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Four Essays on Capital Regulation of Banks Four Essays on Capital Regulation of Banks Schriftliche Promotionsleistung zur Erlangung des akademischen Grades Doctor rerum politicarum vorgelegt und angenommen an der Fakultät für Wirtschaftswissenschaft der Otto-von-Guericke-Universität Magdeburg Verfasser: Eva Schliephake Geburtsdatum und -ort: 01.02.1983, Karl-Marx-Stadt (heute Chemnitz) Arbeit eingereicht am: 20. Juni 2013 Gutachter der schriftlichen Promotionsleistung: Professor Dr. Roland Kirstein Professor Dr. Abdolkarim Sadrieh Datum der Disputation: 24. September 2013 The Essays This collection of essays analyzes optimal capital requirement regulation and its effects on the incentives of stakeholders. The first essay, written together with my supervisor Roland Kirstein was recently published in the Journal of Money Credit and Banking. It analyzes under which conditions a binding capital requirement reduces the incentives of banks to undercut in prices. Based on the strategic capacity commitment model of Kreps and Scheinkman (1983) we show that if the immediate recap- italization insufficiently costly, capital requirement regulation induces banks that compete in Bertrand competition to behave like Cournot competitors. Formally, the binding capital regulation changes the strategic price setting Bertrand game into a two stage game, where banks first have to commit to a loan supply capacity before they compete for loan interest rates. This de- creases the loan supply and increases loan interest rates, resulting in higher profits for banks compared to the unregulated case. In this thesis, I add the online appendix to the published version that provides all the proofs of the propositions. This appendix was not part of the publication due to capacity limits within the journal. The second essay builds on the results of the first essay and analyzes the impact of reduced competition on the efficiency of capital requirement regulation in establishing financial stability. It is shown that if the markets are concentrated, i.e., there are only few banks, the possibility to commit for capacities and the resulting gain of price setting power can increase the efficiency of capital regulation compared to the efficiency under perfect com- petition. The third essay is an equally shared work with Florian Buck from the LMU M¨unchen, which is accepted for publication in the Journal of Banking and Finance. In this paper we analyze the efficient mix of capital regulation and banking supervision. We show that both instruments are substitutes within a feasible set. If we allow for regulatory competition our model shows that the implementation of the optimal policy is not feasible. An agreement on international minimum capital standards may reduce the inefficiencies of international competition among regulators. However, a harmonized capital regulation may reduce the average supervisory effort. The fourth essay concentrates on the regulator's incentives to implement optimal risk weighted capital requirements for risky and safe assets, i.e., government bonds. I show that a regulator that simultaneously regulates the banking sector while also borrowing from the sector is confronted with a conflict of interest. As a result a regulator with fiscal interest may set the risk weight for risky assets to high compared to the weight for government bonds. By doing so the banks' demand for government bonds is increased. This eases government spending. Therefore, the government regulator can indirectly influence his refunding conditions and increase government spending. Essay I Strategic Effects of Regulatory Capital Requirements in Imperfect Banking Competition EVA SCHLIEPHAKE ROLAND KIRSTEIN Strategic Effects of Regulatory Capital Requirements in Imperfect Banking Competition This paper analyzes the competitive effects of regulatory minimum capital requirements on an oligopolistic loan market. Before competing in loan rates banks choose their capital structure, thereby making an imperfect commit- ment to a loan capacity. It is shown that due to this imperfect commitment, regulatory requirements not only increase the marginal cost of loan supply, but can also have a collusive effect resulting in increased profits. This pa- per derives the threshold value from which capital requirements can turn one round Bertrand competition into a two-stage interaction with capacity commitment, leading to Cournot outcomes. Therefore, it provides theoret- ical support for the applicability of the Cournot approach when modeling imperfect loan competition. JEL codes: G21, K23, L13 Keywords: capital regulation, oligopoly, capacity constraint. WEEXAMINETHELIKELYanticompetitive effect of capital re- quirement regulation, as introduced by the international banking regulation under the Basel accords, which has not been examined in the previous literature. A sound bank- ing system is essential for ensuring economic wealth and stability. Since the banking sector is particularly vulnerable to inefficient bank runs and contagion resulting in This research has been made possible by a grant (KL 1455/1-1) from the German Research Foundation (Deutsche Forschungsgemeinschaft) and by the Friedrich Naumann Stiftung fur¨ die Freiheit through grants from the Federal Ministry of Education and Research (Bundesministerium fur¨ Bildung und Forschung). Helpful comments were received from Florian Buck, Thilo Liebig, Werner Neuss, Thilo Pausch, Simone Raab, Marc Steffen Rapp, and Peter Welzel. Constructive input was also given by the participants at the following conferences: the Deutsche Bundesbank Finance Research Colloquium, the 72. Annual Conference of the Verband der Hochschullehrer der Betriebswirtschaft (VHB), May 2010 in Bremen; the Annual Meeting of the European Association of Law and Economics (EALE), September 2010 in Paris; the Annual Conference of the German Economic Association (Verein fur¨ Socialpolitik), September 2010 in Kiel; and the Annual Conference of the German Law and Economics Association (GLEA), December 2010 in Wiesbaden. In addition, we are grateful for the particularly helpful comments of an anonymous referee and one editor. EVA SCHLIEPHAKE is a scientific assistant at Otto-von-Guericke University (E-mail: Eva.Schliephake@ ovgu.de). ROLAND KIRSTEIN is a professor of economics at Otto-von-Guericke University (E-mail: [email protected]). Received March 4, 2011; and accepted in revised form June 13, 2012. Journal of Money, Credit and Banking, Vol. 45, No. 4 (June 2013) C ! 2013 The Ohio State University 676 : MONEY, CREDIT AND BANKING bank panics, the overall aim of banking regulation is to secure financial stability by minimizing the likelihood of bank runs ex ante,andreducingex post contagion when banks fail. To achieve this goal, most countries have introduced a governmental safety net, which includes deposit insurances, and lender of the last resort practice as well as bailout policies. The undesirable secondary effect of such a safety net is the destruction of market discipline, thereby providing strong moral-hazard incentives to exploit the option value of the safety net. Greenbaum and Thakor summarize this idea as follows: The moral hazard engendered by one form of regulation, namely deposit insurance, creates the need for other forms of regulation such as capital requirements. (Greenbaum and Thakor 1995, p. 103) The intuition is that well-capitalized banks have fewer incentives to increase asset risks. A bank endowed with more capital is less likely to exploit the option value of the deposit insurance, thereby reducing the probability of banking default. However, if a binding equity regulation is introduced (or tightened), then banks have to either reduce their assets or increase their capital. In the short run, an immediate increase in capital in order to match the regulatory requirement may prove costly or even impossible. Therefore, the immediate effect of increasing the capital requirements is likely to cause a reduction in the total supply of loans and, accordingly, an increase in the loan interest rate. Our paper demonstrates that a binding regulatory capital requirement may alter the sequence in which strategic decisions are made since it constrains a bank’s lending activities in the short run. This is in line with Brander and Lewis (1986), who analyzed the strategic impact of leverage decisions on output decisions. They argued that increases in a firm’s leverage enhance the output level of the firm in a Cournot oligopoly with random demand. In contrast, we concentrate on the effects of a strategic capital choice in a deterministic Bertrand competition and examine the impact of a capital commitment on the fierceness of the loan rate competition. In the first stage, the capital regulated banks decide on their refunding structure, which consists of equity and deposits. In the second stage, loan rate competition takes place while the bank’s ability to satisfy the demand resulting from the loan rate decision is conditioned by the amount of capital raised and the capital requirement regulation. If recapitalization is costly, then the capital decision in the first stage is an imperfect commitment to capacity for bank loans. Applying the model developed by Maggi (1996) to a bank loan market, we analyze the effects of a capital requirement regulation on the strategic behavior of oligopolistic banks. We show that if the cost of recapitalization is above an identified threshold, banks would no longer have an incentive to undercut each other in the second-stage loan rate competition. Due to the binding precommitment to a loan capacity,
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