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1 The Transmission Channels Between Regulation and Lending

1 The Transmission Channels Between Regulation and Lending

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212 



Post-Crisis Banking Regulation in the European Union



6.1.1 The Ambiguous Effects of Capital Requirements

The most commonly investigated relation is the influence of capital regulations on lending. Capital regulation constitutes a guarantee of bank

soundness, is viewed as a buffer against potential losses, and hence allows

banks to fulfil their function as liquidity providers (Košak et al., 2015).

Insufficient capital requirements may lead to increased bank defaults,

especially during times of crises, when banks are confronted with many

NPLs (Repullo & Suarez, 2013). Well capitalised banks monitor borrowers more intensely (Mehran & Thakor, 2011); as an effect the quality of

loans increases. Less leveraged banks take better, non-distorted decisions

and have less incentives to increase risk in lending, hence capital serves

as an incentive device for prudent bank behaviour (Admati, de Marzo,

Hellwig, & Pfleidere, 2010; Košak et al., 2015).

Empirical evidence for the positive relation between capital and bank

lending is found by Bernanke and Lown (1991), De Haas and Van Lelyveld

(2010), Ivashina and Scharfstein (2010), Gambacorta and Marques-Ibanez

(2011), Cornett et al. (2011), Berger and Bouwman (2013), Carlson et al.

(2013), Košak et al. (2015) and Jiménez et al. (2012).

On the other hand, if capital acts as an incentive device, well capitalised banks are reluctant to grant risky loans (Košak et  al., 2015).

Excessively strict capital regulations may constrain bank activities, reduce

deposit funding, increase the cost of lending and limit credit expansion

(Diamond & Rajan, 2000, 2001; Gorton and Winton, 2014; Repullo &

Suarez, 2013). The lending contraction may be pronounced, especially

if the regulations are linked only to credit risk. In this case, they directly

increase the costs of loan funding (Kopecky & VanHoose, 2004; Thakor,

1996). In a competitive environment banks cannot roll over these costs

to customers, so instead of granting loans they prefer to invest in assets

against which they do not have to hold additional capital (e.g., government bonds). This implies that purely credit risk-based capital requirements may cause banks to substitute lending with non-interest activities.

A different situation would be if banks could roll over the increased cost

to their customers, for instance, through relationship lending. In this

case the increased loan funding costs would not affect the level of lending

(Thakor, 1996).



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213



Other studies underscore that strict capital regulations impose a financing cost for banks, since the levels of capital are chosen for the whole

banking sector without taking account of individual bank characteristics

(Allen, Carletti, & Marquez, 2011; Repullo & Suarez, 2007). Empirical

evidence for the constraining impact of capital regulations is found by

Aiyar, Calomiris, and Wieladek (2012) and Thakor (1996).

Some authors, however, provide counterarguments for equity being

expensive (Admati et al., 2010; Carlson et al., 2013; Hubbard, Kuttner,

& Palia, 2002; Kishan & Opiela, 2000; Stein, 1998). Investors are reluctant to finance new assets of poorly capitalised banks. This financing constraint implies the need to attract deposit funding by increasing deposit

rates, which makes lending more costly. Conversely, well capitalised

banks do not need to increase the deposit interest rate and hence their

lending costs are lower (Mora & Logan, 2010). The importance of capital

regulation for maintaining a desired level of lending is especially apparent

during times of financial crises. Negative shocks to bank capital during

the crisis force banks to cut back lending (Rice and Rose, 2012).

The above mentioned arguments show that capital requirements can

act either as a safety buffer, which improves liquidity provision, or a

costly constraint on lending. Moreover, one could expect that the inclusion of various risk types in the capital adequacy ratios impacts lending

in different ways. Since capital requirements act as incentive device for

prudent borrower screening they should contribute to an improvement

of loan quality. To test the mentioned relations the following hypotheses

are formulated:

H1a:  If capital acts as a safety buffer than strict capital requirements

increase lending.

H1b:  If capital regulation increases the loan financing costs than strict

capital requirements decrease lending.

H1c:  If purely credit risk-based capital regulation causes banks to substitute loans with other assets than the credit risk element of capital regulation decreases lending.



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Post-Crisis Banking Regulation in the European Union



H1d:  If capital regulation causes banks to take on prudent decisions

then strict capital requirements decrease NPL ratios.



6.1.2 A

 ctivity Regulations: Diversification Versus

Specialisation Benefits

Another strand of literature focuses on the impact of banking activity

diversification on lending. Some authors stress that strict regulations, for

instance, the ring-fencing of non-banking and banking functions can prevent conflicts of interest between the respective activities. Strict regulations

prevent banks from subordinating less profitable activities, that is lending,

to more profitable ones, that is investment and trading. Strict activity regulations may thus be conducive to larger credit expansion (Barth, Caprio,

& Levine, 2004; Boyd, Chang, & Smith, 1998). Also, the income derived

from non-interest activities, for instance, investment banking or brokerage, is much more volatile than interest income (Altunbas, Manganelli,

& Marques-Ibanez, 2011). In the event of financial distress, banks that

are more active in the field of non-interest activities would suffer much

higher losses than banks involved only in deposit taking and lending. As a

consequence, the incurred losses may affect their ability to lend.

Another strand of literature puts forward arguments in favour of bank

specialisation, that is, combining deposit taking and lending. It posits that

deposit taking eases lending. The rationale behind this argument is that

both activities, deposit taking and lending, require liquidity provision on

demand. If banks focus on both activities simultaneously this generates

synergy effects in liquidity holding (Kashyap et  al., 2002). Separating

the two activities may lead to constrained lending (Diamond & Rajan,

2001). Also, Booth and Booth (2004) show that banks have an advantage as liquidity providers due to access to deposit insurance and central

bank liquidity measures. Hence if the bank’s profile is focused solely on

the traditional interest activity, this may be conducive to increased lending (Booth and Booth, 2004; Diamond & Rajan, 2001; Flannery, 1994;

Kashyap et al., 2002; Qi, 1998).

On the other hand, liberalising activity regulation allows us to achieve

economies of scale and scope, and diversification benefits, conducive to



6  Banking Regulation and Bank Lending in the EU 



215



the possibility of acquiring more funds for lending (Barth et al., 2004).

According to Altunbas et al. (2009) the involvement of banks in securitisation activities has strengthened banks’ capacity to supply new loans,

due to the transfer of credit risk beyond their balance sheets. This capacity, however, depends on business cycle conditions and, notably, on

banks’ risk positions.

The above mentioned arguments show that activity restrictions can

trigger three possible effects: increased credit expansion due to specialisation; increased credit expansion due to the prevention of lending subordination to other activities; or constrained credit expansion due the

preclusion of diversification benefits.

To verify the functioning of these effects the following hypotheses are

formulated:

H2a: If the specialisation channel holds, activity restrictions increase

lending and banks with higher customer deposit ratios support higher

loan growth.

H2b:  If the preventive channel holds, activity restrictions increase lending and decrease the ratio of non-interest income to assets.

H2c:  If the diversification benefit argument holds then activity restrictions decrease lending.

Moreover, one has to note that the respective bank activities are conducive to various risk profiles (Lepetit, Nys, Rous, & Tarazi, 2008). Thus

it is essential to control for the impact of the specific types of activity

regulation. The exercises here treat real estate activities regulation or securities activities regulation separately.



6.1.3 T

 he Impact of Entry Regulations, Deposit

Insurance and Supervision on Lending

Another important component of banking regulation is entry regulations

for new banks. The intuition is that if more banks are allowed to enter

the market this will be conducive to more lending. Empirical evidence



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Post-Crisis Banking Regulation in the European Union



for this relation has been found by Adams-Kane et  al. (2015), Dages,

Goldberg, and Kinney (2000), Clarke, Cull, Soledad Martínez Pería, and

Sanchez (2005) and Gormley (2010).

The papers that analyse the effects of entry regulations focus on the

implications of the banking market structure and competition in lending. On the one hand, strict entry regulation leads to monopolistic

power of incumbent banks, exacerbates competition and is conducive to

increased lending rates and credit growth constraints (Barth et al., 2004).

Nevertheless, monopolistic structures may increase the franchise value of

banks and prevent credit institutions from excessive risk taking, subsequently improving their lending ability (Keeley, 1990).

In terms of the impact of entry regulations on bank lending the following hypotheses are formulated:

H3a:  If the monopolistic power argument holds, strict entry regulation

increases lending.

H3b:  If the competitive pressure argument holds, strict entry regulation

decreases lending.

Further regulatory aspects that may impact lending, are deposit insurance schemes and supervisory frameworks. Deposit insurance is viewed as

a preventive measure against bank runs, and hence, as a crucial element in

maintaining the liquidity provision function of banks. The access to deposit

insurance guarantees banks a special status, favours ­specialisation in banking activities, and allows banks to achieve synergy effects between deposit

taking and lending (Booth & Booth, 2014), although, Dewatripont and

Tirole (1994) show that in the presence of risk-based capital requirements

deposit insurance may contribute to increased risk taking. Banks, knowing the level of insurance premiums can take on more risk to achieve a

pre-determined return. Hence, the preventive function of deposit insurance might be exacerbated. To counteract moral hazard in the presence of

deposit insurance, accurate supervision is necessary (Barth et al., 2004).

The above arguments lead to the following hypotheses:

H4:  If the specialisation channel holds, deposit insurance accompanied

by stringent supervision increases lending.



6  Banking Regulation and Bank Lending in the EU 



217



H5:  If supervisory power acts as an incentive device, more stringent

supervision decreases NPL ratios.



6.2 Empirical Evidence

To test the above mentioned hypotheses one has to control for a number

of factors that might drive the relation between regulations and lending. Related studies point to differences in lending behaviour of large

and small banks (Altunbas et al., 2009; Beltratti & Stulz, 2012; Berger

& Bouwman, 2009; Carlson et al., 2013; Kashyap & Stein, 1995). In

particular, systemic bank size is expected to impact funding and lending

possibilities. The study controls for both size measures.

One can also expect that bank default risk affects lending behaviour,

since it impacts incentives for borrower screening and weighs on loan

funding possibilities. Berrospide and Edge (2010) find that the perceived

risk level of the bank is an important factor in lending decisions. The

present study uses the z-score as a proxy for bank default risk.

A further crucial element that determines the lending ability of a bank,

is its funding structure and changes. The possibility of attracting stable

customer deposits substantially affects the financing cost of loans and

the banks’ ability to lend (Diamond & Rajan, 2000, 2001; Gorton and

Winton, 2014; Repullo & Suarez, 2013). The specifications thus include

a proxy for the funding structure and its changes.

Related studies suggest that bank lending is also affected by the activity profile of the bank, particularly the share of non-interest activities

(Altunbas et al., 2011). The study uses the ratio of gains from trading

and derivatives to assets as a proxy for the share of non-interest activities.

A substantial factor that might have impacted the lending behaviour

of banks after the recent financial crisis is received state aid. Additional

capital provided to banks, as well as liquidity measures and guarantees,

are expected to stimulate lending. Intervened banks might, however, have

incentives to increase risk taking in their lending decisions, which could

contribute to a decrease of loan quality (Gropp, Gruendl, & Guettler,

2014; Hryckiewicz, 2014).



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Post-Crisis Banking Regulation in the European Union



To separate the demand and supply side factors of bank lending two

demand side control variables are introduced: GDP growth and the

interest rate. These variables are aimed at capturing the macroeconomic

situation that mirrors the demand of enterprises and households for bank

credit.



6.2.1 Data Description

The computation of the banking regulatory indices is based on two surveys conducted by the World Bank in 2003 and 2008. A further survey

was conducted in 2012, but to account for the inertia of bank lending

reactions the study focuses on the regulations that were introduced before

the crisis. The regulatory data from 2012 is analysed after the presentation of the results of the specifications, in order to assess the post-crisis

changes in the light of the obtained results.

The data allows us to measure regulatory features during the sample period with close to 630 indicators and aggregate them into broad

groups of regulations by means of principal component analysis. As mentioned in Chap. 5, the survey encompasses detailed questions to regulators about the banking regulatory framework in their countries. The

questions are grouped into broad categories of regulations: entry into

­banking, capital adequacy, banking activity regulation, auditing standards, liquidity requirements, depositor protection schemes, problematic

institutions’ regulations and supervision. The banking regulatory measures are computed conforming to the method described in Chap. 5.

To test the hypotheses outlined in Sect. 6.1, and to examine the impact

of regulations in more detail, the study also uses regulatory measures on

the respective components of capital and activity regulations; that is, the

operational and market risk elements of capital regulations, and securities

and real estate activity components.

To account for a possible shock resulting from regulatory reforms

between 2003 and 2008, the study also uses indices on regulatory changes.

The regulatory modifications were computed on the basis of changes of

answers to the respective questions in the survey. The lack of change was

assigned a score of 0; increased stringency was assigned a positive number



6  Banking Regulation and Bank Lending in the EU 



219



ranging from 1 to 3, depending on the type of question and extent of the

change; decreased stringency was analogically assigned a negative score.

The ultimate indices for the changes in the respective regulatory groups

were based on the first principal components.

The sample encompasses 886 commercial banks from 27 EU countries

during 2005–14. The data on individual bank characteristics are taken

from the Bankscope database. Only the banks that have at least four consecutive observations are included in the sample. To avoid the excessive

impact of outliers on the results only banks with assets not exceeding

€500 billion but amounting to at least €50 million are included in the

sample.

To separate between the demand and supply side factors of bank lending two demand side control variables are introduced: GDP growth and

the interest rate. The data are drawn from World Bank indicators. These

variables are aimed at capturing the macroeconomic situation that mirrors the demand of the enterprises and households for bank lending.

Since the lending ability of banks may be partially due to the capital

provided by state aid, the specification includes a further dummy variable, INTERVENED, which defines whether the bank has received state

aid. These data are based on the relevant European Commission decision

texts available on the state aid websites of the EC.

The summary statistics (Table 6.1) point to large variation of banking features within the sample. The average loan growth ranges between

−1.69 and 2.01 during the whole sample period and −1.16 and 5.10

during the crisis. The NPL dynamic varies from −1.34 to 1.25 during the

whole period and from −1.38 to 1.84 during the crisis. The statistics also

point to substantial differences in funding structures and their changes.

The customer to bank deposit ratio changes varied between −1.31 to 1.65

during the whole sample period and −3.82 and 2.94 during the crisis. The

mean z-score takes the value of 3.83 over the whole period and 3.35 during the crisis with maximum and minimum values ranging from −10.29

to 220.07 and −3.71 to 112.67 in the respective periods. This points to

a large variation of default risk resistance among banks in EU countries.

One can also observe large differentiation of bank liquidity and bank size.

Table 6.2 presents the correlation matrix between the main variables.

One can draw from the statistics that loan growth is negatively and sig-



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Post-Crisis Banking Regulation in the European Union



Table 6.1  Summary statistics

Variable

Bank characteristics

Loan growth

Customer deposits to bank

deposits change

NPL growth

Z-score

Bank size (log of assets)

Long term funding to short

term funding

Net gains from trading and

derivatives to assets

Liquid assets to deposits and

short term funding

ROA

ROE

Banking regulatory measures

Entry regulations 2003

Capital requirements 2003

Activity regulation 2003

Deposit insurance

regulations 2003

Problematic institutions’

regulation 2003

Supervisory power 2003

Entry regulations 2008

Capital requirements 2008

Activity regulation 2008

Deposit insurance

regulations 2008

Problematic institutions’

regulation 2008

Supervisory power 2008

Entry regulations change

2003–08

Capital requirements

change 2003–08

Activity regulation change

2003–08

Deposit insurance

regulations change

2003–08



Observations



Mean



Std. Dev. Min



Max



732

661



0.07

0.04



0.19

0.3



−1.69

−1.31



2.01

1.65



271

866

886

776



0.22

3.83

6.18

0.44



0.26

11.25

0.86

4.16



−1.34

−10.29

4.47

0



1.25

220.07

8.69

102.6



744



0



0.01



−0.01



0.16



0.5



883



28.52



29.83



303.09



885

885



0.33

4.19



2.1

14.34



−44.3

−149.5



31.21

84.37



886

886

886

886



0.16

0.35

−0.54

−0.13



1.5

1.36

1.22

1.29



−11.73

−1.89

−2.19

−2.64



1.02

2.17

2.09

3.03



886



−0.41



1.37



−4.26



1.36



886

886

785

886

886



0.07

0.39

−0.02

−0.33

−0.26



1.19

1.13

1.28

1.44

1.43



−3.3

−9.08

−1.13

−3.18

−2.78



1.33

1.68

4

2.4

1.76



880



−0.26



1.4



−3.62



1.58



806

886



0.17

−0.14



0.93

0.93



−1.84

−5.88



2.09

7.04



886



−0.03



1.26



−2.75



2.75



886



−0.07



1.3



−2



2.62



886



−0.12



1.13



−2.51



2.66



(continued)



221



6  Banking Regulation and Bank Lending in the EU 

Table 6.1 (continued)

Variable

Problematic institutions’

regulation change 2003–08

Supervisory power change

2003–08



Observations



Mean



Std. Dev. Min



Max



886



0.37



1.36



−3.86



3.27



829



−0.31



1.43



−3.6



2.58



nificantly related to funding structure changes, and specifically to the

increased ratio of customer deposit funding to interbank funding. A significant negative coefficient is also obtained for z-scores and loan growth,

which might indicate that riskier banks tend to increase lending more.

The equity to assets ratio is significantly, positively related to loan growth,

which could give initial support to the hypothesis that well capitalised

banks are able to provide larger credit expansion, although, capital regulations stringency is significantly negatively linked to loan growth. Two

other regulatory variables, activity regulation stringency and problematic

institutions’ supervision, are significantly positively related to loan growth.

Bank individual and systemic size is significantly negatively correlated

with loan growth. Moreover, it is significantly correlated with some of the

regulatory measures. Some of the banking regulatory ­variables are highly

correlated; the majority of them positively, except capital and activity

regulations which are significantly, negatively correlated.

Further initial evidence on the investigated relation can be drawn from

analysis of the characteristics of banks in the top and bottom quartile of

loan growth. The summary statistics, as well as a comparison of means for

the main bank characteristics, are presented in Table 6.3.

The data show that a significant factor impacting loan contraction

during the crisis was the funding structure  change. Banks that experienced an increase of customers deposits, compared to interbank deposits,

contracted lending more. The average customer deposit to bank deposit

growth amounted to 0.09 and −0.24 in the bottom and top quartile of

the sample respectively. This result might be due to the fact that interbank funding was substantially held back during and after the financial

turmoil. Significant differences in loan contraction were also related to



Loan growth

Customer

deposits to

bank

deposits

change

NPL growth

Z-score

Bank size

Net gains from

trading and

derivatives

to assets

Equity to

asstes ratio

Bank systemic

size

GDP growth

Interest rate

Entry

regulations

Capital

regulations

Activity

regulations



Variable



1



−0.07*



Z-score



−0.01



−0.14**



0.09



0.02



−0.05



0.03



−0.02

−0.02

0.04



−0.05



−0.01



0.07**



−0.01

−0.15***

−0.08**



0.48***



0.12*** −0.41***



0.06



0.01



−0.03

0.07

0.02



−0.02



−0.01



1



−0.08**



0.05



−0.04

−0.11**

0.02



−0.15***



1



0.07**



−0.04



0.20***

0.05

−0.10***



1

0.13**



Interest

rate



1



−0.24*** 0.67*** 0.04



Deposit

Problematic SuperActivity

insuarance institutions’ visory

regulations stringency regulation power



−0.36*** 1



1



Entry Capital

regula- regulations

tions



−0.17*** −0.60*** 0.01



1

0.24***

0.03



Net gains

from

trading

and

Equity

Bank

derivatives to asstes systemic GDP

Bank size to assets ratio

size

growth



1

−0.19*** 1

0.00

−0.12*** 1

0.10

−0.04

−0.03



0.10**

0.04

0.09

0.08

0.01

−0.10



−0.02



0.08*



0.12*** −0.06



−0.07*



0.03

0.21**

0.05



−0.08**



0.09***



0.12** −0.04

−0.08**

0.01

−0.14*** −0.05

0.02

0.00



1

−0.09**



Loan

growth



Customer

deposits

to bank

deposits NPL

change growth



Table 6.2  Correlation of the main variables



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