Banking is one of the most regulated industries in the world. Among various regulatory measures, the regulation of bank capital is crucial due to the important role it plays in banks’ soundness and risk-taking behavior, and its influence on the competitiveness of banks. In practice, a key aspect of capital regulation is the calculation of minimum regulatory capital, which is typically based on the credit risk of bank assets.
A unified regulatory capital framework, which applied to all internationally active banks, was first introduced in 1988 by the Basel Committee on Banking Supervision (BCBS). It was commonly known as Basel I (BCBS 1988). However, the risk matrix was very simple in the sense that the risk weights were practically the same for bank loans of different risk. The low sensitivity arguably could have led to severe market distortions as banks swapped low-risk assets against high-risk ones with more favorable risk weighting (regulatory arbitrage). Reflecting this, in June 2004, the Basel Committee on Banking Supervision released a revision of the existing accord on capital regulation, known as Basel II (BCBS 2006). One of the most remarkable changes under the new framework was the introduction of a more risk-sensitive capital standard.
The transition toward a more risk-sensitive capital regime has generated the discussion on its implications for the banking industry. Two major concerns arise. First, it tends to cause substantial changes in the level of bank capital. The study of Ervin and Wilde (2001), which is based on a hypothetical bank portfolio in the United States in 1990, suggests that the minimum capital requirement could drop from 8 percent to 6.8 percent with the introduction of the risk-based capital rule. Similarly, a study conducted by U.S. federal regulators (OCC, FRB, FDIC, and OTS 2004) shows that the new capital rule will cause the minimum required risk-based capital (MRC), the sum of expected and unexpected losses, to drop on average by 12.5 percent.
Across entities, the changes in MRC vary substantially within a range of ?50 percent to 70 percent, with a median reduction of 24 percent. These results raise concerns that the introduction of the new capital standard may cause abrupt and undesirable changes to the banking industry. Second, the greater risk sensitivity in the new capital regime may cause additional volatility in economic activity, sometimes cited as the procyclicality problem. In particular, capital requirements can increase as the economy falls into recession and fall as the economy enters an expansion. The increase in capital requirements during the downswing may result in a credit crunch and thus worsen already adverse economic conditions. The empirical relevance of this concern was later confirmed in several countries, including the United States (Catarineu-Rabell, Jackson, and Tsomocos 2005; Gordy and Howells 2006; Jordan, Pek, and Rosengren 2003; Kashyap and Stein 2004), Spain (Corcostegui et al. 2002), and Mexico (Segoviano and Lowe 2002).
However, there are several major caveats in these studies, which suggest that the above conclusions are debatable. First, these studies focus exclusively on the change in regulatory capital. Nevertheless, in order to understand the impact of regulatory measures, it is more important to examine the change in banks’ actual capital holdings. A well-known fact is that most banks tend to hold a significant amount of capital above the regulatory requirement in practice, either for efficiency reasons or because the capital cushion is established as a precaution against contingencies (adverse events or regulatory penalties; see Barrios and Blanco 2003; Elizalde and Repullo 2006). The existence of capital buffers suggests that banks’ actual capital holdings may not change as remarkably as regulatory capital.
Equally important, if banks hold enough capital buffer during economic downturns, the procyclicality concern tends to be mitigated. Given its importance, the cyclical behavior of bank capital buffer has been investigated by many researchers, but so far the evidence has been mixed. Estrella (2004b), Heid (2005), Koopman, Lucas, and Klaassen (2005), and Peura and Jokivuolle (2004) suggest that the existence of capital buffers can potentially mitigate the volatility in total capital. By contrast, the empirical evidence in Germany (Stolz and Wedow 2005) and Spain (Ayuso, Pérez, and Saurina 2004) shows that capital buffers are also anticyclical; therefore, it is not clear whether actual capital holdings are more volatile than regulatory capital or vice versa.
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