Journal of Banking & Finance 35 (2011) 323330

Contents lists available at ScienceDirect

Journal of Banking & Finance

journal homepage: www.elsevier.com/locate/jbf

Bank capital regulation and credit supply q

Jung-Soon Hyun a, Byung-Kun Rhee b,
a
b

Business School, KAIST, Seoul, Republic of Korea

Division of International Commerce, Pukyong National University, Busan, Republic of Korea

a r t i c l e

i n f o

Article history:
Received 8 July 2008
Accepted 16 August 2010
Available online 20 August 2010
JEL classication:
G21
E44

a b s t r a c t
Banks can meet the need to increase their capital ratio either by issuing new equity or by reducing loans.
It is generally known that banks prefer to reduce assets due to the high cost of equity. With a simple
banking model we show that, if incumbent shareholders are to benet, banks may prefer to reduce loans,
even though they can recapitalize by issuing new equity without any cost. The result holds when banks
hold relatively small amounts of long-term loans, or when the economy is in downturn.
2010 Elsevier B.V. All rights reserved.

Keywords:
Capital adequacy ratio
Credit supply
Recapitalization

1. Introduction
Capital-based regulation has become a major issue in the banking industry after subprime mortgage problems led to the American nancial crisis of 2007. Losses on mortgages and other
mortgage-related securities dramatically reduced the capital base
of many banks. To maintain the minimum capital adequacy ratio,
capital-constrained banks began collecting outstanding loans or
became reluctant to approve new lending. This effort by banks to
raise the capital ratio by loan contraction is alleged to have contributed to the worldwide nancial crisis.
Capital-constrained banks can recover the capital ratio either by
reducing assets or by increasing equity capital. It has been shown,
theoretically and empirically, that banks reduce lending more often than they recapitalize. In a survey of the impact of the Basel Accord, Jackson et al. (1999) argue that banks are likely to cut back
lending when either economic conditions are poor or raising new
capital is costly. Because the bank capital constraint is more likely
to be binding during economic downturns, recapitalization would
not be easy and the bank may meet the capital ratio by reducing
lending. When capital regulation was newly introduced in late
1980s, many American banks reduced their credit supply to meet
the capital requirement. For this reason, Bernanke and Lown

q
This research was partially supported by the Development Fund of the College
of Business Administration, Pukyong National University.
Corresponding author. Tel.: +82 51 629 5760; fax: +82 51 629 5754.
E-mail addresses: jshyun@business.kaist.ac.kr (J.-S. Hyun), bkrhee@pknu.ac.kr
(B.-K. Rhee).

0378-4266/$ - see front matter 2010 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankn.2010.08.018

(1991) and Peek and Rosengren (1995) refer to the credit crunch
that occurred in New England in the early 1990s as a capital
crunch. According to King (2001) and Brana and Lahet (2006),
when Japanese international banks were under capital constraint
in the mid-1990s, they withdrew from East Asian countries, contributing to the outbreak of the Asian nancial crisis in 1997.
Theoretical discussions regarding the preference of banks to reduce loans are focused on the cost related to the issuing of new
capital. Issuing new equity requires a great deal of preparatory
work and is associated with various costs in terms of time and effort. In this sense, Peura and Keppo (2006) assume a time delay on
implementation as well as costs of a xed proportion to the size of
the capital issuance. As suggested in Myers and Majluf (1984),
asymmetric information and information dilution are the costs of
raising equity capital. The signaling effect is another cost that managers may want to avoid. Therefore, the pecking order theory suggests that equity is usually the last method to be used to raise
funds.
This paper is an attempt to suggest another motivation to explain why banks prefer to cut lending rather than recapitalize in
order to raise capital ratios. One effect of recapitalization is the
dilution of controlling rights. In a commentary on the global nancial crisis, Onado (2008) argues that the reluctance of banks to
recapitalize is due not only to the cost of the operation but also
to the fact that it could signicantly dilute existing shareholder value. This dilution effect is not often discussed in banking area, especially in relation to capital regulation. This paper tries to
theoretically analyze the effect of the dilution on a banks decisions
about how to meet its capital requirement.

324

J.-S. Hyun, B.-K. Rhee / Journal of Banking & Finance 35 (2011) 323330

If incumbent shareholders have enough controlling power, the

decision of whether to issue new equity or to reduce debt will be
made in favor of existing shareholders. When a bank issues new
equity, it will decrease the share of incumbent equity holders, thus
weakening their controlling power. Therefore, a bank may be
reluctant to issue new capital and take the easier approach of
reducing assets to maintain the capital ratio.
For the above argument to be meaningful, two assumptions
must hold. The rst assumption is that a managerial decision is
to be made in the shareholders favor. The second assumption is
that even if that is the case, the benet to existing shareholders is
to be maximized. That is, the welfare of potential new shareholders
is not considered as a factor in such a decision.
These two issues are largely covered in corporate governance
literature. The rst one is agency problem which is originated from
Jensen and Merckling (1976). Theoretically, a rm must maximize
the wealth of its owners. However, the agency theory states that
the optimal decision from a managers viewpoint is not always
maximizing the welfare of shareholders. Many empirical studies
show the existence of agency conicts in nonnancial rms. Eisenhardt (1989) provides a thorough list of empirical studies of agency
theory. Recently, Harris and Glegg (2009) have put forward supporting evidence for agency theory with data for privately negotiated stock repurchases.
The agency problem in banking rms may not exactly conform
to that in nonnancial companies. It would not be easy for equity
holders to exert control in large banks. The entrenchment of management is also an important factor. However, James (1984), Brickley and James (1987), Schranz (1993) and Hubbard and Palia
(1995) provide some evidence that the market for corporate control in banking behaves as it does in nonnancial rms. Houston
and James (1995) and Prowse (1995) nd that the frequency of
management turnover is about the same in banks as in nonbanks.
Ferris and Yan (2009) have shown the existence of agency conicts
in the mutual fund industry.
Given the evidence that agency conicts are found in banks to
the same extent as in nonbank organizations, the assumption that
managerial decisions in banks favor the shareholders interests is
partly supported by several studies. Lee and Schweitzer (1989) nd
that after the activation of the Financial Center Development Act of
Delaware in the early 1980s, the decisions of bank holding companies have been consistent with the maximization of shareholder
wealth. Roth and Saporoschenko (2001) suggest that the sensitivity
of a bank CEOs compensation to shareholder wealth increases as
the share of institutional investors increases. Pathan (2009) shows
that strong boards (boards reecting more of bank shareholders
interest) positively affect bank risk-taking in the shareholders favor. With balance sheet information for around 500 commercial
banks from more than 50 countries, Shehzad et al. (2010) nd that
ownership concentration improves banking rm performance.
Because institutional ownership, strong boards and ownership
concentration are factors that improve management monitoring
ability, we may assume that managerial decisions are to be made
to maximize the wealth of shareholders if appropriate monitoring
is guaranteed.
The second issue is whether the benet of existing shareholders
is maximized. This issue can be traced to Myers and Majluf (1984).
They state that We think it more likely that managers having
superior information act in old stockholders interest. We also
think that existing empirical evidence supports our view.1 Significant negative price impacts for newly issued stock found by Korwar
(1981) and Dann and Mikkelson (1984) are suggested as evidence
supporting their view. Schleifer and Vishny (1997) also point out

Myers and Majluf (1984, p. 214).

that the behavior of large investors who pursue their own interests
may not be compatible with the interest of small shareholders. Controlling shareholders non-dilution motives for debt nancing as
mentioned in Du and Dai (2005) is also evidence of decision making
in favor of existing equity holders.
In this context, it is assumed that a banks managerial decisions are made to maximize the wealth of incumbent shareholders. Under this assumption, issuing new equity to the public
means a linear loss of shares in proportion with an increase in
capital ratio. Meanwhile, loan reduction may yield less than a
proportionate decrease of shareholder prot if the bank cuts
the riskiest outstanding loans. A banks loan decisions are made
after considering various types of information about borrowing
rms. However, the central part of the selection procedure is to
assess the credit-worthiness of borrowers. Libby (1979) argues
that the main task of loan ofcers of commercial banks is to
judge the customers ability to pay their obligations. From interviews with bank executives, Nutt (1989) concludes that in loan
decision making, the repayment prospect is the single most
important factor. To be consistent with these ndings, we
assume that the bank cuts the lowest credit assets among those
with the same net present value (NPV) when it reduces the
loans.
In relation to capital regulation and loan contraction, banks
tend to cut relatively high-risk weighted assets when they need
to reduce loans to recover from a weakened capital position as
has been seen in some Asian countries. Using post-Basel period
data, Montgomery (2005) shows that relatively poorly capitalized
Japanese international banks cut back on relatively high-risk
weighted assets. With data from 11 developing countries, Hussain
and Hassan (2006) suggest that the portfolio risk of banks has
dropped during the ve years following the adoption of capital
requirement regulations.
Based on these assumptions, we show that capital-constrained
banks prefer loan reduction over the issuance of new equity.
However, the recapitalization is not uniformly dominated by loan
reduction. From a relationship banking point of view, banks have
multiple interactions with the same customer. Loan reduction
may trigger a subsequent default of outstanding loans, causing
a nonlinear effect on prot loss. This paper shows that banks prefer asset reduction to equity issuance when the new capital regulation is not a dramatic increase of capital adequacy ratio. This
result is meaningful because, in contrast with previous articles
dealing with the same issue, we do not impose any cost on issuing equity.
This paper is organized as follows. In Section 2, the model is
presented. In Section 3, resource allocation under capital regulation is discussed. Section 4 describes the effects of increased bank
capital ratio and Section 5 discusses the interactive effect of NPV
and credit risk of assets. Section 6 concludes with policy
implications.

2. Model
2.1. Agents
We consider a simple banking model with three periods dened
as 0, 1 and 2. A representative bank faces an innite number of
rms. As in Gorton and Winton (1995), there exists a continuum
of entrepreneurs/rms with total mass 1. Each entrepreneur/rm
can be matched with an element in [0, 1]  [0, 1].
At t = 0, each entrepreneur builds a rm, which costs B0. He or
she borrows B0 from the bank as a long-term loan. The entrepreneur pays interest at the end of period 1, but pays both principal
and interest at t = 2. After the rms are developed, each entrepre-

J.-S. Hyun, B.-K. Rhee / Journal of Banking & Finance 35 (2011) 323330

neur exerts effort to increase the productivity of his/her rm. The

additional efforts of each entrepreneur affect the level of output.
The effort level is denoted by x and is assumed to be uniformly distributed in [0, 1].2 Because the number of entrepreneurs can be
matched with an element in [0, 1]  [0, 1], there is a continuum
of rms equivalent to [0, 1] for each effort level x 2 [0, 1].3 The effort level does not change afterwards and banks regard it as a credit rating for each rm.
Production occurs in periods 1 and 2. In the production process,
additional working capital of B1 is required to operate a rm. Moreover, not all operating rms produce output. The level of output of
a rm is determined by three factors: the effort level of the entrepreneur, the overall economic conditions, and the individual shock.
However, it is assumed that these effects cannot be individually
decomposed.
The output of a rm with effort level x is given by


yt x

y with probability /x 1  A Ax;

t 1; 2; 0 < A < 1:
0 with probability 1  /x A  Ax;
1

In this setup, rms with high credit/effort levels have a high

probability of positive production (y), meaning a low probability
of default. Because /(1) = 1 and /(0) = 1  A, a rm with a credit
rating of 1 never defaults, whereas one with a credit rating of 0
does not always default. The probabilities of positive production
during periods 1 and 2 are assumed to be independent. A rm that
realizes zero output at t = 1 may not do so at t = 2 and one that successfully produces a positive output at t = 1 still has a positive
probability of zero output at t = 2. Due to this stochastic independence, rms with the same credit rating have an equal probability
of default at t = 2 regardless of whether they have defaulted at t = 1
or not.
The macroeconomic condition of the economy is denoted by the
probability parameter A, which lies between 0 and 1. The size of
parameter A controls the overall probabilities of positive output.
The greater the value of A is, the higher the probability of zero output for all rms. Hence, large A represents a poor economic condition. The positive output level y is assumed to be large enough to
service the debt.
A representative bank is established at t = 0 by a banker with
capital K. The banker is the manager of the bank and maximizes
his or her own prot. We assume that the banker invests all of
his or her wealth into the establishments of the bank. When the
bank needs to increase capital, it must sell shares to the public.
The bank acquires deposits. To focus on the investment and
capital management of the bank, the amount of deposits are assumed to be xed and normalized to a unit value. For investments,
it either lends to rms or buys government bonds that pay a xed
interest, rf. The lending rate is given by rl and the deposit rate by rd.
Thus, in the absence of risk due to changes in interest rates, the
only risk associated with a loan is the possibility of default. Indeed,
banks are exposed more extensively to credit risk than to market
risk. It is also assumed that the lending rate (rl) is greater than
the deposit rate (rd).
The government does two things: it supplies government bonds
and it determines the capital adequacy ratio, which is dened as
the ratio of capital to the risk-weighted sum of bank assets. The
risk weight of loans is 1 and that of government bonds 0. When
the government announces a high capital ratio, the bank may decide to issue new equity for recapitalization. In this case, the equity
2

The effort level x can be regarded as entrepreneur-specic technology level.

By assuming a continuum of rms, we can apply the law of large numbers for
each effort/credit level. It enables us to solve the problem even though it is an
uncertainty model.
3

325

market opens up so that the bank may sell new shares to the
public.
2.2. Optimal behavior
The behavior of rms is simple. To operate a rm, the entrepreneur applies to the bank for a short-term loan of B1 in each period.
If a rm fails to nance B1, it cannot commence production but
must instead wait for the next period. Those rms that borrow
B1 commence production, and their level of output is randomly
determined by the probability as in Eq. (1).
Firms with output level y can service their debt. Because it is assumed that the output level y is large enough to pay interest, those
rms realize a positive prot of y  (rlB0 + (1 + rl)B1), which is then
consumed by entrepreneurs. Firms with zero output inform the
bank that they cannot pay interest. However, even though they
produced nothing in period 1, they retain the factory and wait
for the next period.
At the end of period 2, a rm pays the principal of its long-term
loan (B0). The scrap value of each rm is assumed to be B0. For this
reason, the bank does not need to establish a loan loss reserve for
long-term debt.
There may be some possibility of false reporting by a rm. Even
though the realized output of a rm is y, it may report to the bank
that its output was zero. The rm has an incentive to do so because,
due to the serial independence of the probability distribution, the
default in period 1 does not affect the banks lending decision in
period 2. Here, myopia for rms and the honest reporting of production are assumed.
The banks behavior is as follows: at t = 0, with 1 unit of deposit
and capital K, the bank faces total demand B0 for long-term loans.4
Because the bank does not, at this point, have any information about
the entrepreneurs seeking loans, the bank approves loans to all
rms.5 If the reserve requirement is q, the banks remaining resources (1  q + K  B0) are invested in government bonds.
During the period 0, the bank collects information about each
entrepreneurs effort level (x), which is then used as a credit rating
for the respective rm. It is assumed that the bank knows the effort
level of each entrepreneur. Even after realization of the rst-period
output level, the bank applies the same credit rating to each rm
because, given the effort level, the output is determined by idiosyncratic shock.
At the beginning of period 1, the bank faces a demand for shortterm loans from all rms. The bank must therefore reallocate resources of 1  q + K  B0 between government bonds and shortterm loans. In contrast to the long-term loan decision at t = 0, the
bank now has information regarding each rm, which is the credit
rating x. Expected prot from an additional short-term loan to a
rm with rating x is /(x)rl(B0 + B1)  (1  /(x))B1, where /(x) is
the probability of positive output as in Eq. (1). Because the banker
is assumed to be risk-neutral, he or she will simply maximize the
expected prot by lending to all rms that give expected prots
higher than that of government bonds. That is, the bank will approve loans to all rms with credit rating greater than x1 such that

/x1 r l B0 B1  1  /x1 B1 r f B1 :

From an NPV point of view, a loan to a rm with credit rating x1 has

zero NPV when we use the government bond rate as a discount rate.
Loans to rms with higher ratings have a positive NPV. In fact, they
can be ordered by NPV, which is equivalent to being ordered by
credit rating. This positive relationship between NPV and the credit
R1 R1
More precisely, total loan demand is 0 0 B0 ds dz B0 . Likewise, in the remainder of this paper, aggregate values denote the integrated sum.
5
If there is any entrepreneur who fails to borrow B0, he or she is ignored because
his or her rm never comes into existence.
4

326

J.-S. Hyun, B.-K. Rhee / Journal of Banking & Finance 35 (2011) 323330

Among the rms that succeed in nancing working capital,

1  A + Ax of rms for each x realize a prot of y  (1 + r)B1  rB0.
The remainder of the rms makes zero prot.
In period 2, the bank has the same amount of funds to be invested and uses the same credit ratings as in period 1. Because
the realized output level of a rm at t = 1 does not affect the expected output of period 2, the bank does not have any incentive
to reshufe its loan portfolio unless the amount of available resources changes. Therefore, the bank provides loans to the same
rms as in the previous period. The allocations are the same as
in period 1. The only difference from the previous period is that
long-term loans are repaid and the banker has more resources to
consume at the end of the period.

Fig. 1. Distribution of rms.

rating is due to the assumption that the amount of the loan is uniform across rms. Later in Section 5, this assumption is relaxed to
analyze the effect of the positive relationship.
Because no operating costs for the bank are assumed, the deposit rate and the risk-free rate are equal. In addition, they can be assumed to be zero without a loss of generality, i.e., rd = rf = 0. For
notational simplicity, r is used to denote the lending rate, which
is the only nonzero interest rate. A reserve requirement rate (q)
is also assumed to be equal to zero.
Because there are rms equivalent to [0, 1]  [0, 1], they can be
represented by a square, as shown in Fig. 1. The indices for the horizontal axis are also used to denote a rms credit rating. When the
bank approves the short-term loan to all rms whose credit ratings
are greater than x, rms that belong to area U and G will commence production. As can be seen from the gure, there is a continuum of rms with the same credit rating. By the law of large
numbers, the proportion of rms with positive output, ex post,
among the rms with credit rating x is equal to the probability
1  A + Ax. Therefore, those rms in area G realize positive output
whereas the remaining rms (U) have zero output.
The prot of the bank is


Z 1
rB0 B1 ds 
B1 ds dz
x
0
1AAz


2  A1  x
A
rB0 B1  1  x2 B1 :
1  x
2
2

px

Z

1AAz

The rst term is the interest received from rms with output y,
and the second term is the loss from those with zero output. When
the prot is positive, it is consumed by the banker.6

3. Allocation under capital regulation

Suppose the capital adequacy ratio is k, and x2 is dened as a
credit rating that satises k = K/[B0 + (1  x2)B1]. The bank can meet
its capital regulation by lending B1 to all rms whose credit rating
is greater than x2. Then, the lowest level of credit at which the bank
actually approves a short-term loan must be x = max{x1, x2}, where
x1 is dened as in Eq. (2). To analyze the effect of increasing the
capital ratio, we assume that capital regulation is binding at k,
i.e., x = x2.
At period 1, the bank approves short-term loans to all rms
whose credit rating is greater than x. It buys government bonds
with the rest of the funds, 1 + K  B0  (1  x)B1. The prot, which
is the dividend to the banker, is equal to the amount given by p(x)
in Eq. (3).
6
The utility function of the entrepreneurs and the banker is simply the sum of the
level of consumption at times 1 and 2. Because entrepreneurs consume residual
prot, the functional form is not of great importance.

4. The effect of an increase in the capital adequacy ratio

In this section, another allocation, in which the capital adequacy
0
ratio (k ) is higher (k0 > k), is considered. This new allocation will be
compared with the one in the previous section in order to analyze
the effect of tightening capital regulation.
The banker facing higher capital regulation has four options: (i)
exit the industry, (ii) recoup the additional capital from his/her
wealth other than that conferred by bank ownership, (iii) issue
and sell new equity to the public, or (iv) reduce assets. In this
study, the rst two options are not considered.
To raise its capital ratio, the bank has to decide whether to issue
new equity or reduce high-risk assets. If rms never default or if
the bank is completely ignorant of the credit-worthiness of the
rms that have obtained loans, then the bank will regard the two
options indifferently. However, in the real world, banks have information, i.e., credit ratings, about the possibility of a rms likelihood of defaulting on its loans.
In the view of the incumbent shareholder, issuing new equities
means losing a part of the share of ownership and reducing assets
may result in less prot. Either way, the banker will have lower
dividends than in the case of a lower capital ratio. However, the
rates of decrease may not be the same for the two options. If the
bank recapitalizes by issuing new equity to the public, the shares
of the incumbent stockholder will be diluted and the dividend will
decrease proportionately. However, if the bank chooses to reduce
its loans, it might do so by cutting only the riskiest ones which
may reduce the prot at a less than proportionate rate. Therefore,
incumbent shareholders prefer the strategy of loan reduction. Theorem 1 describes sufcient conditions for this argument to be true.
Theorem 1. When a bank faces a higher capital requirement,
reducing high-risk loans, rather than issuing new equity to the public,
is preferred by incumbent owners if one of the following conditions
holds:

i B0 0;
0

ii

k
Ab 1  x2 1 rb 1
B0
; where b :
<
k 2rb 1b Ab2 1 rb 1
B1

[Proof in the Appendix]

When the bank issues equity to meet the tighter capital regulation, the incumbent owners share decreases from 1 to k/k0 . Because the bank can hold the same assets as in the case of k and
we do not assume any cost for the issue of new equity, the prot
of the bank does not change. Then the dividend for the incumbent
banker decreases proportionately to p(x)k/k0 , which is due to the
dilution of ownership.
When the bank reduces its loans, it will eliminate those with
the lowest NPV. Because loans to rms with low credit rating have
low NPV, the bank will cut loans to the lowest rated rms. If x0
satises k0 = K/[B0 + (1  x0 )B1], loans to rms with a credit rating

J.-S. Hyun, B.-K. Rhee / Journal of Banking & Finance 35 (2011) 323330

327

(ii) @Q
> 0,
@A
(iii) @Q
< 0,
@r
rA1r
(iv) if x < 12 < 2rA1r
; @Q
< 0 for b < b0 where b0 is dened in
@b
Appendix A.2, and it is a positive value greater than 1  x.

between x and x0 will be eliminated. Because k0 > k, x0 > x must be

true. Thus, the dividend becomes p(x0 ) in Eq. (3), with x replaced
by x0 . Note that loans to rms between x and x0 have positive
NPV and, consequently, p(x0 ) < p(x) holds. However, those eliminated rms actually have the highest chance of defaulting among
the outstanding loans. Therefore, prot decreases at a less than
0
proportionate rate. If this is the case, px0 P pxk=k holds, and
incumbent shareholders will prefer loan reduction.
When the bank does not have any long-term outstanding loans,
as in condition (i) of Theorem 1, the asymmetry mentioned above
applies in a straightforward manner. However, when the bank has
outstanding long-term loans, the result does not hold unilaterally.
Rejecting the additional loan request for working capital means
that the bank gives up receipt of the interest paid by the rm for
the outstanding long-term loan. The magnitude of this additional
loss depends not only on the size of the long-term loan but also
on how many loans are cut, i.e., x0  x. The magnitude of x0  x depends on how much the government increases the capital ratio.
Therefore condition (ii) of Theorem 1 states the upper bound of
the ratio of capital rates below which reducing the amount of loans
is preferred, even with outstanding long-term loans.
When capital ratio is increased to k0 from k, the loss of prot
from the dilution of shares is proportional to x0  x. Meanwhile,
the loss from loan reduction increases in a nonlinear fashion as x0
moves away from x. By increasing the lowest credit level to x0 from
x, the bank loses interest income from the rms in area D in Fig. 2.
But there exists some gain from less default. Firms in area E should
have defaulted, but the bank can prevent possible defaults by not
lending to them. Both area D and E depend on the square of x0  x,
and the loss from loan reduction increases as a quadratic function
of x0  x with zero at x0  x = 0. When the increment of the capital
ratio is moderate, the difference of the minimum credit rate, x0  x,
is small and a lending-cut yields a small loss of prot. Therefore,
asset reduction is preferred by the incumbent banker, but equity
issue is preferred for large x0  x, which is the consequence of a
large increase in capital ratio.
When the inequality of condition (ii) is reversed, equity issue
may be preferred in our setup of costless equity. However, that is
generally not the case because the issuance of equity usually incurs
some type of cost to the bank.
The upper bound for the increase in the capital ratio in Theorem
1 depends on several parameters: the interest rate (r), the ratio of
long-term outstanding loans to short-term ones (b), and the economic condition (A). The sensitivities of the bound to changes of
parameters are summarized in the next theorem.

[Proof in the Appendix]

The rst inequality shows that for the increase of x, the upper
bound in Eq. (4) decreases. The winning edge of loan reduction
comes from cutting (potentially) bad loans. However, this edge
diminishes as the credit ratings of rms in the lower limit (x) increase because the relative gain from cutting the lowest credit level loans becomes negligible. Therefore, when the bank has
relatively high credit rated assets, loan reduction will not guarantee a comparative advantage.
The inequality (ii) in Theorem 2 shows that the upper bound in
Eq. (4) becomes larger as A becomes greater. If A is large, the probability line in Fig. 1 is steep and the default probability drops rapidly as the credit rating improves. Then the effect of cutting the
lowest credit loan is large. Because a large A represents poor economic conditions, inequality (ii) in Theorem 1 is more likely to
hold when the economy is in recession.
The inequality (iii) in Theorem 2 suggests that as interest rate
goes up, the upper bound in Eq. (4) becomes smaller. When the
bank increases the minimum credit level to x0 from x, it faces
two opposite effects. One is the loss of prot from missed interest
income from rms in area D in Fig. 2, and this loss depends on the
level of the interest rate. The other is a saved potential loss from
default by not lending to rms in area E in Fig. 2, and this is independent of interest rate. When the interest rate is high, the loss of
prot grows, and the advantage of loan reduction diminishes.
The effect of the change in b is not uniform. As b approaches
zero, the upper bound Q goes to innity, which is consistent with
condition (i) in Theorem 1. As b grows, the upper bound diminishes
due to the negative effect of outstanding loans. This is true when
rA1r
x < 12 < 2rA1r
holds. Because this condition states that more than
half the rms gain short-term loans from the bank, it is an acceptable assumption. The value of Q diminishes until it reaches a positive value b0 as dened in the proof of the theorem in Appendix
A.2. When the bank has a relatively small b, the increase of the
long-term loan makes it less protable to reduce the risky assets
as the loss from the outstanding long-term loan grows. When b
goes to innity, the value of Q approaches one and the inequality
(ii) in Theorem 1 holds for any increase in the capital ratio. Therefore, if the bank holds huge amounts of long-term loans, issuing
equity is always preferred.

Theorem 2. If we denote the upper bound in Eq. (4) by Q, the effects

of the changes of parameters are as follows:

5. Effect of distinct NPVs with the same credit rating

(i)

@Q
@x

< 0,

Fig. 2. Distribution of rms under different capital rates.

One of the assumptions in the previous sections is that the NPVs

of assets are positively associated with their credit ratings. Loans
with low NPVs are given to rms with low credit ratings and high
NPVs to those with high credit ratings. Therefore, eliminating low
NPV loans is equivalent to taking out loans with high default risk
while maintaining relatively good quality assets.
This positive association should have contributed to the results
favoring the loan reduction policy. To analyze the effect of this
relationship, assets with different NPVs for the same credit rating
are introduced. In the previous sections, the positive relationship
between NPV and credit rating is due to the assumption that the
amount of a loan is same for all rms. In this section, the amount
of working capital required to operate a rm is assumed to be different across rms. There are n levels of working capital, denoted
by B11 ; B21 ; . . . ; Bn1 . For each credit rating, the required working capital
level is evenly distributed that is, the mass of rms applying for
the same amount of loan Bi1 is 1/n for i = 1, 2, . . . , n. Because the

328

J.-S. Hyun, B.-K. Rhee / Journal of Banking & Finance 35 (2011) 323330

amounts of the loans are different, the NPVs of loans depend not
only on the credit rating but also on the amount of the loan. In this
way, we can include in the model both high NPV assets with low
credit ratings and low NPV assets with high credit ratings.
The model can be solved in a similar way except that the bank
has to decide the level of the lowest credit rating to approve the
loan for each loan level Bi1 , i = 1, 2, . . . , n. If we denote the lowest
credit.rating
by xi for any i i, the capital ratio is calculated by
h
P
1
k K B0 n ni1 1  xi Bi1 .
Because there are an innite number of rms for each credit rating and loan level, the law of large numbers is still applicable. Then
the bank prot becomes the sum of prot from each level of shortterm loan, and is written as,




n 
1X
2  A1  xi
A
rB0 Bi1  1  xi 2 Bi1 :
1  xi
n i1
2
2

For the increase of minimum capital ratio, the bank has to cut loans
with low NPVs when they meet the new capital regulation by
decreasing the amount of assets. Among the loans given to rms
applying for the same amount, those given to low credit rms have
low NPVs, and they are the rst ones to be cut off. Therefore, results
similar to those derived in the previous section may hold for each
loan level. However, a disproportionate decrease of bank prot in
loan reduction case is not easily shown due to the existence of multiple levels of loans.
The comparison of prots from the two ways of increasing the
capital ratio cannot be done analytically. A numerical calibration
is used for this purpose. Normalizing the level of long-term loan
(B0) to unity, three different levels of short-term loans are assumed.
A third of the rms apply for 0.5 of working capital, another third of
rms apply for 1.0, and the nal third apply for 2.0. For interest rate
r, 0.04 is used. It is matched with the interest margin of the banks
because r is the lending rate when the deposit rate is 0. Parameter
A is not easily determined. It is regarded as a macroeconomic condition, governing the overall default probabilities of rms. When
A is 0.05, the ratio of non-performing loans (NPL) is around 2% for
x between 0.01 and 0.2. For the same range of x, the NPL ratio rises
to 2.53.5% as we increase the value of A to 0.06 and to 0.07. Three
different values (0.05, 0.06, 0.07) are used for parameter A. The level
of bank capital (K) is set to 0.17 so that the bank meets the initial
capital regulation (k = 0.08) when A is 0.06.
Fig. 3 shows the pattern of change in prots as the minimum
capital ratio increases. The numbers in the horizontal axis denote
the ratio of capital regulations, i.e., k0 /k in Eq. (4). We simulate
the result for k0 /k from 1.0 to 1.3. Solid lines represent the prots
earned when the bank meets the new regulation by issuing equity,
and the dotted lines represent those prots earned by loan reductions. Normalizing the amount of long-term loans to one, the bank
prot is around 5% of the loan. Because a larger A means a higher

p'(loan)

p'(equity)

0.055
A=0.05

0.050
0.045
0.040

A=0.06
A=0.07

probability of default in all rms, prot decreases as the value of

A becomes larger. As we assume the initial capital regulation is
binding, a banks prot monotonically decreases as the regulation
becomes stricter.
For all three values of A, a loan reduction policy gives a higher
prot for the modest increase of minimum capital ratio. However,
recapitalization becomes more protable with a drastic reinforcement of the regulation. This result is consistent with the implication of Theorem 1 in the previous section.
By simulation we are able to derive a similar result with a nonuniform combination of NPV of loans and their credit ratings. It
may be in line with the suggestion of Nutt (1989) that the probability to repay the debt is the most important factor and that the
loan size is relatively unimportant. But there exists a limitation
in the generalization of results. Because we assume an innite
number of assets with the same NPV, the bank can cut the riskiest
ones among them. In reality, banks do not have an innite number
of assets even though there are various combinations of NPVs and
risk ratings. However, this heuristic calibration shows that the results derived from the previous sections may be applied if the
number of assets under consideration is large enough to choose
among them by credit risk.
6. Conclusion and policy implications
When regulatory authorities implement capital regulation, it affects the behavior of banks. If the regulation comes in the form of
an increase in the capital adequacy ratio, banks must either increase their equity capital or decrease their investment assets.
With a simple dynamic banking model, we have shown that if a
banks decision is made by incumbent shareholders, the bank will
nd it advantageous to meet the higher capital ratio by reducing
high-risk assets, even though recapitalization can be achieved by
selling new equity to the public. This result is derived without
imposing any kind of cost on equity issue. Therefore, the reluctance
of banks for equity nance may not be entirely due to the cost of
equity issue.
The results hold under certain conditions. For a modest increase
of minimum capital ratio, banks may prefer to choose the assetreduction strategy when they hold a relatively small amount of
long-term loans or when the economy is in a bad state.
If these results are valid in general, then bank regulation should
be enforced with caution. This is especially the case when the
economy is weak, as the increased bank capital adequacy ratio
may cause a credit crunch. In Basel II, this is more likely to happen.
The new BIS regulation demands that, during the depression, banks
should estimate the default probability more conservatively and
they should establish more capital. However, in our model, banks
have more incentive to reduce assets than to recapitalize when
the economy is in depression, which is represented by the increase
of parameter A. Therefore, a credit crunch is more likely under
Basel II.
Our model can also be extended to analyze the other aspect of
Basel II. In Section 2, we assign the risk weight of one to all loans.
But we can incorporate a risk weight function depending on the
default probability. The effects of various forms of weighting functions or the pro-cyclicality issue can be dealt with through our
model. We will leave them for future study.

0.035

Appendix A. Proof of Theorems 1 and 2

0.030

A.1. Proof of Theorem 1

0.025
1

1.05

1.1

1.15

1.2

1.25 k'/k 1.3

Fig. 3. Comparison of prots in three B1 levels case.

The proof (i) can be easily done by applying b = 0 to the proof of

(ii). Therefore, only the proof for the case (ii) is provided.

329

J.-S. Hyun, B.-K. Rhee / Journal of Banking & Finance 35 (2011) 323330

When a bank issues new equity to meet a higher capital

requirement (k0 ), the funds raised from the new capital are invested in government bonds, which have a zero rate of return.
The total prot is equal to that in equilibrium when the capital ratio is k. If the amount of the newly issued equity is denoted by d,
the following equalities must hold

@Q
3
2Ab 1  xfr2 A1  x  1b r1  xr 2
@b

2
2Ar 2Ab 2r1  x  r  r2 1  x

A1  x2r 2 2r 1 b r1 r1  xg
 2Ab 1  xgb
3

where x0 is the lowest level of credit among those rms able to nance their working capital when the bank reduces the amount of
loans. The rst term is the capital ratio when the bank issues new
equity and the last the ratio when the bank reduces the amount
of loans. The share of the incumbent shareholders becomes K/
(K + d) when the bank issues new equity. If the condition
k K=B0 1  xB1  is applied, it becomes
0

K
k b1x

;
K d k0 b 1  x
where b is the ratio of long-term debt (B0) to short-term debt (B1).
The prot of the bank under new regulation can be denoted by
p0L or p0E , depending on whether the bank reduces its loans or issues
new equity. Accordingly, the following two prot equations are
obtained.



2  A1  x0
A
rB0 B1  1  x0 2 B1 ;
2
2



k
2  A1  x
rB0 B1
px 0 1  x
2
k


A
b 1  x0
:
 1  x2 B1
2
b1x

p0L px0 1  x0
p0E

Subtracting the two prot equations and multiplying 2(b + 1  x)/B1

on both sides yields



2b 1  x
x0  xf2rb 1b
p0L  p0E
B1
A1 rb 1bb2  x0  x 1  x0 1  xcg:
0

If g = K/B1, then x b 1  g=k and x0 b 1  g=k . If these values

are plugged into the above equation, then



2b 1  x
p0L  p0E
B1
 0 n
o
k
2
2 2
2rb 1bk  Ab k 1 rb 1

k
Ag2 1 rb 1:
If the right-hand side of the equation is positive, it is sufcient for p0L
to be greater than p0E . If g is plugged back into the above equation,
inequality (4) is obtained. h
A.2. Proof of Theorem 2
It is easy to see the rst three claims in Theorem 2 by differentiating Q with respect to each parameter and simplifying as
follows:
Ab1x1r1b

(i)

@Q
@x

 rb1bAb2 1r1b < 0 for all x 6 1.

(ii)

@Q
@A

(iii)

@Q
@r

 2Ab 1  xC 3 b C 2 b C 1 b C 0

K d
K
0
k
;
B0 1  xB1
B0 1  x0B1

2rb1bb1x2 1r1b

2 > 0 for all A P 0.

frb1bAb2 1r1bg
2
2Ab1bb1x
 frb1bAb2 1r1bg2 < 0 for all r P 0.

(iv) For the proof of the fourth statement, some qualitative

explanation is needed. By taking a derivative of Q with
respect to b,

where C i is the coefcient of bi (i = 0, 1, 2, 3) in g(b). Observing

because
2Ab 1  x < 0, it sufces to consider g(b) instead of @Q
@b
P 0 is equivalent to g(b) 6 0. Note that g1  x 1  x2
h
i
2r A1 r2 x2 > 0 for x < 1 and C3 6 0, which implies
@Q
@b

that g(b) goes to negative innity as b approaches innity. Hence

the Intermediate Value Theorem guarantees a strictly positive solurA1r
tion b0 that is greater than 1  x. We know that C1 > 0 if x < 2rA1r

holds. Then positive C1 and negative C 3 guarantees the existence of

two distinct real roots, one positive and one negative, for the equation @g
0. In other words, g(b) = 0 has one positive and one nega@b
tive critical values. Having all positive solutions is impossible.
Therefore, there are three cases left as follows: (a) one negative
and two positive solutions, (b) two negative and one positive solutions, (c) two imaginary and one positive solutions. Case (a) should
be excluded because of g(0) = C0 > 0. We conclude that a strictly positive solution b0 that is greater than 1  x is unique either by case
becomes
(b) or case (c). For b < b0, g(b) is positive and @Q
@b
negative. h

References
Bernanke, B.S., Lown, C.S., 1991. The credit crunch. Brookings Papers on Economic
Activity 2, 205247.
Brana, S., Lahet, D., 2006. Capital Requirement and Financial Crisis: The Case of
Japan and the 1997 Thai Crisis. Working Paper No. 06-EFI/05. Universite
Montesquieu Bordeaux IV.
Brickley, J., James, C., 1987. The takeover market, corporate board composition, and
ownership structure: The case of banking. Journal of Law and Economics 35,
161180.
Dann, L.Y., Mikkelson, W.H., 1984. Convertible debt issuance, capital structure
change nancing-related information: Some new evidence. Journal of Financial
Economics 13, 157186.
Du, J., Dai, Y., 2005. Ultimate corporate ownership structures and capital structures:
Evidence from East Asian economies. Corporate Governance 13 (1), 6071.
Eisenhardt, K., 1989. Agency theory: An assessment and review. Academy of
Management Review 14, 5774.
Ferris, S.P., Yan, X., 2009. Agency costs, governance, and organizational forms:
Evidence from the mutual fund industry. Journal of Banking and Finance 33,
619626.
Gorton, G., Winton, A., 1995. Bank Capital Regulation in General Equilibrium. NBER
Working Paper 5244.
Harris, O., Glegg, C., 2009. Governance quality and privately negotiated stock
repurchases: Evidence of agency conict. Journal of Banking and Finance 33,
317325.
Houston, J.F., James, C., 1995. CEO compensation and bank risk: Is compensation in
banking structured to promote risk taking? Journal of Monetary Economics 36,
405431.
Hussain, E., Hassan, K., 2006. Bank Capital Requirement and Bank Credit Risk Taking
in Developing Countries. Working Paper. University of New Orleans.
Hubbard, G., Palia, D., 1995. Executive pay and performance: Evidence from the U.S.
banking industry. Journal of Financial Economics 39, 105130.
Jackson, P., Furne, C., Groeneveld, C., Hancock, D., Jones, D., Perraudin, W., Radecki,
L., Yoneyama, M., 1999. Capital Requirement and Bank Behavior: The Impact of
the Basle Accord. Basle Committee on Banking Supervision Working Paper No.
1.
James, C., 1984. An analysis of the effects of state acquisition laws on managerial
efciency: The case of the bank holding company acquisition. Journal of Law
and Economics 27, 211226.
Jensen, M.C., Merckling, W.H., 1976. Theory of the rm: Managerial behavior,
agency costs and ownership structure. Journal of Financial Economics 3, 305
360.
King, M.R., 2001. Who triggered the Asian nancial crisis? Review of International
Political Economy 8 (3), 438466.
Korwar, A.N., 1981. The Effect of New Issues of Equity: An Empirical Examination.
Working Paper. University of California Los Angeles.

330

J.-S. Hyun, B.-K. Rhee / Journal of Banking & Finance 35 (2011) 323330

Lee, I., Schweitzer, R., 1989. Shareholder wealth effects of interstate banking: The
case of Delawares Financial Center Development Act. Journal of Financial
Services Research 2, 6572.
Libby, R., 1979. The impact of uncertainty reporting on the loan decision. Journal of
Accounting Research 17, 3557.
Montgomery, H., 2005. The effect of the Basel Accord on bank portfolios in Japan.
Journal of the Japanese and International Economies 19, 2436.
Myers, S.C., Majluf, N.S., 1984. Corporate nancing and investment decisions when
rms have information that investors do not have. Journal of Financial
Economics 13, 187221.
Nutt, P.C., 1989. Uncertainty and culture in bank loan decisions. OMEGA
International Journal of Management Science 17, 297308.
Onado, M., 2008. Banks losses and capital: The new version of the paradox of
Achilles and the tortoise. In: Felton, A., Reinhart, C.M. (Eds.), The First Global
Financial Crisis of the 21st Century: Part II, CEPR, pp. 285290.
Pathan, S., 2009. Strong boards, CEO power and bank risk-taking. Journal of Banking
and Finance 33, 13401350.

Peek, J., Rosengren, E., 1995. Bank regulation and the credit crunch. Journal of
Banking and Finance 19, 679692.
Peura, S., Keppo, J., 2006. Optimal bank capital with costly recapitalization. Journal
of Business 79 (4), 21632201.
Prowse, S., 1995. Alternative methods of corporate control of commercial banks.
Federal Reserve Bank of Dallas Economic Review (Third Quarter), 2436.
Roth, G., Saporoschenko, A., 2001. Institutional ownership of bank shares. Financial
Analysts Journal 57 (4), 2736.
Schleifer, A., Vishny, R.W., 1997. A survey of corporate governance. Journal of
Finance LII (2), 737783.
Schranz, M., 1993. Takeovers improve rm performance: Evidence from the banking
industry. Journal of Political Economy 101, 299326.
Shehzad, C.T., de Haan, J., Scholtens, B., 2010. The impact of bank ownership
concentration on impaired loans and capital adequacy. Journal of Banking and
Finance 34, 399408.