The impact of capital requirements on crises in the U.S. and E.U

• Main Author: Jabbour, Ravel
• Other Authors: Cathcart, Lara
• Published: Imperial College London 2013
• Subjects: 658
• Online Access: http://ethos.bl.uk/OrderDetails.do?uin=uk.bl.ethos.650625

Basel capital requirements have attracted a lot of debate surrounding their adequacy as the Basel I and II regulations were shortly followed by the 1990-1991 and 2007-2009 crises. This creates an appropriate scene for comparative purposes with respect to the impact of these requirements: same country of origin (U.S.) and similar outcome (credit crunches). Hence, after providing a brief overview of these regulations in Chapter 2, the aim of Chapter 3 is to apply the methodology in Berger and Udell (1994) over the subprime crisis and investigate any Basel II related impact. We find inconclusive results with regard to the impact of regulatory capital on the crisis and argue that this could be due to overshadowing by other factors such as leverage and liquidity. Chapter 4 looks at changes in co-movement patterns (correlation) between the leverage and capital ratios across the aforementioned crises. We find that the change in the impact of the latter ratio on subsequent crises lies in the changing dynamics between the two regulatory requirements. Therefore, we argue that changes in risk-weights categories introduced in the Basel framework can reverse the relationship between both ratios. This inherently changes the binding constraints on banks between the two crises. Our reasoning is based on a formula we develop linking the two ratios together which is derived from the sensitivity of the risk-based capital ratio to a change in one of its risk-weights. Finally, in Chapter 5, we shift our attention to European countries in order to explore the factors that jointly determine returns, spillovers and contagion. While our findings point out that EU countries might have the incentive to reduce their capital ratios in order to achieve higher returns, nonetheless having a substantial amount of capital can shield them from the effects of spillovers. Hence, it is important to maintain sensible capital ratios to counterweight the aggravating effects of bilateral linkages such as trade and cross-border finance.