Research Discussion Papers, Bank of Finland
No 9/1996:
Bank Capital, Capital Regulation and Lending
Vesa Vihriälä
Abstract: The paper analyzes bank loan supply in a simple value
maximizing partial equilibrium framework. The focus is on the role of bank
capital, capital regulation and the pricing of bank liabilities. The model
is constructed so as to resemble the situation of the Finnish local banks
in the late 1980s and the early 1990s, particularly with regard to capital
regulation which changed subtantially during this period. While equity
capital is assumed exogenous, the bank may choose the amount of
subordinated debt which also counts as regulatory capital. The model shows
that bank characteristics matter for loan supply, when the bank is
penalized for bank failure (capital insufficiency relative to a regulatory
requirement). When this penalty is positive, fair or excessive pricing
(lemons premium) of bank liabilities makes bank lending depend positively
on bank capital but underpricing results in a negative relationship. A
negative relationship may also emerge if the bank anticipates "perverse"
bank support policies ie that capital insufficiency will be rewarded with
transfers from the authorities. Thus both a credit crunch due to lack of
capital and "excessive" risky lending due to moral hazard can obtain in a
single model, depending on the circumstances. The precise nature of capital
regulation is not important, provided a failure to meet the requirement is
sufficiently penalized. The model suggests that the mutually exclusive
hypotheses of credit crunch / excessive lending due to moral hazard can be
tested not only by examining the relationship between bank lending on the
one hand and bank equity and bank costs on the other hand, but also by
examining the relationship of subordinated debt with bank lending and the
capital ratio.
Keywords: bank lending; capital; capital regulation; moral hazard; credit crunch; (follow links to similar papers)
54 pages, April 3, 1996
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