Regulatory capital, market capital and risk taking in international bank lending

Summary

To concentrate

When interest rates fall, banks tend to seek yield by issuing subprime loans. Yet the extent to which banks do this varies widely. What explains the differences between banks? One possible explanation concerns the differences in regulatory capital and market capital. Regulatory capital measures how close a bank is to crossing the regulatory capital threshold. Market-based capital measures the “skin in the game” available to a bank’s shareholders.

Contribution

We first show that regulatory capital and market capital differ considerably over time and between banks. We then use the syndicated loan data to examine whether and how each of the two measures of capital affects the impact of monetary policy on banks’ risk-taking.

Results

We find that low US interest rates are stimulating the issuance of risky US dollar international loans through two mechanisms. First, consistent with the existence of a “regulatory capital channel”, banks with higher levels of regulatory capital are more likely to make riskier loans when interest rates fall. Second, banks with low levels of market capital have a greater propensity to grant riskier loans in response to falling interest rates. This observation implies the existence of a market capital channel, which operates in the opposite direction to the regulatory capital channel.


Abstract

We study the links between US monetary policy, bank capital and risk taking in international bank lending. Using data on syndicated loans, we find that low US interest rates are stimulating the issuance of risky international dollar-denominated loans through two separate mechanisms. First, consistent with the existence of a regulatory capital channel, banks with higher levels of regulatory capital contract riskier loans when interest rates fall. Second, banks with low levels of market capital have a higher propensity to grant riskier loans in response to falling interest rates. This observation implies the existence of a market capital channel, which operates in the opposite direction to the regulatory capital channel.

JEL codes: G21, G32

Keywords: interest rate, bank capital, risk taking, international leveraged loans


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