Abstract
We model how the reduction of required reserves and the introduction of capital rules affect bank risk-taking behaviour in a financially repressed environment. In the absence of capital rules, the reduction of required reserves unambiguously encourages gambling behaviour. The introduction of capital rules only succeeds in mitigating this effect if capital is not too costly and loan default rates are not too high. We use evidence from the Russian banking sector to illustrate the model. We conclude that a moderate amount of financial repression may be preferable to capital rules for the purpose of securing systemic stability if loan default rates are high and the cost of capital is considerable, which may be the case in many emerging banking markets.
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Notes
Emerging financial markets often tend to be restricted by rules governing the composition of bank balance sheets, such as high reserve requirements, interest-rate ceilings, foreign-exchange rate regulations and other types of explicit or implicit taxes on the financial sector (Denizer et al., 1998). For an analysis of the optimal degree of financial repression, see, for example, Bencivenga and Smith (1992), who develop a model in which an increase in reserve requirements represses the development of the financial system.
See for example Rochet (1992) and Dewatripont and Tirole (1994).
We do not model the form of competition explicitly. For an overview on issues concerning competition and bank stability, see Carletti and Hartmann (2002). Repullo (2004) used the framework of Hellman et al. (2000) to introduce the effects of imperfect competition via a framework à la Salop. He finds that imposing deposit rate ceilings does not always guarantee the existence of a prudent equilibrium.
The capital requirement is risk-based because the minimal capital requirement is a function of the only class of risky assets, that is, loans.
This implies an elastic supply of capital funds.
When the rate at which reserves are compensated is lower than the risk-free rate, banks are assumed not to hold voluntarily reserves above what is required by the central bank. If the risk-free rate were lower, a bank could achieve infinite profits by borrowing at a market rate and holding infinite reserves (Mitchell, 1982). However, even when reserves are not compensated, some banks in transition economies do hold excess reserves because they have a only few alternatives to allocate their assets or are faced with low enforcement of creditor rights (Denizer et al., 1998).
In this spirit, prompt corrective action (PCA) rules were introduced in 1991 in the US by the Federal Deposit Insurance Corporation Improvement Act (FDICIA) to allow for early intervention in problem banks to save them from becoming insolvent (Goldberg and Hudgins, 2002). PCA aims at preventing banks from ‘gambling for their resurrection’ (Kane, 1989) by enabling regulators to close down failing banks, even at a positive level of capital.
One alternative way to incorporate monitoring into the model is to let banks incur a variable cost depending on the volume of loans. Gropp and Vesala (2004) and Cordella and Yeyati (2002) let borrowers' default risk depend on the amount of monitoring.
The CBR also installed a battery of other prudential regulations aimed at lowering bank risk behaviour. The additional prudential regulations included, next to capital adequacy rules, a minimal capital requirement, a set of liquidity requirements, credit risk requirements, insider activity standards and a number of non-compulsory guidelines. These regulations are summarised in the CBR Instruction No. 1 of 30 January 1996, ‘On the Procedure for Regulating the Activities of Credit Organizations’.
See Karas and Schoors (2005) for a detailed description of the different data sources used.
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Acknowledgements
Rudi Vander Vennet acknowledges financial support from the Programme on Interuniversity Poles of Attraction of the Belgian Federal Office for Scientific, Technical and Cultural Affairs, contract No. P5/21. The views expressed in this paper are those of the authors and should not be interpreted as reflecting the views of the Executive Board of Sveriges Riksbank. We wish to thank all participants to the Ghent 2006 conference on ‘Risk, regulation and Competition: Banking in Transition’ and two anonymous referees for comments and suggestions.
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Claeys, S., Schoors, K. & Vandervennet, R. The Sequence of Bank Liberalisation: Financial Repression versus Capital Requirements in Russia. Comp Econ Stud 50, 297–317 (2008). https://doi.org/10.1057/ces.2008.7
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DOI: https://doi.org/10.1057/ces.2008.7