The Effectiveness of Regulatory Capital Requirements Prior to the Onset of the Financial Crisis

• Author: Mohamed Azzim Gulamhussen,José Filipe Abreu
• Published date: 01 June 2015
• Date: 01 June 2015
• DOI: http://doi.org/10.1111/irfi.12046

The Effectiveness of Regulatory

Capital Requirements Prior to the

Onset of the Financial Crisis*

JOSÉ FILIPE ABREU†AND MOHAMED AZZIM GULAMHUSSEN‡

†Banco de Portugal and European Central Bank and

‡ISCTE Business School, Instituto Universitário de Lisboa, Lisbon, Portugal

ABSTRACT

We extend the literature on the role of capital requirements as a regulatory

tool by developing a continuous measure of the degree of regulatory pressure

and by examining data on US commercial banks during the economic upturn

that preceded the 2007–2009 financial crisis. Our findings indicate the inabil-

ity of regulatory pressure to force banks to build capital buffers during the

economic upturn that preceded the crisis. These findings are consistent with

the view that banks entered the crisis with inadequate levels of capital. Our

findings support the endeavors of regulators in explicitly demanding capital

buffers in their new regulatory framework.

I. INTRODUCTION

The regulatory framework under which banks conducted their activity prior to

the onset of the 2007–2009 financial crisis has been the object of substantial

criticism (see, among others, Blundell-Wignall et al. 2008; Caprio et al. 2008;

Allen and Carletti 2010). Among these criticisms, the inadequacy of the level

(and quality) of capital is the most preeminent and widely debated. As a result,

worldwide efforts to reform the financial architecture have called for heighten-

ing the minimum capital requirements and increasing capital buffers.1We

contribute to the literature by examining the capital levels and buffers held by

banks during the period of economic upturn that preceded the financial crisis.

We thus address a relevant issue for the design of the new regulatory framework

spearheaded by the Federal Reserve.

* We thank Carlos Branco, José Carlos Dias, Patrick Van Roy, Tiago Nunes and the seminar

participants at the Central Bank of Portugal, the European Financial Management Association

Annual Conference and the ECPR European Consortium for Political Research Standing Group on

Regulatory Governance Third Biennial Conference for their comments and suggestions. We

acknowledge the financial support provided by ‘Fundação para a Ciência e Tecnologia’ (PTDC/EGE-

ECO/114977/2009). The views and opinions expressed in this paper belong to the authors and do

not necessarily represent the views of the institutions with which the authors are affiliated. Any

errors are our own responsibility.

1 See, for example, the Dodd-Frank Act in the United States (Section 616 of the Dodd-Frank Wall

Street Reform and Consumer Protection Act) and the Basel III framework (Basel Committee on

Banking Supervision 2011).

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International Review of Finance, 15:2, 2015: pp. 199–221

DOI: 10.1111/irfi.12046

© 2015 International Review of Finance Ltd. 2015

The literature on prudential regulation takes two opposing views on

minimum regulatory capital. One view contends that minimum capital require-

ments create a necessary cushion that protects banks from losses and ultimately

from failure in the event of unexpected economic downturns or financial crises

(see, e.g., Dewatripont and Tirole 1994; Clare 1995; Goodhart et al. 2003;

Pennacchi 2005). Another view contends that minimum capital requirements

induce banks to increase their risk to compensate for the additional costs of

holding heightened capital, which may ultimately have adverse effects on the

soundness of banks and financial systems (see, e.g., Koehn and Santomero 1980;

Kim and Santomero 1988; Rochet 1992; Blum 1999; Abreu and Gulamhusen

2013a). Both views are grounded on solid theoretical arguments. Whether

additional minimum capital requirements lead banks to build capital buffers or

to incur additional risks remains an unanswered empirical issue. The period of

economic upturn that preceded the recent financial crisis provides an interesting

setting for two main reasons: first, it was a period of economic upturn during

which regulators were expected to pressure banks to build capital buffers to

withstand eventual financial crises; second, regulators were expected to pressure

banks not to take additional risks that might precipitate a financial crisis. The

findings from this setting should be of particular interest because they may shed

light on the design of the new regulatory framework, in which the Federal

Reserve (and the Basel Committee on Banking Supervision) explicitly requires

countercyclical capital buffers to allow banks to withstand future financial crises.

The design of a capital requirements system includes the imposition of a

minimum level of capital and a recommendation that banks operate with an

adequate capital buffer, that is, banks should maintain their capital above the

minimum risk-weighted capital requirements. Empirical studies on the effective-

ness of capital requirements in the United States show that the regulatory

pressure associated with imposing minimum capital requirements causes under-

capitalized banks, that is, banks with a level of capital near the regulatory

minimum, to increase their capital more rapidly than well-capitalized banks.

However, the capacity to force banks to build capital buffers during periods of

economic upturn has received less analytical attention. Of particular interest is

the period prior to the onset of the 2007–2009 financial crisis, when banks had

the opportunity to create capital buffers to withstand the crisis that ultimately

materialized with the economic downturn.

A key feature of this type of study is the definition of the degree of regulatory

pressure, which is difficult (Abreu and Gulamhusen 2013b). Undercapitalized

banks, that is, banks with small buffers or banks that are undercapitalized

relative to the minimum regulatory thresholds, are expected to face increased

regulatory pressure to raise their levels of capital. Previous studies used a

dummy variable (or a set of dummy variables), depending on the size of the

capital buffers, to accommodate discrete regime shifts associated with the intro-

duction of minimum capital requirements. In practice, however, regulators

exert continuous pressure on undercapitalized banks to increase their levels of

capital and this pressure increases as the shortfall of capital increases. A measure

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