Atl Econ J (2008) 36:1–14

DOI 10.1007/s11293-007-9100-z

Bank Capital Regulation, Economic Stability,

and Monetary Policy: What Does the Academic
Literature Tell Us?

David D. VanHoose

Published online: 28 December 2007

# International Atlantic Economic Society 2007

Abstract This paper surveys academic research exploring the macroeconomic and
monetary policy implications of the Basel I and Basel II systems of risk-based capital
requirements. This research indicates that regulatory tightening of capital ratios can
generate aggregate shocks, that capital regulation can enhance the procyclicality
already inherent in banking, and that capital requirements can influence macroeco-
nomic outcomes and alter the monetary policy transmission mechanism. The paper
offers suggestions for future avenues of research on the interplay between bank capital
regulation, the economy, and monetary policymaking.

Keywords Bank capital regulation

JEL Codes E51 . G28

Introduction

Since 1988, under terms of the Basel Accord (now known as Basel I), national bank
regulators have imposed bank capital regulations, both in the form of a traditional
leverage requirement and ‘risk-based’ requirements relating measures of bank capital to
a ‘risk-weighted’ measure of total assets. In light of concerns that banks had developed
arbitrage techniques that undermined the intent of the Basel risk adjustments,
considerable regulatory effort is under way across more than 100 nations to develop
the so-called Basel II system. This new international bank regulatory framework is to be
based on three ‘pillars’: risk-based capital requirements, discretionary supervisory
discipline, and market discipline. Capital regulation is clearly the central pillar, however,
with small banks facing a much more complex, risk-based capital-requirement system

Although any errors are my own, I received very helpful comments on earlier versions from Kenneth
Kopecky, John Pattison, and Jack Tatom. I am grateful for research support from Networks
Financial Institute.
D. D. VanHoose (*)
Hankamer School of Business, Baylor University, One Bear Place #98003, Waco, TX 76798, USA
e-mail: [email protected]

NO9100; No of Pages
2 D.D. VanHoose

than under the Basel I system and large banks required to implement an even more
sophisticated, internal-ratings-based (IRB) system for capital tabulation. The Basel II
system is slated to go into effect gradually with a target completion date of 2011.
Considerable research, reviewed by Santos (2001), Stolz (2002), and VanHoose
(2007), has been devoted to examining the effects of minimum bank capital
requirements on bank balance-sheet choices, portfolio risks, and safety and soundness.
Analyses of the implications of capital requirements at the level of an individual bank
or the banking system typically treat the rest of the economy as exogenous.
Nevertheless, as noted by Bliss and Kaufman (2003), because bank capital regulation
impinges on balance-sheet responses of the banking system as a whole, capital
requirements potentially can affect the broader economy. Furthermore, to the extent
that bank capital regulation affects the channels through which monetary and real
shocks influence equilibrium output and prices, the structure of capital requirements
can alter the monetary policy transmission mechanism. Indeed, bank regulators
conceivably could find themselves in conflict with monetary authorities.
Virtually all studies of the microeconomic effects of bank capital regulation
generate the following common conclusions:
1. Short-run effects of binding risk-based capital requirements are reductions in
individual bank lending and, in analyses that include consideration of
endogenous loan-market adjustments, increases in equilibrium loan rates.
2. Longer-run effects of risk-based capital regulation lead to increases in bank
capital, both absolutely and relative to bank lending.
Taken together, the widespread agreement about these two sets of conclusions
indicates that risk-based capital requirements have the potential to achieve one oft-
expressed objective: increasing the relative size of the ‘capital cushion’ protecting
depositors and deposit insurers from losses in the event of isolated or widespread
bank failures. During a short-run interval in which adjusting equity may prove
costly, however, most of the adjustment to a regulatory capital tightening may occur
via reductions in lending. Hence, it is possible that regulatory tightening of capital
requirements could transmit short-term external shocks to aggregate credit and hence
to the economy. In the longer term, simultaneous adjustments of bank equity and
loans could alter the linkages from monetary policy instruments to the money stock,
total credit, and economic activity. Thus, bank capital regulation has potential short-
run and long-run monetary policy implications.
What has the literature to date revealed about how bank capital requirements may
impinge on interest rates, aggregate bank credit, output and prices, and monetary
policy effectiveness? This paper surveys research on three issues. The first issue,
discussed in “Does Toughening Capital Requirements Boost Bank Capital Ratios and
Create Credit Shocks?,” is the possibility that the toughening of regulatory capital
standards can create a macroeconomic shock in the form of a ‘credit crunch.’ The
second issue, considered in “Procycical Features of a Capital-Regulated Banking
System,” is the potential for capital regulation to contribute to procyclical variations in
total credit that may create procyclical movements in other economic variables. The
third issue, examined in “Monetary Policy Implications of a Capital-Regulated Banking
System,” is the possibility that capital requirements may impinge on monetary policy,
either indirectly through effects on the financial environment faced by central banks or
Bank Capital Regulation 3

directly by impinging on the monetary policy transmission channel. “Conclusion”

provides a summary and a set of suggestions for future research.

Does Toughening Capital Requirements Boost Bank Capital Ratios and Create
Credit Shocks?

Interestingly, there is not strong evidence that the imposition of capital regulation has
contributed significantly to an increase in actual bank capital ratios. Based on estimates
derived from value-at-risk models, Hendricks and Hirtle (1997) conclude that capital
regulation is likely to boost capital levels only very slightly at most institutions (and
possibly reduce capital at some banks). Ashcraft (2001) also finds little evidence that
capital regulation during the 1980s materially influenced bank capital ratios. Flannery
and Rangan (2004) find some influence of capital regulation on actual bank capital
ratios, but they credit greater bank risk aversion and actual risk increases as the main
factors accounting for rising U.S. capital ratios in recent years.
Other authors reach more mixed or even negative conclusions regarding the
contribution of capital regulation to bank equity adjustments. Building on the
simultaneous-equations estimation approach developed by Shrieves and Dahl (1992)
for exploring the interaction between bank capital levels and asset risk, Van Roy
(2005) analyzes adjustments in capital and credit risk at 576 banks in six G-10 nations
between 1988 and 1995. In an effort to control the country and bank fixed effects, Van
Roy includes country dummies and bank and country disturbances in simultaneous
regressions in which capital and a measure of asset risk are interdependent dependent
variables. Among various control variables, he includes a measure of “regulatory
pressure” intended to reflect the degree of bindingness of the Basel I capital
requirements. He finds evidence that low-capital banks in Canada, Japan, the United
Kingdom, and the United States responded to this measure of regulatory pressure by
increasing their capital, but that low-capital banks in France and Italy did not.
Barrios and Blanco (2003) develop partial-adjustment models of bank capital in
response to market forces versus capital constraints. They estimate these alternative
partial-adjustment frameworks using unbalanced annual panel data for 76 Spanish
commercial banks between 1985 and 1991. Barrios and Blanco find that for their sample
of banks, the market-based model better fits the data, indicating that the banks they
considered were not at all constrained by capital regulation during the period of study.
Beatty and Gron (2001) examine data for 438 publicly traded U.S. bank holding
companies between 1986 and 1995. For the entire sample as a whole, their analysis
suggests that pre-regulation behavior and post-regulation behavior of the entire set of
banks was not materially affected by the advent of risk-based capital regulation.
Jackson et al. (1999) review a number of prior studies investigating how capital
adequacy regulations influence actual capital ratios, such as Peltzman (1970), Mingo
(1975), Dietrich and James (1983), Shrieves and Dahl (1992), Keeley (1988), Jacques
and Nigro (1997), Aggarwal and Jacques (1997), Hancock and Wilcox (1994), Rime
(2001), and Wall and Peterson (1987). Jackson et al.’s conclusion is that there is little
conclusive evidence that capital regulation has induced banks to maintain higher
capital-to-asset ratios than they otherwise would choose if unregulated. Jackson et al.
do conclude, however, that on balance, most evidence suggests that in the near term,
banks mainly respond to toughened capital requirements by reducing lending.
4 D.D. VanHoose

In a creative study, Furfine (2001) develops an intertemporal model that yields

optimizing conditions that guide bank decision-making with and without capital
regulation. His approach is then to utilize data from FDIC call reports for 362 banks
with assets exceeding $1 billion to estimate these optimizing conditions directly.
Furfine then utilizes these estimated conditions to conduct simulations of the effects of
changes in capital requirements. Based on his simulation analysis, Furfine’s conclusion
is that, while capital regulation does matter, toughened supervisory scrutiny that
accompanies explicit capital requirements generally has a larger influence on a bank’s
balance-sheet choices. Thus, he finds that the joint effects of tighter capital regulation
and heightened supervision were more likely to have explained responses to the initial
implementation of the Basel Accord in the early 1990s.
Most work points to this particular period as perhaps the most likely example of a
regulatory-induced shock to aggregate credit. Nevertheless, Berger and Udell (1994)
examine whether the risk-based capital requirements put into place in the late 1980s
contributed to the so-called “credit crunch” that occurred in the United States in the
early 1990s. They find evidence that other sources of loan supply reduction or
declines in loan demand during the early 1990s played much more prominent roles
in reducing bank lending. In contrast, Peek and Rosengren (1995a, b) conclude that
there is considerable evidence, at least for New England, that both lower loan
demand and a capital-crunch-induced decline in loan supply together brought about
a decline in lending. Brinkmann and Horvitz (1995) also find evidence of significant
loan supply responses to the Basel I capital requirements.
Chiuri et al. (2002) extend the approach of Peek and Rosengren (1995) to
examine a panel of data for 572 banks in 15 developing countries. They find
consistent evidence – after seeking to control for banking crises that occurred in 10
of the nations – that the imposition of capital regulation induced a reduction in loan
supply and, hence, total lending in these countries. Furlong (1992), Haubrich and
Wachtel (1993), and Lown and Peristiani (1996) also conclude that capital regulation
contributed to a decrease in lending that helped fuel a post-capital-requirements U.S.
credit crunch. Wagster (1999) reaches the same conclusion for Canada and the
United Kingdom. He fails to find support, however, for this result in the cases of
Germany, Japan, and the United States, where he joins Berger and Udell in
concluding that a number of factors played a role in generating a credit crunch.
On net, therefore, the evidence regarding shock-producing effects of tougher
capital regulation is mixed. There is not full agreement that capital regulation alone
has boosted bank capital ratios. To the extent that increases in capital requirements
have contributed to higher capital ratios, other factors appear to have figured into
shocks created by a tightened supply of credit.

Procycical Features of a Capital-Regulated Banking System

The public demand for credit and supply of deposit funds to banks are positively
correlated with variations in economic activity. Hence, banking inherently tends to
be a procylical industry. As noted by Goodhart et al. (2004), financial liberalizations
during the past two decades in many of the world’s nations have added to banking
procyclicality. Relaxations of various controls on loan and deposit interest rates,
credit allocations, and cross-border flows of funds have allowed bank credit supply
Bank Capital Regulation 5

and deposit demand to respond positively to variations in economic activity along

with the public’s credit demand and deposit supply. Thus, today’s economic booms
(busts) naturally tend to engender greater increases (decreases) in equilibrium
quantities of deposits and lending than in prior periods in which bank credit supply
and deposit demand were restrained by various governmental controls.
As also noted by Goodhart et al., regulation also adds to the natural procylical
tendencies of banking. By its nature, the bank supervisory process tends to press
banks to constrict lending during contractions in an effort to protect bank balance
sheets from the risks generated by downturns. During upswings, in contrast, the
supervisors tend to take a hands-off approach that leaves banks freer to expand credit.
A number of observers have suggested that the Basel systems of risk-based
capital requirements enhance the procyclical effects of bank regulation. Indeed,
under Basel II, minimum capital will change alongside a bank portfolio’s perceived
riskiness. As a consequence, capital requirements could increase considerably during
economic downturns that are associated with greater bank portfolio risks. One
consequence of automatically stiffer capital requirements could be an enlargement of
short-term decreases in lending accompanying recessions. Another consequence
could be higher market loan rates that would reinforce economic downturns. In this
way, risk-based capital regulation can potentially add to banking procyclicality.
Borio (2003) stresses factors that might limit the procyclical features of bank capital
regulation, such as greater market transparency and more supervisory discretion –
the other two pillars of Basel II – which he suggests could help mitigate the extent to
which capital actually responds to downturn-induced boosts in risks. Nevertheless,
the fact remains that the design of risk-based capital regulation adds to the natural
and supervisory-enhanced procyclicality of banking operations.
Catarieneu-Rabell et al. (2005) suggest that the rating systems banks utilize could
greatly influence procyclicality under the proposed Basel II system. Utilizing rating
schemes that are more stable over cycles, they argue, such as those produced by
external rating agencies, would not contribute to the procyclical tendencies of capital
regulation. Catarieneu-Rabell et al. conclude that banks would have greater short-run
profit incentives to adopt a rating system conditioned on the current point in the
cycle, which would have an unintended effect of boosting procyclicality.
What is the potential for significant procyclicality to emerge as a byproduct of bank
capital regulation? To examine this question, Estrella (2004) examines a dynamic,
forward-looking model in which a bank chooses an optimal path for its balance sheet
based on its rational expectation of loan losses. He presumes that the mean path for
these losses is already cyclical and shows via simulations that a risk-based capital
requirement is likely to have procyclical effects, which he suggests can be partially offset
only by “judicious calibration” of minimum capital requirements during a downturn.
In an effort to determine how bank capital charges would vary in responses to
changing risks over the course of a business cycle, Kashyap and Stein (2004)
estimate probabilities of U.S. loan default during the period from late 1998 through
2002. Simulations based on these estimates suggest a potential for capital regulation
to generate greater procyclicality both for the banking system and, in particular,
individual banks. Kashyap and Stein’s simulations indicate that banks lending to
lower-quality borrowers are less susceptible to cyclical influences, because they are
already most affected by risk-adjusted capital regulation. In contrast, banks that
6 D.D. VanHoose

regularly lend to higher-quality borrowers are more likely to experience procyclical

capital adjustments as changes in economic conditions move initially less-risky
assets into riskier classifications.
Goodhart et al. (2004) also undertake simulations in an effort to assess the
potential for procyclicality under the forthcoming Basel II standards. These authors
attempt to construct typical bank portfolios for Mexico, Norway, and the United
States, and then simulate how loan ratings of assumed unchanging loan portfolios
would vary during economic booms and busts under both the standardized Basel II
risk-weighting system and the IRB system that the Basel II agreement will require
large institutions to utilize. They conclude that implementation of Basel II has the
potential to considerably add to banking procyclicality.
Gordy and Howells (2006) conduct simulations of bank portfolio volatility under
different rating systems and reach more sanguine conclusions. They argue that
“empirically realistic” rules guiding banks’ reinvestment strategies, which would
induce banks to identify and lend to higher-quality borrowers during economic
downturns, considerably reduce the additional procyclicality associated with capital
regulation. As noted by Goodhart et al., however, at low points of economic cycles
banks realistically may be more hard-pressed than assumed by Gordy and Howells
to locate a significant number of creditworthy borrowers.
In practice, has capital regulation actually proven to be procyclical? There is
surprisingly little evidence on this question. One exception is Ayuso et al. (2004),
who seek to address this question using panel data from the Spanish economy and
banking system for the period from 1986 to 2000. Using a variety of business-cycle
measures, they find evidence of an economically and statistically significant negative
relationship between bank capital and the phase of the business cycle. Thus, Ayuso
et al. conclude that, at least in Spain, bank capital regulation has tended to create
procyclical movements in actual capital.
Can the procyclicality inherent in risk-based capital regulation be reduced?
Pennacchi (2005) suggests that the procyclical features of risk-based capital regulation
can be offset via risk-based deposit insurance. Pennacchi suggests that regulators could
require less adjustment in bank capital to a recession-induced increase in asset risk,
with banks required instead to pay higher deposit insurance premiums via a system
involving a moving average of deposit insurance contracts. Of course, increased
deposit insurance premiums would induce declines in deposits that can also generate a
decrease in lending, although this effect would be offset somewhat by lower insurance
premium payments on the lower deposit base. Nevertheless, Pannacchi concludes that
the result would be less procyclicality than under capital regulation alone. He utilizes
U.S. bank data for the period from 1987 to 1996 to illustrate how adoption of such a
scheme could smooth out cyclical influences, thereby dampening the inherent
procyclicality of risk-based capital regulation.
Pederzoli and Torricelli (2005) offer an alternative suggestion for reducing the
procyclical tendencies of bank capital regulation. They propose adjusting capital
requirements based on ex ante anticipations of asset risk changes instead of ex post
observations of altered risks. Even though procyclical effects would remain under
their proposal, Pederzoli and Torricelli argue using U.S. data, from 1971–2000, that
forward-looking adjustments of risk-based capital requirements would considerably
smooth peaks and troughs of the business cycle.
Bank Capital Regulation 7

Monetary Policy Implications of a Capital-Regulated Banking System

To the extent that monetary policy actions operate through a bank lending channel as
well as through real-balance, interest-rate, and open-economy channels, bank capital
requirements can potentially impinge on the monetary policy transmission
mechanism. One of the earliest attempts to examine the macroeconomic implications
of bank capital regulation is Blum and Hellwig (1995). In their model, which
assumes an unchanging price level, desired investment depends on output prices, the
interest rate, firms’ profits (which in turn vary with aggregate real income), and the
supply of bank loans. With bank lending constrained by a risk-based capital
adequacy requirement, desired investment ultimately must be constrained as well,
and the sensitivity of desired investment to changes in output and prices is also
altered. When the standard income-expenditure-equilibrium condition is satisfied
under specific parameter configurations, the response of real income to an
expenditure shock is larger in the presence of capital requirements. By implication,
aggregate demand is more volatile in the face of capital requirements, which tends to
add to output and price-level volatility.
Cecchetti and Li (2008) introduce three additional features into the Blum-Hellwig
approach: an optimizing central banker, a supply shock, and a revised deposit
demand specification. Their financial-sector framework essentially consists of an IS-
LM-style macro model supplemented by inclusion of a binding capital requirement
ratio, an interest rate-based monetary policy procedure, and an upward-sloping
aggregate supply function with a linear supply shock. Essentially, binding capital
requirements constrain lending and investment and thereby can enhance the response
of equilibrium income to demand and supply shocks. The monetary authority
regards the main potential effects of binding capital requirements as induced changes
in the shape and/or volatility of the IS schedule. One consequence, as in Blum-
Hellwig, is that capital requirements can potentially amplify demand-side shocks.
Therefore, through both demand-side channels and supply-side channels, capital
regulation can enlarge effects of shocks on economic activity.
Cecchetti and Li assume that the monetary authority minimizes a weighted sum of
inflation and output gaps. It sets an interest-rate instrument – that is, determines the
position of the resulting horizontal LM schedule – in a manner that takes into
account any procyclical bias arising from regulatory capital requirements. This
requires expanding the monetary base sufficiently in response to capital-require-
ment-enhanced negative demand or supply shocks to compensate for the resulting
capital and credit deterioration. In this way, the monetary authority stabilizes
aggregate demand in the face of demand shocks, and it moves aggregate demand
into the proper position to balance inflation and output objectives optimally in the
face of aggregate supply shocks. Hence, Cecchetti and Li view capital regulation as
requiring adjustments by monetary authorities but do not view such requirements as
an impediment to the effective conduct of monetary policy.
Of course, the interplay between a bank regulator and a monetary authority could be
more complex than in the analyses of Cecchetti and Li, which presume that the monetary
authority can react more quickly to events than a bank regulator. In contrast, Seater
(2001) provides a macroeconomic framework in which a bank regulator and the
monetary authority simultaneously conduct regulatory and monetary policies. Seater’s
8 D.D. VanHoose

analysis suggests that coordinated bank regulatory and monetary policies would be
appropriate to attain goals involving the mean and variance of aggregate output.
An obvious theoretical limitation of the Blum-Hellwig/Cecchetti-Li approach is that it
fails to fully account for endogenous responses of the banking system to regulation.
Chami and Cosimano (2007) explicitly account for such responses in the context of a
dynamic representative-bank model in which oligopolistic banks recognize in the
current period the potential for capital requirements to be binding in a future period.
Banks base their lending on forward-looking marginal returns and on marginal costs of
loans, which take into account responses of capital in the presence of capital
regulation. Even banks that are not currently constrained by binding capital require-
ments must take into account the probability that capital requirements might bind in
future periods. Consequently, monetary policy’s effects on net interest margins
influence choices by all banks, including those not currently facing binding capital
requirements, when they determine dynamic lending paths. Furthermore, the Chami-
Cosimano model indicates that banks have an incentive to respond to capital regulation
by holding more capital than required, thereby maintaining a capital buffer that permits
a contemporaneous expansion of lending when desired without necessarily placing
themselves in a position of being bound by capital regulation in a later period.
As in Blum and Hellwig and in Cecchetti and Li, Chami and Cosimano’s analysis
indicates that capital requirements make lending more procyclical. Chami and
Cosimano also conclude, however, that capital regulation generates asymmetric
monetary policy effects depending on whether policy actions are expansionary or
contractionary. They suggest that, in the case of an expansionary monetary policy
action, there is a single, “financial accelerator” effect that occurs as the demand for
loans increases. This effect generates a rise in banks’ net interest margins, thereby
inducing them to expand capital and loans.
Chami and Cosimano find that the financial accelerator effect also works in
reverse in the case of a contractionary policy action. In the case of a monetary
contraction, however, they propose the existence of a second, “bank capital
accelerator” effect, in which the banks’ option value of issuing capital decreases
because the capital constraint is less likely to be binding in the future. This induces
balance-sheet responses within the banking system that reinforce the financial
accelerator effect. Banks reduce both capital and loan supply. Hence both loan
demand and loan supply contract during contractions. Because monetary contrac-
tions give rise to both financial accelerator and bank capital accelerator effects while
monetary expansions yield only financial accelerator effects, monetary contractions
induce stronger effects on bank credit than monetary expansions.
Van den Heuvel (2002, 2003) also considers a forward-looking dynamic model of
a capital-regulated financial system. Van den Heuvel’s model, however, emphasizes
the potential for loans to go bad at future dates together with maturity mismatching
issues. As a consequence, capital regulation can cause even banks not facing
immediately binding capital requirements to adjust the dynamic path of their
lending. Total bank lending thereby responds differently to monetary policy actions
when capital adequacy regulations are in force, with low- and high-capitalized banks
choosing different lending paths.
Most studies predict that the immediate effect of binding risk-based capital
requirements is an unambiguous reduction in aggregate bank lending. Thakor (1996)
Bank Capital Regulation 9

suggests capital regulation also potentially reduces the ability of monetary policy
expansions to boost bank lending. This possibility exists because in his framework,
capital requirements induce tougher screening by banks, which thereby fail to respond
to a monetary expansion by increasing lending as much as they would have in a capital-
unrestricted setting. Instead, banks are more likely to respond to a monetary expansion
by boosting deposits and security holdings, thereby operating more like mutual funds.
In the context of a basic credit-multiplier framework with representative profit-
maximizing banks but unchanged market interest rates, Kopecky and VanHoose
(2004b) also conclude that binding capital requirements induce a decline in
aggregate loans and alter the effects of monetary policy actions in the short run. In
addition, binding capital regulation tends to induce banks to engage in a net
expansion of non-loan, security assets. To make this net asset expansion via
increased security holdings possible, banks expand their deposit liabilities in the
short run and thereby come to look more like mutual funds, as suggested by Thakor.
This conclusion suggests that expansionary monetary policy conducted in a banking
system bound by risk-based capital requirements would, at least in the short run, lead
to a rise in total bank security holdings and deposits. In contrast, in the long run an
expansionary monetary policy induces banks to expand equity, which under risk-
based capital regulation thereby enables bank credit to expand.
Within a broader banking-sector framework that allows for interest-rate adjust-
ments, Kopecky and VanHoose (2004a) conclude that in the short run, when bank
equity cannot be readily adjusted, capital regulation does not affect banks’ desired
liability mix. In the long run, however, when banks are able to adjust their equity,
they are able to engage in more lending than in the fixed-equity case because they
are able to issue more equity to satisfy capital regulations. The costs which banks
incur by expanding equity more than they would have in the absence of capital
adequacy regulations can potentially act as a drag on lending even in the long run.
Nevertheless, when both effects of capital requirements on the market loan rate and
induced changes in the composition of bank liabilities are taken into account, the
long-run scale of the banking system, including aggregate bank lending, responds
ambiguously to the presence of capital requirements. Under some circumstances,
aggregate deposits can also increase, although, in general, the long-run effect of
capital regulation on total deposits in the banking system is ambiguous.
Jacques and Shirm (2004) examine the monetary policy implications of capital
regulation in a somewhat simpler banking-sector framework, but in contrast to other
studies they include a role for varying risk weights across bank asset categories. This
leads to the conclusion that the extent to which monetary policy actions influence
market interest rates and exert effects on bank loan and security holdings depends
crucially on the credit qualities of borrowers and security issuers. Jacques and Shirm
also conclude that the effects of monetary policy actions depend on the relative
shares of loans and securities in banks’ asset portfolios. As a result, monetary policy
effects potentially differ depending on whether credit qualities of borrowers are
worsening or improving at the time monetary policy actions are implemented.
An analogous conclusion is reached by Tanaka (2002), who analyzes the effects of
capital regulation within an IS-LM-style framework. As in Cecchetti and Li, Tanaka
finds that the immediate effect of binding capital requirements is to alter the interest
sensitivity and position of the economy’s desired investment relationship and hence
10 D.D. VanHoose

the shape and position of the IS schedule. Thus, monetary (LM) policy actions or
shocks have smaller effects on equilibrium income, but, as in Cecchetti and Li,
expenditure shocks have large impacts. Similarly to Jacques and Shirm, however,
Tanaka allows for variations in credit risk in response to changing economic
conditions that feed back to influence the toughness of capital regulation. His
conclusion is that when borrower credit risk worsens during business cycle downturns,
monetary policy actions become even less effective under capital regulation and that
expenditure shocks have even larger negative effects on real income.
Zicchino (2005) extends the Chami-Cosimano (2001) model to allow for the
possibility of borrower default and to consider a Basel II-style capital adequacy ratio
that is a decreasing function of current macroeconomic conditions. One key
implication of Zicchino’s analysis is that during periods of expansion, banks are
more likely to have to maintain lower levels of capital under Basel II than they would
be required to maintain under Basel I. As a consequence, it is more likely under Basel
II than under Basel I that a credit crunch will result following a contractionary
monetary policy action or as a result of other negative macroeconomic shocks.
Miyake and Nakamura (2006) provide a very different analysis of the
macroeconomic effects of bank capital regulation. They utilize a dynamic over-
lapping-generations model in which there are strategic complementarities between
bank equity and the capital of other firms in the economy. As a consequence, the
short-run effect of the imposition of bank capital regulation is a reduction in
equilibrium income, as well as an enlargement in the effects of productivity shocks
(the only shocks considered in the Miyake-Nakamura framework) on income. In the
long run, however, tougher capital requirements boost bank capital. Via the strategic
complementarities with capital at other firms, there is an increase in equilibrium
aggregate income and greater income stability.
In a lone attempt to evaluate how capital regulation may have affected monetary
policy, Cecchetti and Li (2008) develop Taylor-rule-type reaction functions, which
they proceed to estimate using U.S., German, and Japanese data. These reaction
functions specify central bank interest rate settings as functions of inflation, the
central bank’s inflation target, and the output gap, and the aggregate asset-capital
(leverage) ratio of the banking system. Cecchetti and Li find that the Fed optimally
pushed down the federal funds rate in response to a higher leverage ratio –
interpreted as an indicator of greater banking-system stress under capital regulation –
but that the Bundesbank and Bank of Japan did not.
Does capital regulation alter the effects that monetary policy actions have on the
banking system? Gambacorta and Mistrulli (2004) explore this question using Italian
banking data over the interval from 1992 to 2001. They find evidence of a bank
capital channel in the monetary policy transmission mechanism, in which well
capitalized banks are less constrained in their responses to monetary policy and other
macroeconomic shocks than banks with relatively lower levels of capitalization.
Kishan and Opiela (2000, 2006) evaluate the responses to monetary policy
actions of high-capital and low-capital banks. In their initial contribution, Kishan
and Opiela (2000) find evidence of a bank lending channel for monetary policy.
They examine various categories of banks based on relative sizes and levels of
capitalization and determine that the lending of smaller, low-capital banks are most
susceptible to contractionary monetary policy.
Bank Capital Regulation 11

In their more recent study, Kishan and Opiela (2006) focus specifically on the
lending responses of banks to policy actions depending on their levels of
capitalization and whether policies are contractionary or expansionary. Utilizing
quarterly balance-sheet data of U.S. banks between 1980 and 1999, Kishan and
Opiela conclude that since the advent of risk-based capital regulation, contractionary
monetary policy actions most adversely affect the lending of low-capital banks, and
expansionary monetary policy actions fail to stimulate lending by low-capital banks.

Conclusion

To the extent that there is a bank lending channel of monetary policy, reductions in
bank credit brought about by capital requirements can constrain real investment
expenditures. On one hand, the result is that any procyclical bias inherent in capital
regulation can contribute to procyclicality of aggregate expenditures. On the other
hand, constraining investment spending can also alter the sensitivity of aggregate
expenditures to external shocks. Taken together, these potential macroeconomic
effects of capital regulation translate into a potential for bank capital requirements to
alter both the average performance of a nation’s economy and the stability of real
GDP and employment. Furthermore, these effects indicate an altered responsiveness
of aggregate expenditures to monetary policy actions. Another likely result is
asymmetries of monetary policy effects on bank lending, as capital-constrained
banks cut back on their lending more sharply than unconstrained banks in response
to a monetary tightening, but tend to be less responsive to a monetary easing.
Aggregate bank capitalization relative to total assets and risk-weighted assets
increased noticeably during the 1990s, suggesting on the surface a line of causation
beginning with the implementation of the Basel system of capital regulation. Indeed,
some studies find evidence that implementation of the Basel I requirements may have
contributed to a credit crunch in the early 1990s. A number of studies, however, find less
compelling evidence of a link between capital regulation and credit curtailments, and
some researchers conclude that market forces may have played a greater role in bringing
about the overall increase in bank equity. Studies are somewhat mixed in their
conclusions about just how much of an effect capital requirements had on the aggregate
bank equity upswing, but the general theme running through most work is that capital
regulation probably contributed only slightly to the rise in overall bank equity.
Most research suggests that capital regulation likely enhances procyclical
tendencies already present in the banking industry. Most efforts to evaluate the
extent to which capital requirements add to banking procyclicality have focused on
simulations of model banking systems. The bulk of these studies indicate
considerable potential for capital regulation to have procyclical impacts. The little
empirical work examining actual data indicates that to the extent it has been binding
for the banking system as a whole, capital regulation likely has had at least mildly
procylical effects. Researchers have offered suggested policy changes that might
dampen the procyclical tendencies of the Basel I and Basel II systems of capital
requirements, but so far, no action to alter the Basel II framework has been taken.
Several studies have considered the macroeconomic and monetary policy implica-
tions of bank capital regulation. Some emphasize the potential for capital regulation to
12 D.D. VanHoose

complicate monetary policy by influencing the level of and interest-sensitivity of

aggregate real expenditures. Others suggest that a key effect of capital requirements is to
alter the transmission of monetary policy through the financial sector of the economy. A
few studies suggest that capital regulation may exert effects through both channels. One
key prediction of a number of studies is that monetary policy impacts exerted through
the banking system should be asymmetric, depending on whether or not banks are
capital-constrained, and empirical evidence appears to support this prediction.
What work remains to be done in evaluating the macroeconomic and monetary
policy effects of bank capital regulation? One area that has received very little
attention concerns actual experience with procyclicality under the initial Basel
framework put into place beginning in 1988. Better understanding of this issue
might be provided by country-level and cross-country empirical analyses of the
extent to which the Basel I system may have enhanced the procyclicality in banking.
As evidenced by the variety of approaches to exploring the macroeconomic and
monetary policy implications of bank capital regulation, there are several potential
channels through which capital requirements can affect equilibrium employment,
output, and prices. In addition, there clearly are conflicting views regarding which
are likely to prove most important. Our understanding of the potential scope of
macroeconomic and monetary policy effects of capital regulation could be enhanced
by work aimed at bringing these various channels together within one coherent
theoretical framework. Doing so could yield a full set of implications that could be
subjected to empirical testing.
Given the current state of disagreement – if not disarray – in the monetary policy
literature (see, for instance, Ball et al. 2005), developing a single model capable of
capturing the full range of potential effects might prove to be a highly challenging if
not intractable task. Nevertheless, the set of studies reviewed above offer a host of
predictions that might be subjected to empirical evaluation. Although the literature’s
predictions relating to predicted asymmetric responses of banks to monetary policy
actions have been subjected to econometric scrutiny, there has been very little work
investigating the evidence regarding the extent to which bank capital regulation
impinges on the monetary policy transmission mechanism and on actual policy
choices of central banks. These issues in particular deserve more attention than they
have received to date.
Finally, the supervisory pillar of Basel II entails increased discretion on the part of
bank regulators. This change suggests a greater likelihood of coincident adjustments
of risk-based capital standards and monetary policy settings. Thus, more work
should be done to explore the possibility for regulatory conflict once the Basel II
system is in place and to propose appropriate resolutions of this potential problem.

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