The pro-cyclicality of capital ratios and credit supply, a tale of two sizes – Bank Underground

Mahmoud Fatouh

Small banks tend to have more specialised business models, likely focusing on commercial and retail banking activities, and show limited interconnectedness to other financial institutions. Hence, they are likely to show less intense cyclical patterns compared to large banks. This post investigates whether large and small banks in the UK and US differ in the cyclical patterns of capital positions and credit provision.

Introduction

Following the Global Financial Crisis, the Basel III reforms introduced stricter capital requirements and reinforced them with cyclical components (the capital conservation buffer and the countercyclical capital buffer). The reforms aimed to ensure that banks have sufficient capital resources to absorb losses and reduce the cyclical effects of bank capital (and regulation) on the supply of bank credit in stress. The stricter and more cycle-sensitive capital requirements should reduce the pro-cyclicality of bank capital positions as they discourage unsustainable credit growth in credit booms, and so limit the need for deleveraging in stress.

Under Basel III reforms, systematically important banks face stricter requirements. Small banks mostly face regulatory requirements like those of larger banks but benefit from some exemptions that differ in scope between jurisdictions. Additionally, regulators in various jurisdictions have been trying to create simpler (but not weaker) regulatory frameworks for small banks. Ideally, a framework for smaller banks would take into consideration their simpler and specialised business models, the limited financial stability implications of their failure, and the disproportional compliance costs they face compared to larger banks. For example, the Bank of England is designing a ‘strong and simple’ regulatory regime for small banks with simpler business models.

Owing to simpler business model and weaker interconnectedness, small banks should be less sensitive to cyclical fluctuations insofar as their credit supply and capital positions should be less pro-cyclical than larger banks. In this post, I investigate this hypothesis and study the implications of stricter cycle-sensitive capital requirements under Basel III for these cyclical patterns.

The data

I use bank-level data and GDP growth for the UK and the US. UK bank-level data comes from a confidential data set at the Bank of England and includes financial data on UK banks between 1990 and 2021. The data for US banks runs from 1979 to 2021 and was collected from multiple sources including Refinitiv® Eikon, Capital IQ®, and published financial statements. GDP data was collected from the Office for National Statistics and FRED® for the UK and US respectively. Table A includes summary statistics of the bank-level and GDP growth data. The aim of having a long time series is to have a sample that covers at least a big portion of a credit cycle before the introduction of the much stricter capital requirements by Basel III standards in 2010. Stricter standards would likely affect the cyclical patterns of bank credit and capital positions, potentially reducing the validity of results. Although capital standards existed before 2010, they were significantly weaker. Such time series can be used to answer two questions. First, analysing years up to 2009 can be used to measure the cyclical patterns in a less regulated environment, providing evidence on whether Basel III needed cyclical components. Second, expanding the analysis beyond 2009 provides evidence on whether Basel III addressed the pro-cyclicality of bank capital and lending.

Table A: Summary statistics

1: UK data (£ millions)

Source: Bank of England internal database.

2: US data (US$ millions)

Sources: Refinitiv Eikon, S&P Capital IQ and published financial statements.

Empirical strategy

In order to measure the cyclicality patterns of capital ratios and total lending of banks and investigate whether they differ between small and large banks, I first categorise banks by size. For the UK, I use internal Bank of England classification of small and large banks. Meanwhile, for US banks, I define small and large banks as those in the lowest 80% and the highest 5% of assets distribution, respectively.

Following Fatouh and Giansante (2023), I measure cyclicality of a variable by the correlation between that variable and GDP growth. I estimate this correlation using the following panel regression:

(1)

where, β_i: bank fixed effect; Y_i,t, capital ratio (equity to total assets) or log of total lending of bank i at time t; X_i,t, a set of bank-level controls, including total assets, capitalisation, and ratios reflecting business model (eg, loans to asset and deposits to liabilities); GDP_t, GDP growth rate at time t.

Analysis

I apply the model in Equation 1 to small and large banks separately at the bank-level to detect differences in the cyclical behaviour of capital ratios and total lending. The results of the regressions are presented in Table B.

As the table shows, capital ratios of large banks were positively correlated with GDP growth in the UK and US before the introduction of Basel III in 2010. On average, a 1 percentage point fall in GDP growth was associated with an 80 basis points and 61 basis points drop in capital ratios of large banks in the UK and US, respectively. Meanwhile, capital ratios of small banks were either not correlated (UK) or negatively correlated (US) with GDP growth.

Total lending of large banks was pro-cyclical pre-Basel III, especially in the UK. On average, a 1 percentage point fall in GDP growth was associated with a 302 basis points and 71 basis points fall in total lending of large banks in the UK and US, respectively. The total lending of small UK banks did not show cyclical patterns. However, the total lending of small US banks was pro-cyclical, but significantly less than that of large banks (11 basis points compared to 71 basis points for each 1 percentage point change in GDP growth).

Table B: Regression results for bank capital ratios and total lending

1: UK banks (1990–2009)

Notes: Coefficient estimates of quarterly capital ratios and total lending of UK banks between 1990 and 2009. Capital ratio is equal to equity to total assets, and total lending is the log of net lending. Small and large banks are defined based on internal Bank of England classifications. Standard errors reported between parentheses, * p<0.10 ** p<0.05 *** p<0.01.

2: US banks (1979–2009)

Notes: Coefficient estimates of quarterly capital ratios and total lending of US banks between 1979 and 2009. Capital ratio is equal to equity to total assets, and total lending is the log of net lending. Small and large banks are those in the lowest 80% and the highest 5% of assets distribution, respectively. To ensure robustness of the results, I also run regressions based on different thresholds. Results of the additional regressions are consistent with the baseline results. Standard errors reported between parentheses, * p<0.10 ** p<0.05 *** p<0.01.

In other words, the capital positions of large banks were more sensitive to economic fluctuations than small banks in both the UK and US prior to Basel III. These trends in capital positions affect the credit supply of banks, depending on their size. Large banks become relatively capital-constrained in downturns, and hence tend to ration lending. The lower cyclicality of small banks’ capital positions allows them to keep their supply of credit steadier over the cycle. Nevertheless, as large banks provide most of bank credit, aggregate credit crunches are expected, especially in deep downturns.

Stricter capital requirements and cyclical components (the capital conservation buffer and the countercyclical buffer) introduced by Basel III should reduce the pro-cyclicality of large banks’ capital positions and supply credit. To investigate this, I re-run the regressions above using data sets that extend beyond 2009. As Table C shows, the coefficient on GDP growth for large banks falls from 80 basis points to 43 basis points (at a lower significance level) for UK banks, and from 61 basis points to 29 basis points for US banks. Results for small banks’ capital ratios using the extended sample are consistent with the baseline in Table B.

Post Basel III, the pro-cyclicality of total lending of large banks fell from 301 basis points to 165 basis points for large UK banks and 71 basis points to 49 basis points for large US banks. The pro-cyclicality of total lending of small US banks fell further (11 basis points to 5 basis points) and remained well below that of large banks.

Table C: Regression results for bank capital ratios and total lending; Basel III impact

1: UK banks (1990–2021)

Notes: Coefficient estimates of quarterly capital ratios and total lending of UK banks between 1990 and 2009. Capital ratio is equal to equity to total assets, and total lending is the log of net lending. Small and large banks are defined based on internal Bank of England classifications. Standard errors reported between parentheses, * p<0.10 ** p<0.05 *** p<0.01.

2: US banks (1979–2020)

Notes: Coefficient estimates of quarterly capital ratios and total lending of US banks between 1979 and 2009. Capital ratio is equal to equity to total assets, and total lending is the log of net lending. Small and large banks are those in the lowest 80% and the highest 5% of assets distribution, respectively. To ensure robustness of the results, I also run regressions based on different thresholds. Results of the additional regressions are consistent with the baseline results. Standard errors reported between parentheses, * p<0.10 ** p<0.05 *** p<0.01.

In summary, the capital positions and credit supply were clearly more pro-cyclical for large banks than small banks. The introduction of more cycle-sensitive capital requirements under Basel III reduced differences between the two groups of banks. As such, it can be argued that the cycle-sensitive components of capital requirements are more effective in reducing the pro-cyclicality of credit supply of large banks (than small banks), as well the aggregate supply of bank credit, reducing the severity of credit crunches in deep downturns.

Summary

This post assesses whether small banks’ total lending and capital ratios show different cyclical patterns from larger banks, and whether the introduction of stricter cycle-sensitive capital requirements under Basel III affects these cyclical patterns. The analysis uses data for small and large banks in the UK and US. The empirical results suggest that prior to Basel III reforms, capital positions and credit supply of large banks were much more pro-cyclical than small banks. The introduction of more cycle-sensitive capital requirements under Basel III reduced capital and credit supply pro-cyclicality for large banks, while having smaller effects for small banks. This suggests that the cycle-sensitive capital requirements are more effective in reducing the pro-cyclicality of credit supply of large banks and reducing severity of credit crunch in deep downturns.

Mahmoud Fatouh works in the Bank’s Prudential Framework Division.

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