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

Summary

Focus

When interest rates decline, banks tend to chase yield by issuing risker loans. Yet the degree to which banks do this varies considerably. What explains the differences across banks? One possible explanation relates to differences in regulatory and market capital. Regulatory capital gauges how close a bank is to breaching the regulatory capital threshold. Market-based capital measures how much "skin in the game" a bank's shareholders have. 

Contribution

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

Findings

We find that low US interest rates spur the origination 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 originate riskier loans when interest rates decline. Second, banks with low levels of market capital have a greater propensity to extend riskier loans in response to falling interest rates. This finding implies the existence of a market capital channel, which operates in the opposite direction to the regulatory capital channel.

Abstract

We investigate the links among US monetary policy, bank capital, and risk taking in international bank lending. Using syndicated loan data, we find that low US interest rates spur the origination of risky dollar-denominated international loans through two distinct mechanisms. First, consistent with the existence of a regulatory capital channel, banks with higher levels of regulatory capital originate riskier loans when interest rates decline. Second, banks with low levels of market capital have a higher propensity to extend riskier loans in response to falling interest rates. This finding 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 rates, bank capital, risk taking, international leveraged loans