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Effects of Basel III on Banks’Asset and

Funding Decisions

Jong-Ku Kang*

<Abstract>This paper analyses banks’ responses to the new banking regulation, Basel III, using a model for a representative bank’s optimization. Specifically, the effects of regulations on capital ratio, liquidity coverage ratio (LCR), leverage and deposit reserve requirements are considered. In the model the bank raises funds from both short and long term debt and capital, and its assets consist of loans and safe bonds. Strengthening capital regulations or liquidity regulations tends to reduce the share of loans in bank assets, while strengthening leverage regulations or deposit reserve requirements raises its loan share. The effect of capital regulations on bank loans declines during a boom period and it is likely to be large for those banks whose costs of raising capital are high. Strengthening capital regulations increases the share of short term debt in banks’ liabilities, while tightening other regulations decreases the share of short term debts. It is also found that macro-prudential regulations have a complementary relationship among themselves and macro-prudential regulations tend to weaken the effect of monetary policy on bank lending.

Key words: Macro-prudential regulation, Basel III, Monetary policyJEL classification: G28, E52, G21 * Bank of Korea (Tel:02-750-6610, jongku@bok.or.kr)

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I. Introduction

It is expected that strengthening the Basel III regulations on capital, liquidity and leverage affects the stability of financial systems and macro economies by way of changes in banks’ behavior. Tightening macro-prudential policies, such as the Basel III capital regulations, will have an influence on the macro economy through changes in bank lending. These changes in bank lending may differ depending on the bank business environments. Banks may change asset and liability structures in response to augmented banking regulations, resulting in unexpected consequences to financial markets and systemic stability. For instance, banks may reduce lending in response to enhanced capital regulation and the extent of the decrease in loans may vary depending on the business cycle and banks’ creditworthiness. Stepping up macro-prudential policy could have an impact on the effectiveness of monetary policy and change the way monetary policy is operated optimally. Meanwhile, it is difficult to find comprehensive studies on the effects of financial regulations on banks’ behavior as most previous studies have focused on the effects on a few aspects of it.

This paper analyses a representative bank’s behavior following the heightening of the Basel III capital, liquidity (LCR), leverage regulation and the deposit reserve requirement. Implications for financial stability have been derived from the result of the analysis.

II. Studies on the effects of financial regulations

Before the global financial crisis in 2008, most studies on financial regulations dealt with the issue of effects of capital regulation on banks’ asset soundness and default risks. Kim and Santomero (1988) established a two-period model to analyse the effect of bank capital regulation on the riskiness of bank assets. In the model, a

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representative bank funds from deposits and capital and it has two types of assets: risky and safe assets. The return on assets and cost of funding are exogenously determined. They concluded that the share of high risk assets can increase when the capital regulation is tightened, and thus it is desirable for policy makers to assign different risk weights to different types of assets. Rochet (1992) set up a similar model to Kim and Santomero (1988) except that the cost of deposit funding is an increasing function of the deposit amount. He suggests that as bank owners are protected by ‘limited liability’, a decrease in bank capital may induce a rise in the riskiness of bank assets and the probability of bank default.

Since the global financial crisis, a number of researches have been carried out to analyse the effects of Basel III capital regulation on bank loan interest rates and economic growth. Among the research studies are King (2010), Elliott (2011), BIS Macroeconomic Assessment Group (2011), OECD (2011), and Chun Kim Ko (2012). • •These studies evaluate the impact of a rise in loan interest rates caused by Basel III introduction on economic growth. They estimated the level of loan interest rate required to keep ROE unchanged after strengthening of the Basel III capital regulation. The results of analysis reveal that the impact would be large in emerging economies while it would be relatively small in advanced economies. Meanwhile, Cosimano and Hakura (2011) carried out an empirical estimation using the GMM method and they found that the impact of capital regulation would vary depending on each country’s cost of raising capital and the slope of the loan demand curve. Using a DSGE model, Angelini and Gerali (2012) analysed the impact of capital regulation on bank loans and deposit size, interest rates, investment, and gross domestic production. They argued that though tightening of capital regulations could significantly affect the real economy, their gradual introduction would lessen the negative impact.

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As compared to capital regulation, the effects of liquidity regulation had not been analysed extensively until the global financial crisis. More recently, however, a few research studies on the impact of the Basel III LCR (liquidity coverage ratio) regulation have been carried out. Bech and Keister (2013), after conducting an analysis using a theoretical model, proposed that the LCR regulation could bring about falling call market interest rates and the steepening of the yield curve. Bonner and Eijffinger (2013) carried out an empirical analysis using the Dutch data and found that banks with a lower LCR tend to have higher leverage and less capital. Nicolò, Gamba and Lucchetta (2012) analysed the effects of bank regulations using a dynamic model in which the return on loans is endogenously determined. They proposed that bank lending would have an inverse-U shape relationship with capital regulation changes, while liquidity regulation tightening would bring about a decrease in bank loans.

The model in this paper allows returns on bank lending and safe securities, costs of short and long term debt, and capital all to change endogenously. This assumption is made to reflect banks’ behavior in a monopolistic competitive market. As a change in bank regulations is applied to all relevant banks, it will bring about changes in market interest rates as well. Thus, it would be more appropriate to allow interest rates to be determined endogenously after regulatory tightening. Previous studies including Kim and Santomero (1988), Rochet (1992), Nicolò, Gamba and Lucchetta (2012), and Bech and Keister (2013) assumed either that only one interest rate could move or that no interest rate could change. Another distinctive assumption in this paper is that banks optimize their portfolio considering the volatility of the expected profit as well as its level. Thus, risk averse banks’ behavior is directly incorporated in this model.

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III. A model for banks’ behavior

In this model, at time t, a representative bank raises funds through short and long term debts and capital, and then constructs an asset portfolio with loans and safe bonds. When the returns on assets are determined at time t+1, the bank receives profit that is the difference between asset income and funding cost. The bank runs its businesses in a monopolistic competitive market, and thus its returns on assets are downward sloping and costs of funding are upward sloping. The bank notices that returns on loans and safe assets decrease when it expands those assets. And when the bank seeks more funding, it needs to give higher interest rates and yields to depositors and equity investors. Let and be the amounts of bank loans and safe bonds, and , and be the amounts of short term debt, long term debt and capital, respectively. Then, the equality condition for the bank’s balance sheet can be expressed as . Here, the capital ratio regulation implies the relationship of ≥ , and the liquidity coverage ratio regulation (LCR) the relation of ≥ . Let , , , , and be the rate of return on loans, that on safe bonds, and the costs of raising short term debt, long term debt and capital, respectively. Then, the bank’s expected profit ( ) can be expressed as the following equation (1). (1)

The values of and are not known to the bank as of time t: the rate of return on loans () is uncertain when the lending decision is made at time t. Short term debt () has a maturity of less than one period and it needs to be refinanced during the period from time t to t+1. This makes the period average cost of short term debt () undetermined as of time t as well. Asset returns tend to diminish when asset investment expands and

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fundraising costs increase when the amount of funds to be raised expands. Considering this supposition, returns on assets and costs of raising funds can be expressed as the following equation (2):

, , , (2) Where, and in the above equations are parameters that have positive

values and is expectation error.

As both and are only probability variables, the conditional variance of profit () is as follows:

(3)

Let be a coefficient for risk aversion. It is assumed that the representative bank tries to maximize its expected profit () and minimize the variance of its profit (). Then, the bank’s objective function can be expressed as max .1) Using the first order conditions for maximizing the objective function, budget constraints and the regulatory conditions, one can derive equilibrium values for endogenous variables. As the equilibrium values have very complex equational forms, a simulation analysis with proper numerical values given to the parameters is carried out to evaluate the effects of regulations on bank behavior.

When evaluating the effects of monetary policy, it is assumed that changes in call rate would differently affect the interest rates of financial commodities. Changes in call rate directly influence the cost of funding for banks and firms through changes in the Repo rate. And, changes in firms’ funding cost in the financial market affect

1) According to portfolio theory, an investor’s utility function can be expressed as a form consisting of the expected profit and variance of profit, when the asset returns have a joint normal distribution or when the utility function is a quadratic function.(Sharpe(1964), Lintner(1965), Markowitz(1952)) A return on a portfolio can have normal distribution according to ‘The Central Limit Theorem’.

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their demand for bank loans and loan interest rates. Considering these changes in interest rates and the supply and demand for funds, the representative bank carries out optimization, and then the interest rates changes accordingly.

Each exogenous variables are given numerical values so that domestic banks’ behavior can be explained in the simulation analysis. (refer to <Table 1>). Numerical values are obtained using the data from 2010.1q to 2013.3q to reflect recent bank behavior. The values for , , , , , , , and are derived from interest rates and the balance sheet of commercial banks. Values for , , , and are derived as followed: First, the values for and in the equation from the equation (2) are given the average amount in the balance sheet and the average interest rate, respectively. Then, is derived using the relation of . In the process of providing values to exogenous variables, the total asset amount is normalized to one. Let be the policy interest rate. The effect of monetary policy on interest rates is expressed as the following equations.

, , (4)

III. The Results of Simulation

A. Stability of the model

Before analysing the effect of Basel III, a simulation is carried out to check whether changes in endogenous variables are coincident with the prior expectation. The result shows that the simulation result conforms with actual bank behavior.(refer to <Figure 1>) Looking at it in more detail, when the loan interest rate () rises or the rate of decrease in the return on loans () falls, the bank tends

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to increase loans. When the safe bond interest rate () rises or the rate of decrease in the return on safe bond () falls, the bank expands its holdings of safe bonds. When the unit cost of short-term debt () or the rate of increase in the cost of short-term debt () rises, the bank reduces short-term debt funding. Likewise, when the unit cost of long-term debt () or the rate of increase in the cost of long-term debt () rises, the bank trims down long-term debt funding. When there is a rise in the unit cost of capital () or the rate of increase in the cost of capital (), the bank cuts back capital. A rise of risk aversion () tends to bring about a reduction in loans and an increase in safe bonds. When the variance of the loan interest rate, () and the variance of the short-term debt interest rate, () rise, the bank lessens loans and short-term debt, respectively. When the correlation between the loan and short-term debt interest rates moves up, resulting in a decrease in the variance of net profit, the bank expands loans and short-term debt.2) Meanwhile, it is found that a small adjustment in the exogenous variables does not significantly affect the simulation result.

<Figure 1> Changes in endogenous variables(vertical axis) when there are changes in exogenous variables closely related with the endogenous variables

Loans Safe bonds

2) As in the equation (3) wanes, the bank’s expected utility increases.

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Short-term debt Long-term debt

Capital Loans and safe bonds

Loans and Short-term debt Loans and ST debt and and

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B. Capital regulation strengthening 1. Effects on assets (loans and safe bonds)

Strengthening regulations on the capital ratio (capital/loan = ) can affect the size of assets and asset composition. The result of simulation reveals that when the regulatory capital ratio rises, bank loans decrease greatly while safe bonds decrease slightly, causing the share of safe bonds in assets to rise.(Refer to <Figure 2>) As banks have to use more capital, which is more expensive than debt, when the regulatory capital ratio rises, the net return on loans decreases, inducing banks to curtail the amount of loans. And the strengthening of capital regulations tends to increase capital while decreasing short and long term debts. This brings about a reduction in the need for the bank’s holding of safe bonds to meet the LCR regulation. (LCR regulation requires banks to keep the ratio of safe assets to short-term debt at more than 100%) Looking at <Figure 2>, the rates of changes in loans and safe bonds tend to increase when the regulatory capital ratio increases from 8% to 20%. This is because when the regulatory capital ratio is high, banks will have a heavier burden in raising additional capital and prefer reducing loans to accumulating capital in response to capital regulation strengthening. When Basel III is fully implemented, banks’ capital ratio is expected to rise further, causing the effect of changes in the regulatory capital ratio on bank loans to become larger.

<Figure 2> The effect of regulatory capital ratio () on assets1)

Loans Safe bonds Total assets

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Safe bonds/assets ratio Rate of changes Rate of changes in loans2) in safe bonds2)

Note: 1) When there is no capital regulation, the bank’s optimal capital ratio turns out to be 8% in the model. Thus, the simulation is carried out for a regulatory capital ratio higher than 8%. 2) These are derived from and , respectively.

The extent of the decrease in loans following the raising of regulatory capital ratios may depend on the bank’s funding cost and its return on assets. <Figure 3> shows that the strengthening of the regulatory capital ratio can greatly decrease the amount of loans when the cost of raising capital is high or when the cost of debt is low. Banks usually prefer reducing loan size rather than expanding capital following the strengthening of the regulatory capital ratio when the cost of raising capital is high. When the cost of debt is low, banks tend to expand loan size. Then, banks need to hold more capital due to the capital ratio regulation and this is followed by a rise in the cost of capital. In this situation, if capital ratio regulation is strengthened, the cost of capital will move up to a very high level, causing banks’ net return on loans to decrease and inducing them to reduce the scale of lending. Meanwhile, the extent of banks’ response to changes in capital regulation can be influenced by returns on assets and the degree of risk aversion as well. These variables’ influence seems small according to <Figure 3>. When the return on loans is high3) or that on safe assets is low, the influence of capital regulations on the scale of loans appears to be large, When bank’s

3) The enlargement of loan size after the expansion of the return on loan can cause capital size to increase as banks have to meet the regulatory capital ratio. This results in a hike in the cost of raising capital. In this situation, a further strengthening of capital ratio regulation will raise the cost of capital more greatly.

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risk aversion is high, the influence turns out to be small.

<Figure 3> The decrease in bank loans after strengthening of capital regulation (vertical axis) with different levels of funding cost or asset return (horizontal axis)

Cost of capital Cost of long-term debt Cost of short-term debt () () ()

Loan interest rate Safe bond yield Risk aversion () () ()

Noet: Vertical axis represents , which is the rate of decrease in loans

after strengthening of capital ratio regulation

The result on <Figure 3> implies that the influence of capital regulation on loan size can be small in a boom period and it can be large in a recession period. In a boom period, banks’ cost of raising capital tends to fall due to their credit worthiness enhancement and profit increase, and banks’ cost of debt is likely to rise mainly due to an upward movement of the policy interest rate. These changes can cause the effect of capital regulation on loans to decrease in a boom period. In a recession period, however, the strengthening of

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capital regulation may bring about significant reduction of bank loans, deepening the recession. The above result also implies that the influence of capital regulation on loan size can be large in those banks whose cost of raising capital is high due to low credit ratings and profitability. Banks in emerging market economies tend to have high costs for raising capital, and thus their loans are likely to decrease greatly when the Basel III counter cyclical capital buffer (CCB) is strengthened.

Changes in asset structure following capital regulation strengthening are depicted in <Figure 4>. For this analysis, it is assumed that there are two types of loans: loan with high expected returns versus low expected returns and household loans versus corporate loans. The figure on the left-hand side shows that a rise in the regulatory capital ratio induces the bank to enlarge the share of loans that have higher expected returns. This is because banks usually prefer expanding assets with high expected returns in response to the rise of cost of funding due to capital ratio regulation intensification to lessen the loss incurred from the funding cost rising.

Next, the impact of the regulatory change on the share of household loans is analysed. Let , , , and be the return on household loans, the return on corporate loans, deposit interest rate, and the regulatory capital ratio, respectively. And, let the risk weight for corporate loans4), that for household loans be 1(=100%) and , respectively. According to the result of the theoretical analysis in <Appendix 3>, if the relation of is satisfied, then the relation of holds. (refer to <Appendix 3> p32 33) Looking at the figure on the right-hand side, the share ～of household loans expands as the regulatory capital ratio rises when the regulatory capital ratio is low. The share, however, 4) This is the risk weight in the risk weighted assets when calculating the denominator of

BIS capital ratio.

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decreases with regulatory capital when it is high. When the regulatory capital is low, household loans decrease less than corporate loans after a rise in the regulatory capital ratio because the risk weight of household loans is smaller than that of corporate loans ( ). When both types of loans continue to decrease following further intensifying of the capital regulation, the rate of return on corporate loans tends to increase more greatly than that on household loans.5) This results in a fall in the share of household loans.6) Thus, the share of household loans can have an inverse-U shape relationship with the regulatory capital ratio.

<Figure 4> Changes in asset structure following changes in the regulatory capital ratio()

Loans with higher expected return Household loans /total loans1) /total loans2)

Note: 1) The basic model is extended so that the situation with two different types of loans can be analysed. The loans with a higher expected return have greater than the other loans by 2%. Meanwhile, it is found that other exogenous variables, such as , do not affect the share of household loans.

2) The risk weight for corporate loan is given 100%, and that for household loan 62%7). Refer to <Appendix 2> for the numerical values of exogenous variables.

5) The rate of return on corporate loans tends to vary more greatly across different corporations than that on household loans does. This implies the slope of the corporate loan demand curve is steeper than that of household loan demand curve. <Appendix 2> shows the same result as this conjecture. Thus, when banks reduce loans after the strengthening of capital regulations, the extent of increase in rate of return on corporate loans is greater than that on household loans. This causes the rate of return on corporate loans to become greater than that on household loans.

6) This is the case where rises faster than , resulting in . 7) This is derived from the domestic banks’ risk weight for household loan during 2010～

2013.

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2. Effects on funding

<Figure 5> reveals that when the capital ratio regulation is strengthened, the ratio of debt to capital decreases because more capital should be accumulated. Banks tend to prefer curtailing loan rather than accumulating capital when the cost of capital rises greatly due to a hike in the regulatory capital ratio enforcing banks to hold more capital. Thus, the size of increase in capital following strengthening of capital regulation is likely to diminish. A rise in the regulatory capital ratio causes long-term debt to decrease more than short-term debt and this brings about a worsening of the maturity structure of debt.8)

<Figure 5> Changes in debt and capital following changes in the regulatory captial ratio()

Short-term debt Long-term debt Capital

Total debt Short-term debt Capital/total /total debt

8) Capital regulation strengthening causes bank profit to decrease and it makes banks increase the share of short-term debts which has a lower cost of funds than long-term debt.

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C. Liquidity coverage ratio (LCR) regulation

1. Effects on assets

The Basel III LCR regulation is scheduled to be introduced in Korea from 2015. For the analysis, it is assumed that LCR is the ratio of short-term debt to safe bonds. <Figure 6> shows the effect of LCR regulatory strengthening: the bank increases safe bonds while reducing loans. When LCR is high and LCR regulation is strengthened, banks begin to reduce safe bonds as well, causing total assets to decrease greatly. This is because as banks enlarge their safe bond holdings following the strengthening of LCR regulation, the return on safe bonds falls. And at some point, it becomes more beneficial for banks to reduce short-term debt rather than expanding safe bonds to meet the LCR regulation. When LCR is high, the effect of strengthening of LCR regulations on loans tends to diminish: as banks reduce loans following strengthening of LCR regulations, the return on loans increases, causing banks to reduce their lending by less in response to the further strengthening of LCR regulations.

<Figure 6> Effect of changes in LCR () on assets

Loans Safe bonds Total assets

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Safe bonds Rate of changes Rate of changes /total assets in loans1) in safe bonds1)

Note: 1) The rates of change are and , respectively.

2. Effects on funding

The effects of LCR regulation strengthening on debt are demonstrated in <Figure 7>. When LCR regulation is stepped up, banks are constrained to reduce short-term debt and thus long-term debt tends to expand. Meanwhile, the decrease in banks’ demand for short-term funds can cause the yield curve to steepen in the financial market. As the size of the decrease in short-term debt is larger than that of the increase in long-term debt, total debt tends to diminish. Where LCR is low and LCR regulation is intensified, however, the size of the decrease in short-term debt can be smaller than that of the increase in long-term debt, having total debt expand. The cost of long-term debt rises as more long-term debt is demanded by banks, causing long-term debt to increase by less. The maturity structure of bank debt will be improved as more long-term debt is used. The bank’s capital is also found to decrease. This is because as the scale of lending declines, it does not need to hold excess capital to meet the capital ratio regulation.

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<Figure 7> Effects of LCR () strengthening on debt and capital

Short-term debt Long-term debt Capital

Total debt Short-term debt Capital/total funding /total debt

D. Other regulations

1. Leverage ratio (capital/assets) regulation9)

<Figure 8> exhibits the effects of raising the regulatory leverage ratio: assets and debt shrink mainly due to a large decrease in safe bonds and short-term debt, respectively. Banks try to scale down safe bonds to lessen the decrease in profit resulting from the leverage regulation strengthening. And, when safe bond holding is scaled down, banks have to reduce short-term debt as well in order to meet the LCR regulation. The size of loans has an inverse-U shape relationship with the regulatory leverage ratio: when the

9) An analysis is carried out for the effects of introducing leverage regulation where the capital ratio and LCR regulations are already in force.

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leverage regulation is intensified from a situation where the regulatory leverage rate is low, the bank expands loan to compensate for the loss caused by the regulatory strengthening. As the regulatory leverage ratio rises further, the cost of raising capital becomes greater and the rate of return on loans smaller, making it beneficial for the bank to reduce lending. Meanwhile, the pattern of movements in the size of capital is similar to those in the size of loans as banks have to meet the capital ratio regulation.

<Figure 8> Effects of leverage ratio () regulation1)

Loans Safe bonds Total assets

Short-term debt Long-term debt Capital

Loans/total assets Short-term debt Capital/total funding /total debt

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2. Effects of deposit reserve requirement

For analytical convenience in this section, it is assumed that all debts consist of deposits. Banks need to put aside a portion of both their short-term and long term deposits to meet the reserve requirements. <Figure 9> demonstrates the effects of raising deposit reserve requirements on the short-term and long-term debts: the sizes of assets and funding decrease while the share of loans in total assets rises and that of short-term debt in total debt falls. Intensifying the reserve requirement brings about a rise in the cost of debt funding resulting in banks’ net profit decreasing and a reduction of their holdings of loans and safe bonds. When the size of loans decreases, so does that of capital as banks do not need to hold excess capital to keep the capital ratio regulations. Meanwhile, banks reduce safe bonds more than loans as safe bonds expected returns are less than those on loans, causing the ratio of loans to total assets to rise. The safe bond reduction is followed by short-term debt reduction as banks need to meet the LCR regulation, resulting in a decline in the share of short-term debt in total debt.

<Figure 9> Effects of deposit reserve requirement1)

Loans Safe bonds Total assets

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Short-term debt Long-term debt Capital

Loans/total assets Short-term debt Capital/total funding /total debt

Note: 1) An analysis is carried out for introducing a reserve requirement regulation where a capital ratio and LCR regulations are already in force.

E. Monetary policy and macro-prudential regulations

This section analyses the effects of macro-prudential regulations on the effectiveness of monetary policy. <Figure 10> shows that intensifying macro-prudential regulations gives rise to weakening of the credit channel of monetary policy.10) This is because when the regulatory capital ratio is high, banks tend to enlarge loans to a lesser extent in response to a fall in the policy interest rate. The cost of raising capital is generally high in a recession period, and thus it is more likely that the effectiveness of monetary policy would be weak in a recession period.

10) It is found that in case where the cost of capital responds more sensitively to the policy interest rate than debt does, the effectiveness of monetary policy could be enhanced.

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It is found that strengthening LCR regulation lowers the effectiveness of monetary policy as well. When the regulatory LCR is high, banks need to use more long-term debt whose funding cost is higher than short-term debt, causing them to increase loans by a lesser amount in response to a fall in the policy rate.

<Figure 10> Changes in the effectiveness of monetary policy (vertical axes) after changes in the regulatory capital ratio and LCR1 (horizontal axes)

Changes in capital ratio () Changes in LCR ()

Note: 1) The effectiveness of monetary policy is measured by ( ). The graphs show that the effectiveness of monetary policy decreases as the capital ratio () or LCR () rises.

<Figure 11> indicates that tightening leverage regulations brings about weakening of monetary policy effectiveness. Raising the regulatory leverage ratio makes banks use more capital, pushing up the cost of capital. In this situation, banks increase loans to a lesser extent when the policy rate falls. In contrast, raising the deposit reserve requirement results in an improvement in monetary policy effectiveness. Raising the reserve requirement causes the scale of capital to decline and this in turn reduces the cost of raising capital. Thus, banks can increase loans to a greater extent after the policy rate is cut.

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<Figure 11> Changes in the effectiveness of monetary policy after changes in the leverage ratio and reserve requirements1)

Leverage ratio () change Reserve requirement ratio () change

Note: 1) The effectiveness of monetary policy (vertical axes) is measured by ( ).

F. Relationship among macro-prudential regulations

If there is a complementary relationship among regulations, intensifying one regulation can reinforce the effectiveness of another regulation. If two regulations are not complementary, tightening one regulation could bring about a weakening of the effectiveness of the other regulation. To analyse the impact of one regulation on other macro-prudential ratios, it is assumed that the other macro-prudential ratios can move without regulatory constraints.11)

<Figure 13> reveals that tightening capital ratio regulation helps enhance the LCR and the leverage ratio. When the regulatory capital ratio is raised, banks tend to reduce short-term debt and increase safe bonds resulting in a rise in the LCR.12) To keep LCR above 100% in this case, however, the regulatory capital ratio needs to be increased greatly. This suggests that it is not desirable to keep LCR high by raising the regulatory capital ratio. Intensifying capital ratio regulation causes the leverage ratio to rise as capital expands and total assets decline. 11) If regulations on the other macro-prudential ratios are in place, these ratios will not

change though one regulation changes, as banks need to keep them at the levels required by the regulations.

12) If the LCR regulation is in force, safe bond holdings decrease, as seen on page 10.

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<Figure 13> Effects of strengthening of regulatory capital ratio () on other macro-prudential ratios LCR Leverage ratio

<Figure 14> shows that tightening LCR regulation facilitates improvement in the capital ratio and the leverage ratio. When the regulatory LCR is raised, banks expand capital while reducing loans, bringing about an increase in the capital ratio. In cases where short-term debt falls due to the enhancement of LCR regulation, banks tend to use more capital along with long-term debt.

<Figure 14> Effects of raising the regulatory LCR () on other macro-prudential ratios

Capital ratio Leverage ratio

The regulatory LCR, however, needs to be raised greatly to keep the capital ratio above 10%. Thus, it is not advisable to raise the capital ratio by raising the regulatory LCR. LCR regulatory tightening helps the leverage ratio improve as capital expands while loans decline.13)

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<Figure 15> demonstrates the effects of leverage regulation strengthening: it helps push up the capital ratio but drag down the LCR. When the leverage ratio rises, capital is built up, boosting the capital ratio, and safe bonds decline resulting in a fall in the LCR.

<Figure 15> Effects of regulatory leverage ratio () on other macro-prudential ratios

Capital ratio LCR

IV. Conclusions

Strengthening the Basel III regulations on capital, liquidity and leverage is expected to affect the stability of the financial system and the macro economy by way of changes in banks’ assets and funding structure. This paper analyses banks’ responses to the new macroprudential regulations, using a model with a representative bank’s optimization. Specifically, the effects of capital, liquidity (LCR), leverage and deposit reserve requirement regulations on banks’ asset management and funding decision are considered.

It is found that strengthening of capital regulation (capital to loan ratio) and liquidity regulation (safe bonds to short term debt ratio,

13) It is found that when both the capital ratio and LCR regulations are in force, strengthening LCR regulations could cause the leverage ratio to decrease as capital is reduced due to the scaling back of loans.

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LCR) tends to reduce the share of loans in bank assets. As the net return on loans decreases due to intensified capital regulation, lending becomes less attractive. Raising the LCR makes banks increase safe bond holdings, raising the share of safe bonds. On the other hand, tightening leverage regulation (capital to assets ratio) and deposit reserve requirements increases the share of loans in the banks’ asset portfolios. When these two regulations are tightened the cost of funding increases and bank profits decrease. In order to compensate for the decrease in profits, banks expand the share of loans in assets as loans have a higher rate of return than safe bonds do.

The effect of capital regulations on bank loans can be large for those banks whose cost of raising capital is high, but the effect may weaken during a boom period when the cost of raising capital is generally low due to the enhanced creditworthiness of banks. Tightening capital regulations increases the share of short term debt in banks’ liabilities, while tightening other regulations decreases the share of such short term debt.

Macro-prudential regulations have a complementary relationship with one another: Tightening the capital regulations tends to raise the liquidity ratio and the leverage ratio, while tightening the liquidity regulations can raise the capital ratio and the leverage ratio. Strengthening of leverage regulations may increase the capital ratio but lower the liquidity ratio. When macro-prudential regulations are intensified, the effectiveness of monetary policy on bank lending may weaken and the slope of the term structure of interest rates may steepen.

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13. Rochet, Jean-Charles, "Capital Requirements and the Behavior of Commercial Banks," European Economic Review 36, pp.1137-1178, 1992.

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15. Thomas F. Cosimano, T. and D. Hakura (2011), “Bank Behavior in Response to Basel III: A Cross-Country Analysis,” IMF Working paper, WP/11/119, May 2011

29

<Appendix 1> The numerical values for exogenous variables

Note: 1) It is assumed that deposit interest rates and rate of return on equity need to be larger than the rate of increase in CPI, 2) I is the variable in from the equation (2) and each of the values is obtained from the banks’ B/S, 3) Considered that fact that the average maturity of bonds in banks’ B/S is about 33 months. 4) The coefficient of regression with each interest rate as a dependent variable and call rate as an independent variable. 5) Capital has a longer maturity than deposits, which means that is less that . 6) The criterion for dividing short-term debt from loan-term debt is 3-months.

variable value reference

7.0% The average of the highest interest rates on loans actually made by the domestic banks

3.5% Set so that the equilibrium ratio of safe assets to total assets can conform to the actual ratio of domestic banks

2.7% Rate of increase in the consumer price index1)

2.7% Rate of increase in the consumer price index1)

2.7% Rate of increase in the consumer price index1)

2.13 5.3%, average bank loan interest rate, I = 0.82)

1.0 3.3%, 3-year3) government bond average yield, I = 0.22)

1.5 3.0%, 3-month CD rate average, I = 0.22)

0.83 3.3%, saving deposit interest rate average, I = 0.722)

10.0 3.5%, set so that values of the equilibrium ratio of capital to total assets can conform to the actual ratio of banks

0.2 Variance of loan interest rate

0.15 Variance of CD interest rate

∙ 0.1 Covariance between loan and CD interest rates

1.0 Follows the previous theoretic studies

0.08 Actual capital to loan ratio from banks B/S

0.98 The effect of call rate on the loan rate4)

1.14 The effect of call rate on the government bond rate4)

1.25 The effect of call rate on the CD rate4)

1.14 The effect of call rate on the saving deposits rate4)

1.0 - (-)5)

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<Appendix 2>

Values for exogenous variables with different types of loans

Note: 1) it is derived from the relation of average interest rate = ｢ *(ratio of each loan to asset)｣

variable value reference

8.0% The average of the highest interest rates on corporate loans actually made by the domestic banks

6.0% The average of the highest interest rates on household loans actually made by the domestic banks

1) 6.3 5.47%, corporate loan interest rate average, I = 0.4

1) 2.1 5.17%, household loan interest rate average, I = 0.4

0.62 Risk weight for household loans derived from banks’ reports

0.17 Variance of corporate loan interest rate

0.22 Variance of household loan interest rate

0.1 Covariance between interest rates on corporate loans and CDs

0.1 Covariance between interest rates on household loans and CDs

0.2 Covariance between interest rates on corporate loans and household loans

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<Appendix 3> A Theoretical Analysis

In the main text, a model with monopolistic competition is analysed using a simulation. To get a deeper insights, a model with pure competition and one with monopolistic competition are theoretically analysed. In a market with pure competition, banks consider the rate of return on assets and cost of funds to be constant as they are not affected by their own actions.

1. Effects of capital ratio regulation on asset size

(Pure competition) B/S equilibrium: Capital ratio: Expected profit: Variance of profit:

Objective function: max

Optimal loans:

Rate of changes in loans after the regulatory capital ratio changes:

,

The relations of

,

, and

hold.

(Monopolistic competition) The following conditions are included in those for pure competition.

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, ,

Optimal loans:

Where is much greater than , < 0 can hold.

Let ≈, then

holds.

In this case, when , then is satisfied.

2. Asset structure with pure competition Let there be corporate loans and household loans.

B/S equilibrium: Capital ratio: Expected profit: Variance of profit: Objective function: max

Optimal loans:

is equal to

33

where,

If , then holds.

3. Debt structure with pure competition

Let there be short-term debt and long-term debt. B/S equilibrium: Capital ratio: Expected profit: Variance of profit: Objective function: max

Optimal loans:

where,

34

where, , ,

As all elements in the above equations have positive signs, is satisfied. 4. Effects of monetary policy (Pure competition)

Let be the policy interest rate. The relations of , and are added into the basic model.

Optimal loan:

If , then

is positive, otherwise it is

negative.

(Monopolistic competition)

The following conditions are included in those for pure competition.

, ,

35

Let .

As is greater than or in the denominator of the above equation, the sign would be determined mostly by the relative size of compared to . When the cost of debt reacts more sensitively to changes in the call rate than the cost of capital does, strengthening capital regulations may enhance the effectiveness of monetary policy.