The Shadow Cost Of Bank Capital Requirements

Roni Kisin
Washington University in Saint Louis – John M. Olin Business School

Asaf Manela
Washington University in Saint Louis – John M. Olin Business School

February 21, 2016

Review of Financial Studies, Forthcoming

Abstract:

This loophole — liquidity guarantees to asset-backed commercial paper conduits — was exploited by the largest banks before the crisis of 2008. We show theoretically that a bank’s use of the loophole reveals its private compliance cost, which takes into account both the costs of issuing equity and the effectiveness of capital regulation. We find that increasing capital requirements would impose a modest cost — $220 million a year for all participating banks combined per 1pp increase, and $14 million on average.

The Shadow Cost Of Bank Capital Requirements – Introduction

Capital requirements are an important tool in the regulation of financial intermediaries. Leverage amplifies shocks to the value of an intermediary’s assets, increasing the chance of distress, insolvency, and costly bailouts. Following the recent financial crisis, prominent economists and policy-makers have called for a substantial increase in capital requirements for financial intermediaries. Nevertheless, proposals to increase capital requirements face fierce and successful opposition from financial intermediaries, apparently driven by their private costs of capital requirements. Despite the central role of these costs in shaping the regulation, they have not been measured empirically.

We use bank’s own actions to infer their perceived compliance costs. Prior to the financial crisis of 2007–2009, banks had access to a costly loophole that helped them bypass capital requirements. Since, according to the banking industry, higher regulatory ratios decrease profitability, a profit maximizing bank would trade off the cost of the loophole against the benefit of reduced capital. Therefore, data on loophole use, together with information on its costs, reveal the shadow costs of capital requirements. This approach, first used by Anderson and Sallee (2011) to study fueleconomy standards, allows estimating the shadow costs of regulation without the need to estimate demand elasticities and other unobservables.

To examine this intuition empirically, we set up a simple model and take it to data on bank’s provision of liquidity guarantees to asset-backed commercial paper conduits (ABCP). As documented by Acharya, Schnabl, and Suarez (2013), banks that provided liquidity guarantees to ABCP conduits effectively held the risks of the underlying assets. Instead of treating such guarantees as risky assets, however, banks were allowed to include only ten percent (zero before 2004) of these guarantees in the calculation of regulatory capital ratios. Therefore, this loophole allowed banks to decrease their economic capital ratios while keeping their regulatory ratios within the guidelines.

The Shadow Cost of Bank Capital Requirements

While the loophole benefited banks by relaxing their regulatory constraints, using it was costly, as banks had to pay an incremental cost for using ABCP conduits. Therefore, for constrained banks that use the loophole, the ratio of the marginal cost of using the loophole to its marginal capital relief reveals the shadow cost of the regulatory capital constraint.

Our approach allows us to estimate the shadow costs of capital regulation for constrained banks that used the loophole. We identify 18 US bank holding companies that sponsored and provided liquidity guarantees to ABCP conduits in the pre-crisis period, using detailed data on ABCP conduits from Moody’s Investor Service and banks’ quarterly reports.2 Although few in numbers, these institutions account for about half of all US bank assets. Consistent with the model, we show that they were much more constrained by capital regulations than the rest of the banking universe. These large, heavily levered banks were at the epicenter of the recent financial crisis, and are still the subjects of (and active participants in) the policy debate on capital requirements.

We derive the marginal capital relief from exploiting the loophole for each regulatory capital ratio (tier 1 risk-based, total risk-based, and tier 1 leverage ratio). The benefits can be calculated using our data; they are higher for banks that achieve a higher reduction in regulatory ratios using the loophole. The marginal cost—an incremental cost of exploiting the loophole—is harder to quantify. For our baseline estimates, we use the 30 day ABCP spread over financial commercial paper, which is positive and stable during the pre-crisis period. In addition, because this spread may not capture the full marginal cost of exploiting the loophole, we derive an upper bound for it (and hence for the shadow costs) that allows for arbitrary measurement error.

The Shadow Cost of Bank Capital Requirements

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