and the economy experiences a financial crisis. I study banks' risk management and compare it with loan loss provisioning preferred by a regulator that internalises effects on bank future profits.
The paper highlights a fundamental inefficiency in economies with financial intermediation and presents novel implications for the cyclicality of bank capital regulation. So far, much attention has focused on inefficiently high bank risk-taking in the run-up to financial crises. In contrast, I focus on inefficiently low bank risk-taking during financial crises. The reason for the latter inefficiency is that a regulator can mitigate the risk of binding bank funding conditions by increasing a bank's future profits to offset decreases in bank equity.
The first main policy implication is that banks should build up capital buffers during normal times. The idea is to make banks more resilient to loan losses as a way of reducing ex ante the severity of financial crises and of lowering their frequency. Intuitively, a small reduction in loan supply during normal times - because of costly capital buffers - is traded off against a large reduction during times of financial crisis.
The second main policy implication is that banks should be given ample time to rebuild capital buffers following a financial crisis and that regulation should increase bank profitability in that process. The idea is to raise the prospect of future profitability during the financial crisis with a view to increasing a bank's access to outside funding and reducing ex post the severity of a financial crisis. Intuitively, a small reduction in loan supply during the recovery - because of temporarily elevated bank profit margins - is traded off against a large reduction during the financial crisis.
This paper studies optimal bank capital requirements in a model of endogenous bank funding conditions. I find that requirements should be higher during good times such that a macroprudential "buffer" is provided. However, whether banks can use buffers to maintain lending during a financial crisis depends on the capital requirement during the subsequent recovery. The reason is that a high requirement during the recovery lowers bank shareholder value during the crisis and thus creates funding-market pressure to use buffers for deleveraging rather than for maintaining lending. Therefore, buffers are useful if banks are not required to rebuild them quickly.
JEL classification: E13, E32, E44
Keywords: financial frictions, financial intermediation, regulation, counter-cyclical capital requirements, market discipline, access to funding
Read the full paper at: https://www.bis.org/publ/work771.htm