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An Examination of Spillover from Basel III Jing Wen* Graduate

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An Examination of Spillover from Basel III Jing Wen* Graduate Risk Migration from the Banking Industry to the Real Economy: An Examination of Spillover from Basel III Jing Wen* Graduate School of Business Columbia University [email protected] December 4, 2020 Abstract This study investigates whether bank regulations pertaining to capital and liquidity, which are designed to promote a resilient banking system, cause risk migration from the banking industry to the real economy. Specifically, I examine whether borrowers increase their risk-taking after incurring higher borrowing costs due to Basel III. Using a difference-in-differences research design to compare borrowers of banks that are more affected by Basel III (i.e., banks with $250 billion or more in total consolidated assets) with borrowers of banks that are less affected, I find that the borrowers more affected by Basel III (a) experienced a relative increase in loan costs, (b) displayed a relative increase in accounting- and market-based volatility, and (c) incurred a relative increase in investments in risky activities with uncertain benefits. These findings suggest that borrowers are exposed to moral hazard: to compensate for the increased borrowing costs, they are incentivized to take on more risk in pursuit of higher expected returns. Such results are not driven by adverse selection, time trend, or bank size. This study highlights a potential unintended consequence of bank regulations on borrower risk-taking. Keywords: Banking Regulation, Basel III, Real Economy, Risk Migration, Risk-Taking JEL Classifications: G21, G28 *I am very grateful to the members of my dissertation committee for their guidance, support, and many helpful insights: Urooj Khan (advisor), Fabrizio Ferri, Doron Nissim, and Stephen Penman. I thank Cyrus Aghamolla, Emily Breza, Thomas Bourveau, Matthias Breuer, Jonathan Glover, Matthieu Gomez, Émilien Gouin-Bonenfant, Moritz Hiemann, Alon Kalay, Sehwa Kim, Lisa Yao Liu, Giorgia Piacentino, Shiva Rajgopal, Stephen Ryan, Stephanie Schmitt-Grohé, Robert Stoumbos, and Anjan Thakor. I also thank seminar participants at Columbia Bernstein Center Research Lightning Talks, Columbia Business School, Columbia Deming Center Doctoral Fellowships Seminar, Columbia Financial Economic Colloquium, Columbia Economic Fluctuation Colloquium, University of Texas at Austin PhD Symposium, and fellow PhD students. I am also grateful for the helpful insights shared by Evan Picoult, as well as anonymous bank analysts and regulators. Finally, I thank the Deming Center at Columbia Business School, the Chazen Institute for Global Business at Columbia Business School, as well as the Sanford C. Bernstein & Co. Center for Leadership and Ethics at Columbia Business School for their generous financial support. All errors are my own. The most recent version of the paper is available here. The Online Appendix is available here. 1. Introduction Following the 2008 financial crisis, the Basel Committee on Bank Supervision (the “Basel Committee”) proposed Basel III, a new set of regulations pertaining to bank capital and liquidity, to address perceived weaknesses in the banking system revealed by the crisis. One of the prime objectives of the Basel Committee was to strengthen the resilience of the banking sector and reduce the risk of economic failure due to the “spillover from the financial sector to the real economy” (Basel Committee, 2010). In this paper, I investigate whether bank regulations, such as Basel III, themselves set the stage for an additional kind of spillover, namely risk migration from the banking industry to the real economy even in the absence of a total collapse. Specifically, I examine whether the regulatory burden imposed on banks under Basel III increased the risk-taking of corporate borrowers in the United States (the “borrowers”). In this paper, I measure risk-taking using eight alternative metrics, including everything from accounting- and market-based volatility to different types of investments that have uncertain benefits and are hard for banks to monitor. A few theorists predict that bank regulations—aimed at promoting a more resilient banking system—may increase subsequent borrower risk-taking (Hakenes and Schnabel, 2011). They suggest that when borrowers’ loan costs are exogenously increased due to the introduction of bank regulations, borrowers, regardless of their fundamentals, may undertake riskier projects with higher expected returns to compensate for the increase in their borrowing costs. This moral hazard is analogous to the effect of the increased cost of capital: the higher the cost of capital, the higher the required return, and the higher the required return, the higher the risk-taking. The prediction, however, may not be certain, depending on a myriad of factors, including the severity of burden imposed by a bank regulation, the extent of information asymmetry between banks and borrowers, and the extent of borrowers’ dependency on banks. For example, a bank 1 regulation may be designed in a lenient way and, thus, may not necessarily impose much burden on banks. In such a case, the regulation may not increase the cost of lending of banks and risk- taking of borrowers. Moreover, if there is little information asymmetry between banks and borrowers, borrowers faced with greater loan costs due to bank regulations may be incentivized to reduce their risk-taking in the hope of being able to renegotiate better terms in the future. Furthermore, when borrowers are not dependent on bank loans, they may be able to obtain low cost funding from nonbank sources (Glancy and Kurtzman, 2018). In such circumstances, these borrowers may not need to adjust their risk-taking. Whether bank regulations increase borrower risk-taking is, therefore, theoretically ambiguous and, thus, an open empirical question. Examining this question is important. Typically, to ensure the stability of the financial system, bank regulators focus their attention on maintaining banks’ strong capital and liquidity positions. However, the stability of borrowers is also a key to the stability of the financial system (Boyd and De Nicoló, 2005; Hakenes and Schnabel, 2011). The risk of borrowers contributes greatly to the stability of banks, as loans compose the majority of bank assets. 1 The risk of borrowers feed back to the banking system through loan delinquency, and such feedback may increase the systemic risk in the banking system. In fact, it was the massive default by household borrowers that was often blamed for the failure of banks during the 2008 financial crisis (Baily, Litan, and Johnson, 2011). Moreover, the syndication of corporate loans may pose another threat to the systemic risk in the banking system as “syndication increases the overlap of bank loan portfolios and makes them more vulnerable to contagious effects” (Cai et al., 2018). This issue has concerned at least one regulator. In 2018, Pablo D’Erasmo at the Research Department of the Federal Reserve Bank of Philadelphia expressed concerns about the potential 1 https://www.federalreserve.gov/releases/h8/current/default.htm 2 increase in borrower risk-taking resulting from the higher rates that accompany bank regulations and called for more research “to measure the economic effects of higher capital requirements to gain a firmer understanding of what amount of bank capital is optimal” (D’Erasmo, 2018). To the best of my knowledge, there has been no empirical research regarding the unintended consequences of bank regulations on borrowers risk-taking. Prior research on the effect of bank regulations on financial stability has focused exclusively on banks’ risk-taking choices (e.g., Ongena, Popov, and Udell, 2013) rather than borrowers’ risk-taking decisions. This paper, therefore, investigates the occurrence and magnitude of the increase in borrower risk-taking resulting from bank regulations, in this case from Basel III, and serves as a cornerstone for future research and regulators to understand the full effects of bank regulations. To investigate the effects of bank regulations on borrower risk-taking, I compare banks and borrowers in the syndicate market that are “more affected” by Basel III with banks and borrowers that are “less affected.” I focus on banks and borrowers participating in the syndicated loan market, because the risk of syndicate borrowers is more likely to systemically affect banks in those syndicates. In this paper, banks and their borrowers are deemed “more affected” by Basel III if the banks have $250 billion or more in total consolidated assets. Banks and their borrowers are deemed “less affected” if not meeting that criterion. Under the regulations, banks with $250 billion or more in total consolidated assets are subject to additional Basel III provisions and, thus, greater regulatory burdens. The most common and costly of these additional Basel III provisions are: the advanced approaches rule (AA), the supplementary leverage ratio (SLR), the liquidity coverage ratio (LCR), the enhanced SLR, and the enhanced rule for Global Systemically Important Banks (GSIBs), although not all of these provisions are applicable to every bank with $250 billion or more in total consolidated assets. Despite the wide variability and disparate applicability of the 3 regulations, I use the difference-in-differences (DD) research design to estimate the average treatment effect of greater exposure to regulatory burdens under Basel III. Since Basel III is not likely to have resulted from changes in any individual bank’s or borrower’s fundamentals, I use Basel III as an
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