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Basel II and Bank Lending Behaviour

The new Basel accord is slated to come into effect in India around 2007 raising the question of how the revised standards will influence bank behaviour. Using a simple theoretical model, it is shown that the revised accord will result in asymmetric differences in the efficacy of monetary policy in influencing bank lending. This will, however, depend on a number of factors, including whether banks are constrained by the risk-based capital standards, the credit quality of bank assets and the relative liquidity of banks' balance sheets. The basic model is empirically explored using data on Indian commercial banks for the period 1996-2004. The analysis indicates that the effect of a contractionary monetary policy will be significantly mitigated provided the proportion of unconstrained to constrained banks in the system is significantly high.

Basel II and Bank Lending Behaviour

Some Likely Implications for Monetary Policy

The new Basel accord is slated to come into effect in India around 2007 raising the question of how the revised standards will influence bank behaviour. Using a simple theoretical model, it is shown that the revised accord will result in asymmetric differences in the efficacy of monetary policy in influencing bank lending. This will, however, depend on a number of factors, including whether banks are constrained by the risk-based capital standards, the credit quality of bank assets and the relative liquidity of banks’ balance sheets. The basic model is empirically explored using data on Indian commercial banks for the period 1996-2004. The analysis indicates that the effect of a contractionary monetary policy will be significantly mitigated provided the proportion of unconstrained to constrained banks in the system is significantly high.

D M NACHANE, SAIBAL GHOSH, PARTHA RAY

I Introduction

E
ver since its publication in June 1999, the New Capital Adequacy Framework (or Basel II as it is popularly called) has generated intense debate among policy-makers and academia alike.1 As is well known by now, the new accord incorporated three major elements or “pillars”: (a) minimum capital requirements, based on weights intended to be more closely aligned to economic risks than the 1988 accord; (b) supervisory review, which set basic standards for bank supervision to minimise regulatory arbitrage; and, (c) market discipline, which envisages greater levels of disclosure and standards of transparency for the banking system. The revised standards are intended to be applicable to large, internationally active banks in both the US and elsewhere [BIS 2004, Caruana 2004].

Recognising that the risk-based capital standards need to evolve along with changes in financial markets and improvements in risk measurement and management by banks, one of the primary purposes of the revised accord is to align regulatory capital requirements more closely with the underlying credit risks in the activities of banks, thereby reducing distortions existing in the current accord.2 This is sought to be accomplished, in part, by incorporating credit ratings into the regulatory capital standards and allowing the risk-based capital requirements on certain assets to vary as the credit ratings of the underlying borrowing entities change [Nachane et al 2004b, Monfort and Mulder 2000].

The likely impact of the accord on the behaviour of banks has occasioned much discussion. In particular, it has been argued that the behaviour of banks could be different depending on whether they are capital-constrained or not – an issue fraught with significant implications for monetary policy. This question forms the main focus of this paper. To this end, we engage in an analytical exercise designed to capture certain basic features of the Indian environment supplemented by a preliminary empirical analysis.

The rest of the paper is organised as follows: A brief discussion of the relevant literature is contained in Section II. The basic framework of the model along with the implications of Basel II for constrained and unconstrained banks is detailed in Section III. The subsequent section presents some preliminary empirical results. Certain policy concerns and concluding observations emanating from the study are addressed in Section V.

II Received Literature

Existing theory suggests a number of (possibly conflicting) ways in which regulatory capital may alter bank lending behaviour and correspondingly, the efficacy of monetary policy, often with conflicting results. Models such as those by Chami and Cosimano (2001) and Van den Heuvel (2002) emphasise the relationship between monetary policy and bank capital, tracing the impact of changes in monetary policy on bank capital and lending via the altering of bank profitability. Alternately, under the bank lending channel hypothesis, monetary policy has a direct effect on the supply of bank loans as banks fund loans, at least in part, with reservable deposits. Van den Heuvel (2002) notes that a binding regulatory capital requirement limits the ability of capitalconstrained banks to increase lending in response to an expansionary monetary policy, thereby, to an extent, reducing the potency of monetary policy. In contrast, Stein (1998) notes that bank capital might mitigate adverse selection problems. In the event of a contractionary monetary policy, capital-constrained banks are less likely to increase their issuance of reservable deposits and more likely to decrease lending, thus making monetary policy more potent. One possible explanation for these seemingly conflicting findings is that important cross-sectional differences exist in how banks respond to monetary policy shocks [Kashyap and Stein 1994, Peek and Rosengren 1995a, Kishan and Opiela 2000]. However, central to all these theories is the notion that monetary policy affects, either directly or indirectly, the supply of bank loans, and that the strength of this relationship can be influenced, at least in part, by regulatory capital standards.

An alternative way to address the issue of how regulatory capital standards influence bank lending and monetary policy is to examine empirical studies of the 1988 accord. Studies such as those by Hall (1993), Haubrich and Watchel (1993),

Economic and Political Weekly March 18, 2006 Wagster (1996), Jackson et al (1999), Furfine (2000), Aggarwal and Jacques (1998), Rime (2001) and Ghosh et al (2003) suggest that banks altered the composition of their balance sheets in response to the risk-based capital standards, generally migrating to assets of higher credit risk. If the composition of banks’ assets has an influence on the efficacy of monetary policy, and is subsumed under the credit view of monetary policy, then asset substitution resulting from a revised accord may impact the transmission process. Other studies, such as those by Kashyap and Stein (1994) and Thakor (1996) have demonstrated that riskbased capital standards alter the relationship between money and bank lending, with implications for the effectiveness of monetary policy. In addition, Berger and Udell (1994), Hancock and Wilcox (1993) and Peek and Rosengren (1995b) have examined the role played by capital standards during the credit crunch of the 1990s. While prior research is a pointer to the fact that the 1988 accord had a significant influence on bank portfolio composition and monetary policy, the existing research is limited in its applicability to the revised accord as some key elements of the forthcoming revised standards differ significantly from the old accord.

The present study contributes to the literature on bank capital regulation by examining how the forthcoming revisions to the risk-based capital standards are likely to alter bank lending and the efficacy of monetary policy. Resorting to a modification of recent work by Peek and Rosengren (1995a) and Kishan and Opiela (2000), an asymmetric response is shown to emerge in banks’ reaction to monetary policy under the revised accord. Specifically, systematic differences are shown to exist in the effectiveness of monetary policy, depending not only on whether banks are constrained by the revised risk-based capital standards, but also on the credit quality and relative liquidity of the assets held in the portfolio of the capital-constrained banks. In addition, it is demonstrated that under a revised Basel Accord, changes in credit ratings are also likely influences on the efficacy of monetary policy.

III A Theoretical Model

The preceding sections raise the issue of how the imposition of a revised risk-based capital standards (i e, one where capital requirements are based on credit rating and can migrate as the credit ratings on asset change) will influence bank lending and the transmission mechanism of monetary policy.

The model described is akin to Peek and Rosengren (1995a) and Kishan and Opiela (2000), with one major exception: it explicitly recognises that banks are subject to a risk-based capital requirement and as a result, includes, in addition, equations (11),

(12) and (13). Peek and Rosengren (1995a) examine the model under the assumption that the leverage ratio is binding, while Kishan and Opiela (2000) assume that the regulatory capital standards are not binding.3

The following assumptions lie at the core of the analytical set up:

  • In the spirit of Bernanke and Blinder (1988), reserve requirement are supposed to apply only to demand deposits.
  • There is a mark-up interest rate pricing of deposits, loans and securities (with reference to the policy rate);
  • Non-interest incomes/off-balance sheet incomes are ignored for analytical tractability; and
  • The risk-weights on loans and securities are specified in terms of a single security.
  • Banks are assumed to hold three assets: reserves (R),4 securities

    (S) and loans (L) and two types of liabilities: demand deposits (DD) and time deposits (TD). They are subject to the traditional balance sheet constraint:

    (1) R + S + L = DD + TD + K, where K denotes capital.

    We first model the liability side and subsequently turn to the asset side. On the liability side of the balance sheet, bank capital is assumed to be fixed in the short run, since both theoretical considerations [Stein 1998] and empirical evidence [Cornett and Tehranian 1994] suggest that raising capital can be costly for banks, more so, if they are constrained by risk-based capital standards [Jacques and Nigro 1997]. Demand deposits are assumed to be related inversely to the bank rate (rBK), and the amount of time deposits depends on the spread between the rate banks pay on time deposits (rTD) and the mean rate on term deposits in the market (rTDM). Therefore,

  • (2) DD = a0 – a1 rBK
  • (3) TD = f0 – f1(rTD–rTDM)
  • On the asset side, given the level of demand deposits, banks are required to hold reserves (R), such that,

    (4) R = α DD with α being the reserve requirement ratio.5

    In addition, banks are assumed to hold securities in fixed proportion to the level of demand deposits, netted for the quantum of reserves,

    (5) S = h0 + h1 DD – R; h0> 0, 1 > h1> 06

    Furthermore, the loan market is assumed to be imperfectly competitive, with banks possessing some market power. Thus, effectively an inverse relationship is postulated between the demand for loans and the differential between the interest rate offered on loans (rL) relative to some mean rate in the market (rLM).

    (6) L = g0 – g1 (rL – rLM); g0> 0, g1> 0

    Finally, interest rates on time deposits, loans and securities are assumed to be a mark-up on the bank rate (the policy variable) as follows:7

  • (7) rTDM = b0+ϕ rBK
  • (8) rLM = c0+ϕ rBK (9a) rS = e0+ϕ rBK (9b) rSD =q0+ϕ rTD
  • Given (1) to (9b), banks are assumed to maximise profits, such that:

    (10) π = (rL – θ) L + rS S – rDD DD – rTDTD

    where the first term is the interest income on loans netted for loan losses, the second term is the interest income on securities and the third and fourth terms are the interest expense on demand and time deposits, respectively. In their attempt to maximise profits, banks face a regulatory constraint:

    (11) K ≥γSS + γLL

    Equation (11) recognises that banks are subject to risk-based capital requirements, where γi (i=S, L) measure the risk-based capital requirements for securities and loans, respectively.

    In order to explicitly incorporate credit ratings, the risk-based capital requirements for bank loans and securities can be written as:

    (12a) γL = ρ ΩL

    (12b) γS = ρ ΩS

    Economic and Political Weekly March 18, 2006

    where ρ is the specified regulatory minimum capital ratio.8 Furthermore, the risk-weights on loans and securities ΩL and ΩS are both a variable and a function of the credit rating of the underlying entity such that:

    (12c) ΩL = ΩL(cL) such that ∂ΩL/∂cL<0

    (12d) ΩS = ΩL(cS) such that ∂ΩS/∂cS<0

    Under an external ratings approach, ΩL varies inversely with the credit rating of the borrowing entity in the loan contract, cL and ΩS varies inversely with the credit rating of the borrowing

    9, 10

    entity underlying the security, cS.

    Constrained and Unconstrained Banks

    It is useful to distinguish between constrained and unconstrained banks in this set-up. Substituting (12a) through (12d) into (11), and using equations (1) to (9), the Lagrangian so obtained is maximised with respect to loans (L). The first-order conditions are employed to solve for L in the unconstrained case; by a similar method, other key variables are solved for.

    Unconstrained Banks

    Assuming banks are not constrained by the risk-based capital standards, a change in the bank rate can be shown to influence banks’ portfolio composition such that:

  • (13) ∂L/∂rBK = [–g1a1 (1–h1)/(f1+g1)] < 0
  • (14) ∂S/∂rBK = [–a1 (h1–α)] < = > 0
  • (15) ∂R/∂rBK = –a1 α < 0
  • (16) ∂TD/∂rBK = [f1 a1 (1–h1)/(f1+g1)] > 0
  • (17) ∂DD/∂rBK = –a1< 0
  • (18) ∂(DD+TD)/∂rBK = [–a1 (g1+f1h1)/(f1+g1)] < 0
  • The results of (13) through (18) demonstrate that an increase in the policy rate will increase banks’ issuance of time deposits, as banks seek to replace funds lost as a result of a decrease in demand deposits; the increase in the former, however, being insufficient to offset the fall in the latter, there would be an overall decrease in deposits (see 18). Given the contraction of liabilities, banks will reduce assets in response to the increase in the bank rate. Specifically, the decrease in demand deposits will lead to a contraction of reserves, with the impact on securities being uncertain. Kishan and Opiela (2000) argue that for banks that are unconstrained by the regulatory capital standards or alternately, hold large portfolio of securities relative to reserves, (h1 – α) will be positive, resulting in a decline in securities holding in response to a rise in the bank rate. Despite the changes in securities and the increase in time deposits, banks will reduce loans in response to a contractionary monetary policy, the magnitude of the decline being determined by the interest sensitivity of demand deposits (a1), time deposits (f1) and loans (g1).

    Constrained Banks

    Alternately, banks may be constrained by the revised risk-based capital standards. Under this condition, differentiating the Lagrangian and using the first-order conditions to solve for the key results yields:

    (19) ∂L/∂rBK = [ρΩS a1 (h1 – α)]/ρΩL < = > 0

  • (20) ∂S/∂rBK = [–a1 (h1 – α)] < = > 0
  • (21) ∂R/∂rBK = –a1 α < 0
  • (22) ∂TD/∂rBK = [a1(1–h1) ρΩL+a1(h1–α) ρΩS]/ρΩL <=>0
  • (23) ∂DD/∂rBK = –a1< 0
  • (24) ∂(DD+TD)/∂rBK = [a1(h1–α) ρΩS–a1h1 ρΩL]/ρΩL <011
  • The results are fundamentally different from the unconstrained case in that the risk-based capital requirements on both loans and securities play a critical role in how assets and liabilities respond to changes in monetary policy. Specifically, not only do ρΩL and ρΩS influence how loans, time deposits and total deposits change as monetary policy changes, but the relative magnitude of the risk weights (ρΩS/ρΩL) is an important factor. We refer to this as the relative risk parameter.

    As a point of comparison between the 1988 accord and the new accord, capital requirements on loans and securities under the 1988 accord were fixed (footnote 10). Under a situation where bank portfolios are comprised on securities slotted in the 20 per cent risk bucket (ΩS=0.2) and commercial loans, which have 100 per cent risk weight (ΩL=1.0), then the relative risk parameter would be 0.2. In contrast, under the revised Basel Accord, owing to the dependence of risk weights on credit ratings, the “relative risk” parameter will be variable within a certain magnitude.12 Given the greater granularity of risk weights for commercial loans under the revised accord, the efficacy of monetary policy will vary depending on the credit quality of the borrowing entities. Assuming (h1 – α)<0, if the relative risk parameter is 0.13, as it would be if banks had portfolios comprised of commercial loans rated below BB–, then monetary policy would be less effective under the revised accord than under the 1988 accord. Alternately, if the relative risk parameter is unity, as would be the case if the portfolio is comprised of loans rated AA– or better, then monetary policy would be more effective under the revised accord vis-à-vis the 1988 accord.

    From the preceding example, and the results obtained from (19) and (20), it can be seen that (h1– α) also differentiates the response of capital constrained banks to changes in monetary policy. As such, three cases merit attention:

    Case 1: (h1 – α) > 0: In this case, banks have a large securities portfolio relative to their holding of reserves (a more liquid balance sheet). This might be the case if securities are a substitute for external debt financing, and in the event of a contractionary monetary policy, banks cannot switch costlessly between demand and time deposits, thus making external debt financing costly [Kashyap and Stein 1994]. In this case, a rise in the bank rate increases time deposits but lowers demand deposits, thereby leading to an overall decline in deposits. This view is in consonance with the lending view of monetary policy which argues that banks do not fully insulate their lending activities from shocks by switching between types of deposits [Kashyap and Stein 1994].

    Case II: (h1 – α) < 0: In this case, banks do not hold a large securities portfolio relative to their holding of reserves, thereby making their balance sheet less liquid. In this case, the impact of a monetary policy shock on time deposits is indeterminate and depends on the relative magnitude of certain parameters (h1, α, ΩS, ΩL). In the event of a contractionary monetary policy, while the response of time deposits is not clear, a priori, the decline in total deposits is greater and less deposits are available to support loans. This, in essence, is supportive of the bank

    Economic and Political Weekly March 18, 2006 lending channel that the decrease in demand deposits is not fully offset by the rise in time deposits consequent upon a contractionary monetary policy action. With a shrinkage in liabilities, total assets decline as well. Given the fact that these banks are constrained by the risk-based capital standards and have a relatively small holding of securities portfolio, banks respond to the decline in total deposits by liquidating some loans. Because the risk-based capital standards place a capital requirement on both loans and securities, liquidating loans frees up some capital which banks can use to acquire interest bearing securities.

    Case III: (h1 – α) = 0: In this case, banks holding of securities portfolio is evenly matched by their holding of reserves. A contractionary monetary policy leads to an unambiguous decline in deposits, shrinking the overall asset base. Since these banks are constrained by the risk-based capital standards, banks respond to the decline in total deposits by lowering their reserve holding, whilst keeping their portfolio of securities unaltered.

    Equations (19) to (24) provide an analysis of the impact of changes in the bank rate on various components of banks’ balance sheets under the assumption that securities have a non-zero risk weight. In case the assumption is relaxed and it is assumed that securities have a zero risk weight (ΩS = 0), the results for time deposits, total deposits and loans change significantly.13 To see this, note that an expansionary monetary policy would lead banks to substitute demand deposits for time deposits, with the change in total deposits being positive. On the asset side, part of the increase in deposits would result in an increase in reserves, depending on the relative response of securities vis-à-vis reserves (i e, the sign of h1– α). Regardless of what happens to securities, banks keep their loan portfolio unaltered. This is the Kashyap and Stein (1994) result: monetary policy is not effective in changing bank lending. In the case where h1 exceeds α, banks choose to increase their securities holdings, but not their loans, because, at the margin, an increase in loans would require already capital-constrained banks to add additional capital, while increasing government securities (because of the zero risk weight), entails no additional capital, but yet allows banks to increase profits.

    Collectively, the results for capital-constrained banks concur with Kishan and Opiela (2000) in finding that bank capitalisation is critical to explaining cross-sectional differences in the response of banks to changes in monetary policy. Explicit incorporation of the risk-based capital standards into the framework shows that this response is asymmetric: the relative liquidity of constrained banks’ balance sheets and the credit quality of the banks’ loans and securities are also critical components towards understanding how banks respond to changes in monetary policy.

    IV Empirical Analysis

    The theoretical model, while highly simplified, indicates that constrained and unconstrained banks are likely to exhibit differential responses to changes in monetary policy. The loans, reserves and deposits of unconstrained banks would respond negatively to bank rate changes, while the response of their time deposits would be in the same direction as the bank rate changes. The response of constrained banks would be similar as far as reserves and deposits were concerned, but neither the response of loans nor that of time deposits is clear-cut a priori. Thus, the theoretical model indicates that a priori the response of securities, reserves and demand deposits are likely to be identical in both instances.

    To explore the proposition, we employ annual data on commercial banks for the period 1993-2004. The data are culled from the yearly RBI publication, Statistical Tables Relating to Banks in India, which provides annual data under major heads of assets and liabilities as well as the income and expenditure profile of banks. Information on the monetary policy indicators, viz, the bank rate and yield on 364-day treasury bills is sourced from the Handbook of Statistics on the Indian Economy [RBI 2004].

    To test the validity of the comparative static results following from the theoretical exercise, we conduct a simple pooled regression to examine the response of the basic bank balance sheet variables to a change in the bank rate, the monetary policy indicator. It may be mentioned that the bank rate was activated as a signalling rate in April 1997, and was therefore dormant for a major part of the sample period. Therefore, to judge the robustness of the results, we also employ the primary market yield on 364-day treasury bills as the alternate monetary policy indicator [Prasad and Ghosh 2005].

    We adopt two methodologies for classifying banks as unconstrained. First, we compute the leverage ratio (defined as capital plus statutory reserves to total assets) and classify banks as unconstrained (resp, constrained) depending on whether their leverage ratio exceeds (resp., falls short of) the median leverage ratio of banks in the sample. This variable is computed across all the banks (public, private and foreign banks) for the period

    Table 1: Effects of Monetary Policy on Constrained and Unconstrained Banks

    (based on RBC Ratio Criterion)

    Variable Unconstrained Banks Constrained Banks All Banks Bank Rate YLD-364 Bank Rate YLD-364 Bank Rate YLD-364 (Yield on 364-day TBS) (Yield on 364-day TBS) (Yield on 364-day TBS)

    1.1 Loans -0.104 (0.013)* -0.101 (0.012)* -0.064 (0.031)** -0.061 (0.025)** -0.100 (0.011)* -0.098 (0.011)* R-square 0.119 0.122 0.086 0.103 0.127 0.125 1.2 Investments -0.123 (0.013)* -0.117 (0.014)* -0.083 (0.038)** -0.073 (0.033)* -0.121 (0.012)* -0.114 (0.013)* R-square 0.155 0.139 0.095 0.099 0.156 0.142 1.3 Reserves -0.054 (0.013)* -0.060 (0.013)* -0.036 (0.034) -0.037 (0.029) -0.053 (0.011)* -0.058 (0.012)* R-square 0.035 0.042 0.024 0.034 0.035 0.043 1.4 Demand deposits -0.092 (0.014)* -0.091 (0.014)* -0.064 (0.035)*** -0.058 (0.029)** -0.092 (0.013) * -0.089 (0.013)* R-square 0.086 0.083 0.063 0.069 0.088 0.087

    1.5 Aggregate deposits -0.104 (0.013)* -0.104 (0.013)* -0.076 (0.034)** -0.070 (0.028)* -0.103 (0.012)* -0.101 (0.012)*

    R-square 0.119 0.118 0.101 0.116 0.122 0.122 Number of observations 535 535 41 41 576 576 Time period 1996-2004 1996-2004 1996-2004 1996-2004 1996-2004 1996-2004

    Notes: *, ** and *** indicate significance at 1, 5 and 10 per cent, respectively. Robust standard errors in parentheses.

    Economic and Political Weekly March 18, 2006 1993-2004.14 Given that the new private banks became operational in 1995 and 1996, this provides us with an unbalanced panel of banks ranging from a low of 56 for the years 1993 and 1994 to a high of 64 banks for the period 1996-2004; with 63 banks being operative in the year 1995.15

    An alternate way to classify banks as unconstrained is based on their risk-based capital (RBC) standards. Specifically, if the RBC of a bank is equal to or above the regulatory capital ratio, the bank is classified as unconstrained (otherwise it is constrained). Since the RBC standards for banks are reported from the period beginning 1996 onwards, this sample encompasses a balanced panel of 64 banks for a reduced time span beginning 1996 through 2004.

    We, therefore, have four sets of panel observations comprising two sets of banks: the first set of banks which comply with the regulatory minimum capital standards, defined in terms of either their leverage ratio or their risk-based capital ratio (unconstrained banks) and the second set of banks which did not comply with such standards (constrained banks). The primary purpose of the empirical exercise is to examine the response of a change in the monetary policy indicator on (a) loans, (b) investment, (c) reserves, (d) time deposits and (e) aggregate deposits, for the entire sample as also for the unconstrained and constrained banks separately. Tables 1 and 2 report the relevant results.

    It is clear from Table 1 that the response of constrained and unconstrained banks to a monetary policy shock is significantly different, whether judged in terms of the bank rate or the yield on 364-day T-bill rate. Specifically, as predicted by the theoretical model, constrained banks exhibit a more pronounced (negative) response to the monetary shock vis-à-vis unconstrained banks. A bank experiencing a lack of equity is constrained to supply a volume of loans determined by its regulatory capital; a monetary contraction drains demand deposits and to the extent that such a loss is not offset by an increase in time deposits, the magnitude of the contraction in loan supply is far higher than for unconstrained banks.

    Table 1 also presents the response of all banks (aggregate of constrained and unconstrained) to a contractionary monetary policy. What is interesting, however, is the fact that the overall response of banks is more akin to the response of unconstrained banks. This finding is a straightforward application of the Haltiwanger-Waldman (1991) proposition (number 6), which observes that one group of agents (in this case, the unconstrained banks), which has a disproportionate importance – relative to its own share over the total number of agents – is influential in shaping the aggregate equilibrium.

    Table 2 reports the case where unconstrained is defined with reference to banks’ leverage ratio. In this case, given that the proportion of unconstrained banks to total banks is of the same order as the proportion of constrained to total banks, the results weakly support the theoretical premise that the response of investment, reserves and in particular, demand deposits of unconstrained banks, is more or less matched by those of constrained banks.

    Not surprisingly, therefore, the overall equilibrium, as defined by the response of all banks in the sample, is “in between” those of constrained and unconstrained banks. What is clear in this case is that, in several instances, unconstrained banks exhibit a greater response to monetary contraction vis-à-vis constrained banks. This is consistent with the analytical framework which predicts that the interest sensitivity of demand and loans as also the “relative risk parameter” will dictate the response of these two categories of banks.

    V Concluding Observations

    The results demonstrate that whether monetary policy can be made more or less effective in influencing bank lending depends on more than just whether banks are constrained under the revised Basel Accord. More importantly, the analysis indicates that the effect of a contractionary monetary policy will be significantly mitigated provided the proportion of unconstrained to constrained banks in the system is significantly high. From a macro standpoint, consistent with Bliss and Kaufman (2002), the implications are that if the goal of the monetary authority is to simultaneously provide credit to the economy and manage interest rates, the revised Basel Accord could pose challenges for monetary policy formulation.

    Existing research on the Basel Accord has raised the question of how revisions to the accord are likely to influence the efficacy of monetary policy. To explore this issue, the paper extends the basic framework of Peek and Rosengren (1995a) and Kishan and Opiela (2000) to examine the efficacy of monetary policy (via the bank lending channel) under the revised capital standards. The findings reveal that the effectiveness of monetary policy to influence bank lending differs according to whether banks are, or are not, constrained by the risk-based capital standards. In

    Table 2: Effects of Monetary Policy on Constrained and Unconstrained Banks

    (defined in terms of leverage ratio)

    Variable Unconstrained Banks Constrained Banks All Banks Bank Rate YLD-364 Bank Rate YLD-364 Bank Rate YLD-364 (Yield on 364-day TBS) (Yield on 364-day TBS) (Yield on 364-day TBS)

    2.1 Loans -0.117 (0.012)* -0.112 (0.013)* -0.170 (0.014)* -0.144 (0.015)* -0.144 (0.009)* -0.127 (0.009)* R-square 0.206 0.196 0.279 0.178 0.242 0.181 2.2 Investments -0.131 (0.014)* -0.127 (0.015)* -0.188 (0.014)* -0.160 (0.016)* -0.159 (0.010)* -0.142 (0.011)* R-square 0.208 0.200 0.307 0.197 0.257 0.194 2.3 Reserves -0.066 (0.014)* -0.072 (0.016)* -0.119 (0.013)* -0.103 (0.015)* -0.093 (0.010)* -0.086 (0.011)* R-square 0.055 0.067 0.165 0.109 0.102 0.084 2.4 Demand deposits -0.108 (0.014)* -0.105 (0.015)* -0.147 (0.015)* -0.125 (0.016)* -0.128 (0.010) * -0.114 (0.011)* R-square 0.142 0.139 0.199 0.127 0.171 0.130

    2.5 Aggregate deposits -0.110 (0.013)* -0.112 (0.014)* -0.173 (0.014)* -0.147 (0.015)* -0.141 (0.009)* -0.128 (0.010)*

    R-square 0.162 0.170 0.292 0.188 0.225 0.174 Number of observations 374 374 376 376 750 750 Time period 1993-2004 1993-2004 1993-2004 1993-2004 1993-2004 1993-2004

    Notes: *, ** and *** indicates significance at 1, 5 and 10 per cent, respectively. Robust standard errors in parentheses.

    Economic and Political Weekly March 18, 2006 addition, the effectiveness of monetary policy in influencing bank lending is also dependent on the credit quality of banks’ loans and securities and the liquidity of banks’ balance sheets. In addition, the findings indicate that the response is asymmetric: the relative liquidity of constrained banks’ balance sheets and the credit quality of the banks’ loans and securities are also critical components towards understanding how banks respond to changes in monetary policy.

    mrn

    Email: nachane@igidr.ac.in

    Notes

    [The views expressed here and the approach pursued are the authors’ personalopinions.]

    1 A discussion on the Basel Accord and its rationale and implications foremerging economies is contained in Nachane et al (2004a, 2005).

    2 As observed by the BIS (2004), “…the Committee has sought to arriveat significantly more risk-sensitive capital requirements that are conceptuallysound and at the same time pay due regard to particular features of thepresent supervisory and accounting systems in individual membercountries.”

    3 Clearly, a much richer setting would necessitate a multi-period model[Kopecky and Van Hoose 2004]; the present model, however, confinesitself to the short-run adjustment by banks to changes in monetary policy.

    4 Comprising of cash in hand and balances with monetary authorities. 5 Banks are assumed to hold no excess reserves. 6 The fact that h1 is less than one signifies that banks do not invest their

    entire demand deposits in securities; otherwise, it would be akin to someform of “narrow banking” [Litan 1987].

    7 In contrast, Peek and Rosengren (1995a) and Kishan and Opiela (2000)assume all these interest rates respond equally to changes in the policy(bank rate) variable.

    8 The ratio is currently fixed at 9 per cent for Indian scheduled commercialbanks (except RRBs).

    9 For commercial loans, ΩL varies between 20 and 150 per cent with thecapital requirement, at the margin, on AAA-rated loans equal to 1.8 percent (0.9*20 per cent) and for loans rated BB- or lower, equal to 13.5per cent (0.9*150 per cent). This occurs because, under the external ratingsapproach, while ρ remains fixed at 9 per cent, ΩL varies inversely withthe external credit rating of the borrowing entity, with ΩL (in percentage)equaling 20, 50, 100 or 150.

    10 By way of comparison, under the 1988 accord, the risk-based capitalrequirements on loans and securities are invariant with respect to changesin credit ratings. In that case, (12a) and (12b) can be expressed as:γL= ρΩ*L with ∂Ω*L/∂cL= 0; γS = ρ Ω*S with ∂Ω*S/∂cS = 0; where ρ is fixed and Ω*L and Ω*S are independent of changes in credit risk.

    11 We assume ΩL> ΩS. Economically, this would mean that the risk weighton loans exceeds that on securities. This is in line with the risk weightsas advocated by regulators.

    12 To see this, note that for commercial loans, ΩL varies between 20 and 150 per cent. Accordingly, the relative risk parameter (ρΩS/ρΩL) =(0.9*0.20/0.9*1.5)=0.13 for commercial loans rated BB- or lower. Forcommercial loans rated AA- or better, (ρΩS/ρΩL) = (0.9*0.20/0.9*0.20)=1.0

    13 Several studies in the literature, notably, Kashyap and Stein (1994) andBlum and Hellewig (1995) employ this assumption.

    14 The expanded sample comprises of 27 public sector banks, 15 old privatebanks, 8 ‘de novo’ private banks and 14 foreign banks.

    15 This imbalance for the year 1995 and the later years arises because onenew private banks became operational in 1996, although most othersbecame operative in 1995.

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    Economic and Political Weekly March 18, 2006

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