The pro-cyclicality of capital ratios and credit supply, a tale of two sizes – Bank Underground

Mahmoud Fatouh

Small banks are likely to have extra specialised enterprise fashions, doubtless specializing in industrial and retail banking actions, and present restricted interconnectedness to different monetary establishments. Therefore, they’re prone to present much less intense cyclical patterns in comparison with giant banks. This publish investigates whether or not giant and small banks within the UK and US differ within the cyclical patterns of capital positions and credit score provision.

Introduction

Following the World Monetary Disaster, the Basel III reforms launched stricter capital necessities and bolstered them with cyclical parts (the capital conservation buffer and the countercyclical capital buffer). The reforms aimed to make sure that banks have adequate capital assets to soak up losses and scale back the cyclical results of financial institution capital (and regulation) on the provision of financial institution credit score in stress. The stricter and extra cycle-sensitive capital necessities ought to scale back the pro-cyclicality of financial institution capital positions as they discourage unsustainable credit score progress in credit score booms, and so restrict the necessity for deleveraging in stress.

Below Basel III reforms, systematically essential banks face stricter necessities. Small banks principally face regulatory necessities like these of bigger banks however profit from some exemptions that differ in scope between jurisdictions. Moreover, regulators in varied jurisdictions have been attempting to create easier (however not weaker) regulatory frameworks for small banks. Ideally, a framework for smaller banks would consider their easier and specialised enterprise fashions, the restricted monetary stability implications of their failure, and the disproportional compliance prices they face in comparison with bigger banks. For instance, the Financial institution of England is designing a ‘robust and easy’ regulatory regime for small banks with easier enterprise fashions.

Owing to easier enterprise mannequin and weaker interconnectedness, small banks must be much less delicate to cyclical fluctuations insofar as their credit score provide and capital positions must be much less pro-cyclical than bigger banks. On this publish, I examine this speculation and examine the implications of stricter cycle-sensitive capital necessities below Basel III for these cyclical patterns.

The information

I exploit bank-level information and GDP progress for the UK and the US. UK bank-level information comes from a confidential information set on the Financial institution of England and consists of monetary information on UK banks between 1990 and 2021. The information for US banks runs from 1979 to 2021 and was collected from a number of sources together with Refinitiv® Eikon, Capital IQ®, and printed monetary statements. GDP information was collected from the Workplace for Nationwide Statistics and FRED® for the UK and US respectively. Desk A consists of abstract statistics of the bank-level and GDP progress information. The purpose of getting a very long time collection is to have a pattern that covers no less than an enormous portion of a credit score cycle earlier than the introduction of the a lot stricter capital necessities by Basel III requirements in 2010. Stricter requirements would doubtless have an effect on the cyclical patterns of financial institution credit score and capital positions, probably lowering the validity of outcomes. Though capital requirements existed earlier than 2010, they have been considerably weaker. Such time collection can be utilized to reply two questions. First, analysing years as much as 2009 can be utilized to measure the cyclical patterns in a much less regulated atmosphere, offering proof on whether or not Basel III wanted cyclical parts. Second, increasing the evaluation past 2009 gives proof on whether or not Basel III addressed the pro-cyclicality of financial institution capital and lending.

Desk A: Abstract statistics

1: UK information (£ tens of millions)

Supply: Financial institution of England inside database.

2: US information (US$ tens of millions)

Sources: Refinitiv Eikon, S&P Capital IQ and printed monetary statements.

Empirical technique

With the intention to measure the cyclicality patterns of capital ratios and whole lending of banks and examine whether or not they differ between small and huge banks, I first categorise banks by dimension. For the UK, I exploit inside Financial institution of England classification of small and huge banks. In the meantime, for US banks, I outline small and huge banks as these within the lowest 80% and the best 5% of property distribution, respectively.

Following Fatouh and Giansante (2023), I measure cyclicality of a variable by the correlation between that variable and GDP progress. I estimate this correlation utilizing the next panel regression:

(1)

the place, β_i: financial institution fastened impact; Y_i,t, capital ratio (fairness to whole property) or log of whole lending of financial institution i at time t; X_i,t, a set of bank-level controls, together with whole property, capitalisation, and ratios reflecting enterprise mannequin (eg, loans to asset and deposits to liabilities); GDP_t, GDP progress price at time t.

Evaluation

I apply the mannequin in Equation 1 to small and huge banks individually on the bank-level to detect variations within the cyclical behaviour of capital ratios and whole lending. The outcomes of the regressions are introduced in Desk B.

Because the desk reveals, capital ratios of enormous banks have been positively correlated with GDP progress within the UK and US earlier than the introduction of Basel III in 2010. On common, a 1 share level fall in GDP progress was related to an 80 foundation factors and 61 foundation factors drop in capital ratios of enormous banks within the UK and US, respectively. In the meantime, capital ratios of small banks have been both not correlated (UK) or negatively correlated (US) with GDP progress.

Whole lending of enormous banks was pro-cyclical pre-Basel III, particularly within the UK. On common, a 1 share level fall in GDP progress was related to a 302 foundation factors and 71 foundation factors fall in whole lending of enormous banks within the UK and US, respectively. The full lending of small UK banks didn’t present cyclical patterns. Nevertheless, the full lending of small US banks was pro-cyclical, however considerably lower than that of enormous banks (11 foundation factors in comparison with 71 foundation factors for every 1 share level change in GDP progress).

Desk B: Regression outcomes for financial institution capital ratios and whole lending

1: UK banks (1990–2009)

Notes: Coefficient estimates of quarterly capital ratios and whole lending of UK banks between 1990 and 2009. Capital ratio is the same as fairness to whole property, and whole lending is the log of internet lending. Small and huge banks are outlined primarily based on inside Financial institution of England classifications. Normal errors reported between parentheses, * p<0.10 ** p<0.05 *** p<0.01.

2: US banks (1979–2009)

Notes: Coefficient estimates of quarterly capital ratios and whole lending of US banks between 1979 and 2009. Capital ratio is the same as fairness to whole property, and whole lending is the log of internet lending. Small and huge banks are these within the lowest 80% and the best 5% of property distribution, respectively. To make sure robustness of the outcomes, I additionally run regressions primarily based on completely different thresholds. Outcomes of the extra regressions are in step with the baseline outcomes. Normal errors reported between parentheses, * p<0.10 ** p<0.05 *** p<0.01.

In different phrases, the capital positions of enormous banks have been extra delicate to financial fluctuations than small banks in each the UK and US previous to Basel III. These developments in capital positions have an effect on the credit score provide of banks, relying on their dimension. Massive banks turn out to be comparatively capital-constrained in downturns, and therefore are likely to ration lending. The decrease cyclicality of small banks’ capital positions permits them to maintain their provide of credit score steadier over the cycle. However, as giant banks present most of financial institution credit score, mixture credit score crunches are anticipated, particularly in deep downturns.

Stricter capital necessities and cyclical parts (the capital conservation buffer and the countercyclical buffer) launched by Basel III ought to scale back the pro-cyclicality of enormous banks’ capital positions and provide credit score. To analyze this, I re-run the regressions above utilizing information units that reach past 2009. As Desk C reveals, the coefficient on GDP progress for giant banks falls from 80 foundation factors to 43 foundation factors (at a decrease significance stage) for UK banks, and from 61 foundation factors to 29 foundation factors for US banks. Outcomes for small banks’ capital ratios utilizing the prolonged pattern are in step with the baseline in Desk B.

Put up Basel III, the pro-cyclicality of whole lending of enormous banks fell from 301 foundation factors to 165 foundation factors for giant UK banks and 71 foundation factors to 49 foundation factors for giant US banks. The professional-cyclicality of whole lending of small US banks fell additional (11 foundation factors to five foundation factors) and remained nicely beneath that of enormous banks.

Desk C: Regression outcomes for financial institution capital ratios and whole lending; Basel III impression

1: UK banks (1990–2021)

Notes: Coefficient estimates of quarterly capital ratios and whole lending of UK banks between 1990 and 2009. Capital ratio is the same as fairness to whole property, and whole lending is the log of internet lending. Small and huge banks are outlined primarily based on inside Financial institution of England classifications. Normal errors reported between parentheses, * p<0.10 ** p<0.05 *** p<0.01.

2: US banks (1979–2020)

Notes: Coefficient estimates of quarterly capital ratios and whole lending of US banks between 1979 and 2009. Capital ratio is the same as fairness to whole property, and whole lending is the log of internet lending. Small and huge banks are these within the lowest 80% and the best 5% of property distribution, respectively. To make sure robustness of the outcomes, I additionally run regressions primarily based on completely different thresholds. Outcomes of the extra regressions are in step with the baseline outcomes. Normal errors reported between parentheses, * p<0.10 ** p<0.05 *** p<0.01.

In abstract, the capital positions and credit score provide have been clearly extra pro-cyclical for giant banks than small banks. The introduction of extra cycle-sensitive capital necessities below Basel III decreased variations between the 2 teams of banks. As such, it may be argued that the cycle-sensitive parts of capital necessities are simpler in lowering the pro-cyclicality of credit score provide of enormous banks (than small banks), as nicely the mixture provide of financial institution credit score, lowering the severity of credit score crunches in deep downturns.

Abstract

This publish assesses whether or not small banks’ whole lending and capital ratios present completely different cyclical patterns from bigger banks, and whether or not the introduction of stricter cycle-sensitive capital necessities below Basel III impacts these cyclical patterns. The evaluation makes use of information for small and huge banks within the UK and US. The empirical outcomes counsel that previous to Basel III reforms, capital positions and credit score provide of enormous banks have been far more pro-cyclical than small banks. The introduction of extra cycle-sensitive capital necessities below Basel III decreased capital and credit score provide pro-cyclicality for giant banks, whereas having smaller results for small banks. This means that the cycle-sensitive capital necessities are simpler in lowering the pro-cyclicality of credit score provide of enormous banks and lowering severity of credit score crunch in deep downturns.

Mahmoud Fatouh works within the Financial institution’s Prudential Framework Division.

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