Bank Behavior Under Capital Regulation: What Does The Academic Literature Tell Us?

This paper reviews academic studies of bank capital regulation in an effort to evaluate the intellectual foundation for the imposition of the Basel I and Basel II systems of risk-based capital requirements. The theoretical literature yields general agreement about the immediate effects of capital requirements on bank lending and loan rates and the longer-term impacts on bank ratios of equity to total or risk-adjusted assets. This literature produces highly mixed predictions, however, regarding the effects of capital regulation on bank asset risk and overall safety and soundness. Research also indicates that bank capital regulation can have procyclical macroeconomic effects and can impinge on the effectiveness of monetary policy. Although empirical research provides some support for the macroeconomic and monetary policy implications of risk-based capital requirements, conclusions about actual bank balance-sheet and risk adjustments to capital regulation are also mixed. Thus, the intellectual foundation for the present capital-regulation regime is not particularly strong. The mixed conclusions in the academic literature on banking certainly does not provide unqualified support for moving to an even more stringent and costly system of capital requirements.