In a working paper put forward by the Bank of England (BoE), a study has been performed on whether the UK banking sector has experienced a change in the way institutions deal with changes in capital requirement, and in particular pre- and post-crisis. The study includes results based on aggregated market data as well as firm based data of over 100 UK banks between 1989 and 2013.
What do aggregate data suggest about behaviour?
The aggregated study, which was based on bank balance sheet growth, capital resources and overall requirements, showed that both the aggregated annual loan growth and annual risk-weighted assets experienced a downfall at the height of the crisis whilst at the same time the overall sector capital requirement and capital ratio began a considerable upturn. As pointed out in the article, a similar, although more subtile patterns was seen in the early 1990s following the higher requirements introduced by the Basel I risk-based capital standards.
Albeit the result of the aggregated study seem to indicate that there may have been a change in the way banks manage capital ratios and balance sheets in response to higher capital requirement after the crisis, it is difficult to draw any firm conclusions from aggregated data. This is due to the possibility that the apparent changes seen pre- and post-crisis can be significantly influenced by the largest banks in the UK, given their more substantial weight in the aggregate analysis.
What do granular data suggest about behaviour?
To further study the behaviour of UK banks, BoE performed a firm based study to evaluate; i) how capital requirement affect banks' capital ratios and, ii) how did banks move towards new targets in response to higher capital requirements before and after the crisis.
In response to the first question, the result of the study highlighted a positive and statistical significant relation between banks’ target ratios and capital requirements. This relationship would therefore suggest that banks react to higher requirements by raising capital ratio. However, an additional study showed that banks did not raise capital ratios by the full amount reflected by the increase in the capital requirement. Instead, banks tended to raise capital ratio by around 30% of the increase in requirement within the first six months and by around 80% of the range in the long-run. Based on over 100 banks across the given 25 year period, these results reflect how banks, on average, altered capital ratios in response to changes in capital requirements over the studied time period. Additionally, the study was performed to evaluate whether banks’ behaviour changed after the crisis, however no statistical evidence was found that would indicate that post-crisis behaviour would differ from that seen pre-crisis.
To answer the second question, the BoE studied the change in annual growth in response to increase in capital requirement pre- and post-crisis. The result shows that post-crisis, firms place more emphasis on raising capital levels, and in particular in better-quality tier 1 capital. In comparison, the pre-crisis response to a one percentage point increase in capital requirements resulted in around a 30 basis points increase in the annual growth rate of total regulatory capital, whilst the post-crisis response resulted in more than a 50 basis points increase. The same comparison with respect to the tier 1 capital shows that the post-crisis response was over 40 basis points compared to around 10 basis points in the pre-crisis case.
While the presented paper does not investigate the driving factors of these changes, the authors suggest the possibility that the tougher capital requirements under Basel III (set for 2019) influenced banks’ capital and balance sheet practices during the post-crisis period in the performed study. This could indicate that some of the findings may, therefore reflect the forward-looking nature of banks’ responses during the years immediately after the crisis and the negotiation period of Basel III.
The initial results of the studies performed in the working paper of BoE would indicate that the way banks respond to changes in capital requirements indeed have changed after the crisis. In particular, the result suggest that banks are raising more capital in response to higher requirements compared to pre-crisis, and especially better-quality tier 1 capital which has seen a significant increase after the crisis.