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Capital shocks and bankgrowth-1973 to 1991

Herbert L. Baer andJohn N. McElravey

For over a decade the U.S.depository system has beencharacterized by increasinglystringent regulatory capitalrequirements for banks, in-

creasingly volatile earnings, and rising failurerates. However, the impact of these develop-ments on the behavior of financial institutions isa subject of considerable debate. Some observ-ers point to the contraction in lending by domes-tically chartered banks and thrifts during 1991and wonder if overly rigid capital requirementsare to blame (Martin Feldstein, 1992; RichardBreeden and William Isaac, 1992; and MichaelKeran, 1992). Others have argued that lossessuffered by depository institutions have been toblame. A third group argues that neither of thesedevelopments has had a significant impact onbank behavior or the economy.

This article develops testable hypothesesabout the growth of financial intermediariesunder the assumption that issuing new equity is acostly way for banks to smooth shocks to theirequity position. We draw heavily on previousattempts to confirm the hypothesis that nonfi-nancial firms are forced to rely strongly on inter-nal financing because of capital market imper-fections. The article has three goals. First, weask whether most banks manage their total assetsas if it is costly to raise additional equity fromexternal sources. Second, we examine how pastchanges in capital requirements have affectedbank behavior. Finally, we explore the role thatvarious shocks to the depository system haveplayed in the recent slowdown in bank lendingand the monetary aggregates. To address these

issues we study to the behavior of publicly trad-ed bank holding companies. In June of 1991these holding companies accounted of two thirdsof the total assets held by U.S. based holdingcompanies and independent banks.

We report the following findings:1) Banks manage their asset growth as if there

are significant costs associated with issuingnew equity and selling existing assets. Thisis consistent with the research of others whofind that issuing new equity dilutes thewealth of existing shareholders.

2) Following the implementation of explicitminimum capital requirements, the propor-tion of variation in asset growth explainedby regulatory capital ratios jumped dramati-cally.

3) As the regulatory capital requirement hasincreased, so has the level of capital atwhich banks begin shrinking their assets.

4) Between June 1989 and June 1991, theproportion of banks whose growth wasconstrained by capital requirements reacheda twenty-year high. Capital-constrainedbanks controlled two-thirds of the assets inour sample.

Herbert L. Baer, formerly an Assistant Vice Presi-dent at the Federal Reserve Bank of Chicago, iscurrently a Financial Economist with the WorldBank. John N. McElravey is an Associate Econo-mist at the Federal Reserve Bank of Chicago. Theywish to thank Charles Calomiris, George Kaufman,Robert Laurent, Patrick McAllister, Larry Mote,Steve Strongin, Larry Wall, and Paula Worthingtonfor helpful comments.

2 ECONOMIC PERSPECTIVES

TABLE 1

Major changes in regulatory capital requirements

1981 Introduction of primary capital requirements-5percent of balance sheet assets for regional banksand 6 percent for community banks.

1983 Primary capital requirements for regional banksextended to so-called multinational banks.

1985 Primary capital requirements set equal to 5.5percent for all banking organizations.

1986 Federal Reserve announces its intention to developa risk-based capital requirement.

1989 The tier 1 and total risk-based capital requirements(4 and 8 percent of risk-based assets) are adoptedwith phase-in scheduled to begin at year-end 1990.Loan-loss reserves are excluded from tier 1 capital.

1990 Regulators adopt a new tier 1 leverage limit.Published regulations indicate that most banks willbe required to maintain a ratio of at least 4 to 5percent of assets.

1991 FDICIA requires closure when the tier 1 leverageratio falls below 2 percent and mandates theinclusion of interest rate risk in risk-based capital.

1992 Regulators require banks to maintain a tier 1 risk-based capital ratio of 6 percent to be consideredwell-capitalized.

5) Of those banks that were constrained duringthe 1989-91 period, two-thirds were capital-deficient because of losses incurred duringthe period, while one-third were constrainedbecause of low levels of capital at the begin-ning of the period.

6) The increase in regulatory capital require-ments for banks can explain only about one-third of the recent slowdown in the growthof bank assets and liabilities. Other factorssuch as beginning-of-period capital defi-ciencies, losses, and asset recycling played alarger role in that slowdown.Our findings indicate that in order to realize

their full profit potential through growth, banksmust now maintain significantly higher capitalratios than they did a decade ago. Banks that donot maintain these higher capital ratios areforced to shrink. This has three implications.First, with the penalties for capital deficiencyrising, losses to the Bank Insurance Fund (BIF)should moderate in the near future. Second,given the increases in bank equity requirementsand the quantity of assets and liabilities fromfailed and undercapitalized institutions whichneed to be recycled to healthy institutions, the

depository system was unable to grow at previousrates without issuing significant (and potentiallycostly) amounts of new capital. According to ourestimates, the banking system would have had toissue new shares equal to 28 percent of existingregulatory equity in order to absorb these newassets. Finally, since increased capital require-ments accounted for only one-third of the disrup-tion to bank capital positions, policymakersshould view with great skepticism proposals toweaken bank capital requirements.

In order to understand how capital regula-tions have affected bank behavior in the recentpast, we will first take a broad look at the rela-tionship between firm capital and firm growth,and then proceed to a specific analysis of howchanging regulations affected bank asset growthin the 1980s and early 1990s.

The cost of raising new capitaland asset growth

During the 1980s, bank regulators adoptedincreasingly stringent capital requirements. Le-verage constraints were progressively tightenedand risk-based capital requirements were intro-duced. Table 1 presents a chronology of thesechanges. (A detailed discussion of the changes

appears in Box 1.) While the re-cently implemented risk-basedcapital requirements have receivedthe most publicity, Baer and McEl-ravey (1993) show that until thepassage of the FDIC ImprovementAct (FDICIA), the leverage restric-tions remained the binding con-straint for most banks.

With the greater regulatoryemphasis on bank capital havecome increased penalties for banksthat maintain inadequate capitallevels. To adjust to a shortfall, abank may take one or more of thefollowing actions: retain more ofits earnings, shrink its assets, reduceits portfolio risk, or issue new equi-ty. A bank will choose among theseactions on the basis of their relativecosts. While these costs can bedifficult to measure, the theory andreality of corporate finance suggestthat it is often more costly to issueequity than to increase retainedearnings or to sell assets.

FEDERAL RESERVE BANK OF CHICAGO

3

Whether firms decide to issue new sharesdepends on the degree of information asymme-try and the value of options embedded in thedebt contracts. The dilution associated with newshare issuance can be quite large relative to theamounts issued. For example, a study of 121industrial firms found that on average, everydollar of new equity issued caused a 28 centreduction in the market value of existing

shares—a marginal dilution rate of 28 percent(Asquith and Mullins, 1986).' Obviously, thesefirms would have been willing to incur substan-tial costs rather than issue new shares. Shareissuance by banks also results in dilution, but theavailable studies do not directly calculate themarginal dilution rate.' The wealth transfer fromexisting shareholders that occurs when newshares are issued can be thought of as a lemons

BOX 1

The changing nature of capital requirements

Capital regulation of banks in the United Stateschanged dramatically during the 1980s. Prior to1981, federal banking regulators did not enforcespecific uniform guidelines for capital adequacy.'Rather, they imposed capital requirements subjec-tively, taking into account the results of examinationsof individual banks as well as capital levels at otherbanks with similar characteristics. Regulators per-suaded a bank with capital below its peers to increaseits capital. Since bank assets were not becoming anyless risky, the relatively steady decline of the indus-try's capital cushion during the 1960s and 1970ssuggests that this system of peer-based capital re-quirements was not particularly effective as imple-mented (Peltzman, 1970).

As the 1970s drew to a close, regulators becameincreasingly concerned that banks were holdinginadequate capital given the riskiness of their assets.In response, the three federal banking regulatorsannounced minimum "primary capital ratios" forbanks and bank holding companies in December1981. Primary capital included common and pre-ferred equity, mandatory convertible debt instru-ments, perpetual debt instruments, and loan-lossreserves. After a phase-in period, the minimumprimary capital ratio was set at 5.5 percent of totalassets. In addition to raising the amount of capitalheld by banks, the explicit capital requirement alsolinked the total asset size of the banking system tothe system's total primary capital.

The treatment of loan-loss reserves as primarycapital was significant because reserving for loanlosses would not decrease a bank's regulatory capi-tal. To illustrate, a bank first reflects prospectivelosses in its loan portfolio by making a provision forpossible loan losses. These loan-loss provisionsreduce the bank's equity and increase its loan-lossreserve. Only when a loan is actually charged off isthe loan-loss reserve, and therefore primary capital,reduced. However, this treatment of loan-loss re-serves as regulatory capital was questionable to theextent that it was already allocated to absorb expect-

ed losses in a bank's loan portfolio. If the reserve isan accurate reflection of the losses embedded in abank's loan portfolio, then it should not be includedin the measure of the bank's ability to withstandadditional unexpected losses, that is, its regulatorycapital ratio.' Because loan-loss reserves were in-cluded in the measure of capital adequacy, a bank'sequity cushion could have eroded while its primarycapital ratio remained unchanged. To the extent thatregulatory actions were based on primary capital,banks that should have been facing pressure to raiseadditional equity or reduce total assets (or, at least,reduce asset risk) could argue that they had sufficientcapital.'

In the latter half of the 1980s, in an effort toovercome some of the deficiencies in primary capital,regulators introduced a plan for risk-based capitalrequirements. The product of protracted internationalnegotiations, the risk-weighted capital ratio measuresa bank's capital with respect to the default risk of itson- and off-balance-sheet credit exposures. Regula-tors, the banking industry, and the press have dis-cussed at great length the appropriate risk weightingsfor on- and off-balance-sheet activities. In addition,the types of financial instruments that qualify ascapital for regulatory purposes, as well as theiramounts, have been more restrictively defined. Whilea detailed discussion of risk-based capital require-ments is beyond the scope of this paper, one feature iscrucial: risk-based capital requirements may con-strain total bank lending to the private sector, but theydo not constrain the total assets held by the bankingsystem. Indeed, a bank that is below the minimumrisk-based capital ratio could come into complianceand still show asset growth by selling assets withhigher risk weights and purchasing assets with lowerrisk weights. For example, commercial loans (100percent risk weight) could be exchanged for Treasurysecurities (zero risk weight) so that total assets couldstill show growth while risk-weighted assets woulddecline.


premium—compensation to the purchasers ofnew shares for the possibility that existing share-holders are misrepresenting the firm's condition.

Many firms behave as if it is costly to raiseadditional debt or equity from external sources.Calomiris and Hubbard (1992) show that duringthe 1930s, firms willingly incurred significanttax penalties to avoid dividend payouts thatwould have required raising additional funds

from outsiders. Studies by Fazzari, Hubbard,and Petersen (1988), Himmelberg and Petersen(1992), and Fazzari and Petersen (1990) docu-ment the extent to which the costs of externalfinance constrain investment by high-growthfirms. A study by Hubbard and Kashyap (1992)documents the impact of collateral requirementson agricultural lending.

The internationally negotiated risk-based capitalrequirements do not preclude national regulatorsfrom implementing more stringent standards for thebanks they supervise. Concerned that the risk-basedguidelines did not properly account for interest raterisk, U.S. regulators tightened the old primary capitalstandard and added it to the risk-based requirementsfor U.S. banks. The result was the leverage ratio.Under rules effective since January 1991, banks witha CAMEL rating of 1 are required to have tier 1capital (the sum of common equity, certain preferredstock, and minority interests in equity accounts ofconsolidated subsidiaries less goodwill) equal to atleast 3 percent of total balance sheet assets. As ofJune 1991, few of the nation's banks had a CAMELrating of 1. For all other banks, the minimum tier 1leverage ratio is to be 3 percent plus an additionalcushion of at least 100 to 200 basis points. Banksexperiencing growth are expected to maintain strongcapital positions above minimum regulatory levels.Bank holding companies with consolidated assets inexcess of $150 million are also required to adhere tothese guidelines.

Given the imprecise nature of the leverage limitrule, it is difficult for an outside observer to say withany certainty which leverage standard any particularbank was being held to.' However, former FDICChairman William Seidman estimated that mostbanks would face a minimum leverage ratio of 4.5percent (Holland, 1990). Others believe that mostbanks and bank holding companies were in factbeing subjected to a 5 percent leverage ratio. Evi-dence presented in this article suggests that the re-quirements began to affect bank behavior once thetier 1 equity ratio fell below 7.0 percent.

If, in fact, most banks were being required tomaintain a tier 1 leverage ratio in excess of 4.5 per-cent or 5 percent, then the adoption of the leveragelimit represented a significantly tighter capital re-quirement than the primary capital standard, becausetier 1 capital excludes loan-loss reserves. Under theleverage limit, banks found it necesssary to raiseadditional equity or decrease total assets as soon as

problem loans are identified and reserved for, ratherthan waiting until they were charged off. Perhapsmore surprising, the leverage limit also appears tohave represented a tighter capital requirement thanthe new risk-based capital standards (Baer and McEl-ravey, forthcoming 1993). We believe that thisoccurred because banks constrained by the leverageratio could not adopt a program of asset substitutionto avoid shrinkage. Perhaps in recognition of thisfact, regulators have recently advocated eliminatingleverage ratio requirements.

Responding to the FDIC Improvement Act, inSeptember 1992 regulators set new minimums for thetier 1 leverage ratios and the tier 1 and total risk-based capital ratios. In order to be considered well-capitalized, a bank must now maintain a tier 1 lever-age ratio of 5 percent, a tier 1 risk-based capital ratioof 6 percent , and a total risk-based capital ratio of 10percent. The adoption of these new rules wouldappear to eliminate much of the uncertainity concern-ing the minimum leverage ratio. However, banksmust continue to manage both their leverage andtheir risk-based capital ratios.

'During the 1950s and 1960s, the Federal Reserve Systemcalculated a type of risk-based capital standard called the"Form for analyzing bank capital," or ABC Form. Howev-er, it does not appear that any attempt was made to enforcecapital requirements based on this approach. Paul M.Horvitz (1968) noted that "individual bank scores on thecapital adequacy formula show a very wide dispersionwhich indicates that probably neither the banks nor theFederal Reserve take it very seriously."

'In fact, it appears that many of the larger bank holdingcompanies were underproviding for loan losses becausetheir market-to-book ratios were below 1 for much of the1980s.

'Of course, banks could face funding pressure from con-cerned depositors and investors.

'In its 1991 annual report, Citicorp states that "Citicorp hasnot been advised by the Federal Reserve Board or theFederal Financial Institutions Examination Council as to aspecific required leverage ratio applicable to it."

FEDERAL RESERVE BANK OF CHICAGO 5

BOX 2

Some definitions

end-of-period assets

L, end-of-period liabilities

Regulatory growth model

St new shares issued

RE, retained earnings using regulatory accounting

E, end-of-period regulatory equity: E, 1 + RE,+ S t

e t

the do-nothing regulatory equity ratio:

the level of E t at which regulatory intervention begins

the bank's optimal regulatory equity-to-asset ratio

Et_ 1 + RE,

Et-,

DUMO-DUM8 dummy variables based on the bank's do-nothing capital ratio, e",

Market growth model

r the percentage change in the net market value ofthe existing portfolio of assets and liabilities during period t

Vt end-of-period market value of equity: V, 1 11+rd+S,

v the do-nothing market value equity ratio: (l+rt)Lt-1

v* the uninsured bank's optimal market value of equity ratio: V

At

DMCAP V,

MDUMO-MDUM8 dummy variables based on the bank's do-nothing market capital ratio, v7

E,

A tEt-i+REt

e

E '

RINT

Testing the relationship betweencapital and asset growth at banks

We seek to determine whether financialintermediaries, like their nonfinancial counter-parts, find it costly to bridge the gap betweendesired and actual capital levels by adjustingtheir asset portfolios. This is by no means thefirst article to explore the response of intermedi-aries to disturbances in their capital positions.Wall and Peterson (1987) examine the factorsinfluencing banks' capital ratios. Peek andRosengren (1991) document the negative impactof declines in regulatory capital on the growth ofcommercial banks in New England. Bernankeand Lown (1991) study interstate variation inasset growth as well as the behavior of banks inNew Jersey and report similar results. Furlong

(1992) develops implicit estimates of banks'desired capital ratios and finds that they haverisen during the 1980s. Finally, Hancock andWilcox (1992) examine the impact of capitalshortfalls on various aspects of bank growth. Ofthese papers, only Hancock-Wilcox and Furlongfocus on changes in behavior of banks over time,and none examines the behavior of well-capital-ized banks in any detail.

This article seeks to build on previous re-search in two ways. First, we wish to determinewhether most banks manage their total assets asif it is costly to raise additional equity fromexternal sources. Second, we wish to determinewhether past changes in capital requirementshave affected bank behavior. In order to accom-plish these goals, we first examine the behavior


of banks under two different scenarios:1) banks are uninsured and face information

asymmetries when selling assets or issuingequity;

2) banks have access to underpriced depositinsurance and face information asymmetrieswhen selling assets or issuing equity.

The behavior of uninsured, unregulatedintermediaries

In the absence of deposit insurance andregulation, banks would not behave differentlythan other firms that hold significant amounts offinancial assets. Information asymmetries, mor-al hazard, bankruptcy costs, and taxes wouldjointly define the bank's optimal capital struc-ture.

The market value of existing shares V, isone component of a banks' capital structure.

Vr = (1-8)S„

where r, is the change in the net market value ofthe portfolio of assets and liabilities held at theend of the previous period and 8 is the dilutionassociated with new equity S, issued in period t.Let v, denote the ratio of V to total end-of-periodliabilities L,. The bank's optimal ratio of equityto liabilities, v: would of course vary with thecomposition of its assets and liabilities. Credi-tors would charge undercapitalized banks a riskpremium to cover potential losses due to declin-ing asset values and bankruptcy costs. If infor-mation asymmetries make it costly to issue newequity to existing shareholders, a key state vari-able for the bank is its "do-nothing" marketequity ratio,

exceeds the lemons premium associated withissuing additional equity, the bank will issueequity.

We would expect that

(1) A

f — d13 )

/4,_ I V:

where A is the bank's total assets at the end ofthe period, and dP is a set of possibly unob-served variables which measure the profitabili-ty of a bank's future investments. The optimalratio of market capitalization to assets, v*, isunobservable. However, we could use V,_,IL,_,as a proxy v*, and estimate equation (1).

The behavior of insured intermediarieswith asymmetric information

When underpriced 100 percent depositinsurance is available, a bank's capital structureis determined by a regulatory constraint tied toregulatory measures of bank equity rather thanby creditor estimates of net worth. The bank'send-of-period regulatory equity is given by

E,= E + RE, + S„

where E, denotes end-of-period regulatoryequity, RE, denotes retained earnings, and S,denotes new equity issued in period t. Both E,and RE, are based on regulatory accountingprinciples.

Let E' denote the equity-to-asset ratio atwhich regulators begin constraining a bank'sassets. We assume that if E,_,+RE, < A,_,,then asset growth at a bank is subject to theconstraint

V,(1-8)S Vv" =

L,_,(2) A,— [E,_, + RE, + S A:

l.

Er

If investors believed that changes in assetvalues were permanent, the growth in a bank'sassets would be determined primarily by therelative magnitudes of and v:. When >the bank will expand until v't v: or until profit-able investment opportunities are exhausted,whichever comes first. When v7 < v i*, the bankwill face pressure to shrink its assets until thelemons premium incurred by selling additionalassets equals the risk premium charged by credi-tors. If at this point the risk premium on its debt

If p = 0, a capital-deficient bank is notpermitted to grow. If p = 1, then a capital-deficient bank is forced to return immediatelyto compliance. If 0 < p < 1, then the bank ispermitted to return to compliance over time.

If banks find it costly to issue new equityor to sell assets in response to a shortfall inregulatory equity, their optimal regulatorycapital ratio e* will exceed the regulatory mini-mum. For a given level of regulatory equity, E,will have an optimal quantity of assets A*, an


optimal ratio of regulatory equity to assets of E *,and an adjustment function 0 which describeshow the bank adjusts to disturbances to its regu-latory capital position.

The bank's optimal regulatory equity ratioc*, would of course vary with the composition ofits assets and liabilities and the parameters of theregulatory constraint. If information asymme-tries make the issuance of new equity costly toexisting shareholders, a key state variable for thebank is its do-nothing regulatory equity ratio,

REt+Er-1E"i =

When £"t > £*, the bank will expand until rt= E * or until profitable investment opportunitiesare exhausted, whichever comes first. When rs>

> E', the bank will face pressure to shrink itsassets until the lemons premium incurred byselling an additional dollar of assets just offsetsthe benefits of a greater capital cushion. When

> e7, the bank becomes subject to the regulato-ry constraint of equation (2). In this case,growth will depend on the ratio of c7. and Er,although it is possible that banks with highervalues of E * might choose to shrink more rapidlythan those with lower levels of E * .

For a given bank, the arguments of 0 areE', and c*. The following simple model revealssome of the econometric issues involved inestimating the asset growth function 0:

A E'!(3) ---= = 0 ( " , dA 0, � 0 02 � o ,

where i denotes the bank and dP measures themarginal value added from expanding intermedi-ation activities. The do-nothing capital ratio c't isdirectly observable, while the variables Et', E*, anddP, are not. The first argument of 0 reflects theregulatory constraint in equation (2). The sec-ond argument of 0 represents the rate of assetgrowth that would permit the bank to end theperiod with E, = without issuing additionalshares.

The structure of 0 will change when theregulatory constraint changes. As table 1 docu-ments, regulatory capital requirements have beenraised at several points over the last decade; thusit would be inappropriate to estimate 0 in a timeseries format. However, EVE,, , can be used as a

proxy for Enielin order to estimate 0 cross-sectionally. We call this proxy RINT.

For estimation purposes, we linearize 0 inthe following fashion:

A.(4) = E B. DUM.. + E c.pum. RINT

*1 '

+ dP + t

where i denotes the ith bank, j denotes one ofseven capital categories based on the bank's do-nothing capital ratio, t denotes time, DUN ,, is 1if the ith firm is in capital class j and zero other-wise, RINT, is the ratio of internally generatedregulatory capital in period t to total regulatorycapital at the end of period t-1, and dP is a vec-tor of unobserved variables measuring the ithfirm's growth prospects. If external capital iscostly and firms are unwilling to drive theirequity ratio below E *, we would expect the coef-ficient on RINT to be between zero and one.Like the models specified by Bernanke andLown (1991), Hancock and Wilcox (1992), andPeek and Rosengren (1991), this model alsoallows a bank's capital level to affect its growth.Unlike theirs, however, our model also allowsfor the possible willingness of well-capitalizedbanks to forego growth opportunities in order tomaintain their optimal capital ratios.

The estimates of the coefficient on RINTmay be subject to omitted variables bias. Inparticular, dP, may be positively correlated withRINT. This may lead us to infer a significantlink between growth in regulatory capital andasset growth, when in reality the relationship isbetween profit opportunities and asset growth.There are, however, many reasons to believe thata positive coefficient on RINT would not resultsolely from omitted variable bias. First of all,many of the reasons why banks make or losemoney have nothing to do with the profitabilityof their future lending opportunities. For exam-ple, duration mismatches and ceilings on depositinterest rates can explain a significant amount ofcross-sectional variation in bank earnings, yetthey have little to do with the inherent profitabil-ity of lending opportunities. In addition, sincethere was frequently a long lag between thedeterioration of a bank's loan portfolio and in-creases in its loan-loss reserves, changes in assetgrowth due to changes in lending environmentshould have been incorporated in bank behavior


before they were reflected in earnings. Evenmore fundamentally, losses on the existing port-folio need not have any significant implicationsfor the profitability of future lending opportuni-ties. Losses are merely evidence of a change inenvironment or an inappropriate risk assessmentby the lender. They do not imply that lendingwill not be profitable once the bank adjusts tothe new environment or employs an improvedrisk-assessment procedure.

Even though there are many reasons tobelieve that cross-sectional variation in RINTis not simply proxying for the profitability oflending opportunities, it would be foolish todismiss concerns about omitted variables bias.Instead, we will seek to ensure that our resultsare robust. First, we will present two estimatesof 0, one using the levels of variables in equation(4), the other using changes in the variables inequation (4). Second, we present estimates ofequation (4) which also include changes in thebank's share price. This should capture changesin banks' future expected profitability.'

When estimating 0, it may also be possibleto identify the regulatory constraint. If a bank isoperating on the regulatory constraint, only thedo-nothing capital ratio c and the regulatoryminimum capital ratio u will be important inexplaining a bank's growth rate; variation inother variables should not be associated withdifferences in asset growth. Even if the coeffi-cient on RINT is nonzero because of omitted

variable bias, a positive coefficient would indicatethat factors other than regulatory capital levels aredriving bank behavior.

The sample

To test for the changing impact of regulatorycapital requirements on the growth of U.S. bank-ing institutions, we studied the behavior of U.S.bank holding companies included on the currentCompustat data base, as well as those carried inthe Compustat research file.' Share price data aswell as certain balance sheet and income state-ment items came from the Compustat data base.Table 2 provides descriptive statistics for thesample for the time periods under study.

We present the results obtained by estimatingequation (4) on cross sections for four differenttwo-year periods, December 1973 to December1975, December 1979 to December 1981, De-cember 1984 to December 1986, and June 1989to June 1991. We estimated similar modelsfor other time periods. The results were consis-tent with those reported here. In a given crosssection, each bank holding company is represent-ed by a single observation. The key independentvariables for estimating equation (4) are thelevel of the do-nothing capital ratio, and thegrowth in the capital base of the bank holdingcompany (BHC) that was due to retained earn-ings, RINT. These variables are calculated overtwo-year intervals, for example, year-end 1984to year-end 1986.

TABLE 2

Sample characteristicsa(billions of dollars)

Do-nothingbook equity

ratio° N1973-75assets N

1979-81assets N

1984-86assets N

1989-91assets

DUMO 0-3 2 $ 4 3 $ 13 4 $ 10 7 $ 39DUM3 3-4 11 124 6 259 4 160 7 272DUM4 4-5 22 162 12 297 4 106 12 612DUM5 5-6 27 131 21 162 19 631 15 363DUM6 6-7 29 79 47 184 38 275 17 286DUM7 7-8 19 40 42 127 45 241 33 336DUM8 >8 25 34 40 72 47 185 41 264

Sampletotal

135 574 171 1,114 161 1,608 132 2,172

'The period 1989-91 is June 1989 to June 1991. All other periods are December to December.

b(beginning-of-period equity + earnings retained during period)(beginning-of-period assets)


9

TABLE 3

Sample characteristics

RINT Asset growthPeriod' DUMO DUM8 DUMO DUM8

(---annual rate---)

1973-75 90 118 0 91979-81 56 121 —15 14

1984-86 7 130 —9 351989-91 46 121 —13 10

aThe period 1989-91 is June 1989 to June 1991. Allother periods are December to December.

We use the ratio of equity to total assets tomeasure the adequacy of capital for regulatorypurposes. Previous work by Baer and McEl-ravey (1993) showed that risk-based capitalrequirements did not have a significant impacton bank growth over the period covered by thisstudy. Each BHC was assigned to one of sevencategories depending on its end-of-period equi-ty-to-asset ratio. Using this classification, wethen generated a set of dummy variables with theprefix DUM, based on the leverage ratio (ratio ofbook value of equity to assets). For instance,DUM3 takes on the value 1 if the bank's do-nothing capital ratio is between 3 and 4 percent;otherwise it takes on the value 0. The definitionof the categories, the corresponding dummyvariables, and the distribution of the banks foreach two-year sample period are given in table2. That table suggests that it was not unusual forbanks in our sample to have inadequate regulato-ry capital. During the period 1989-91, for exam-ple, twenty-six BHCs with 41.5 percent of theassets in the sample had do-nothing capital ratiosbelow 5 percent. In the earlier period 1984-86,fifteen BHCs with 19.6 percent of the assets inthe sample had do-nothing primary capital ratiosbelow the crucial 5 percent level. Table 3 pre-sents values of RINT and asset growth for eachtime period for banks in the lowest and highestcapital categories.

Determinants of asset growth

One of the central propositions of this paperis that banks manage their assets as if they find itcostly to issue new equity. This implies thatgrowth in assets will be closely linked to the rateof internal capital generation, RINT. Table 4presents two tests of this hypothesis. The esti-mation results presented in table 4 ignore thepossible impact of regulatory constraints onasset growth. Model I includes only one vari-able, RINT. In every case, the coefficients onRINT lie between 0 and 1, as predicted by thetheory. Depending on the time period, variationin RINT across BHCs explains 30 to 40 percentof the variation in firms' asset growth rates. Thevalues of the intercepts indicate that banks withno retained earnings experience no asset growth.Moreover, banks appear to respond similarly topositive and negative earnings. When the coeffi-cient on RINT is allowed to take on differentvalues for RINT > 100 and RINT < 100, thecoefficients are similar in value.

These results remain robust even when wereestimate Model I in first differences to elimi-nate possible biases caused by omitted firm-specific differences in long-run profitability. Infirst differences form, there is a positive, statisti-cally significant relationship between RINT andasset growth. Moreover, the coefficient esti-mates for RINT and MINT are generally close toone another. This suggests that the high correla-tion between RINT and asset growth is not beingdriven primarily by omitted, firm-specific differ-ences in long-run profitability. To determinewhether these results merely reflect the behaviorof poorly-capitalized banks or also reflect thebehavior of well-capitalized banks, we reesti-mated Model II using data for banking organiza-tions with do-nothing capital ratios above 7percent (results not shown). We find that forthese well-capitalized banks, the coefficient onMINT continued to be positive and significantlydifferent from zero at the .01 level.

These results leave open the possibility thatcross-sectional variation in RINT is correlatedwith unanticipated cross-sectional changes in(rather than levels of) in long-term profitability.One measure of the unanticipated change inlong-term opportunities is the rate of change inthe value of a bank's existing equity claims,DMCAP. The last panel of table 5 uses bothRINT and DMCAP to explain asset growth.' Inall cases, RINT continues to be significant.

The persistent importance of RINT in ex-plaining asset growth and changes in assetgrowth suggests that well-capitalized and poor-ly-capitalized BHCs in our sample find externalsources of regulatory capital to be significantlymore expensive than internal sources. Thisrelationship does not appear to be merely a resultof a correlation between RINT and long-run orshort-run differences in profit opportunities.


TABLE 4

Relationship between internally generated equity and bank holding company asset growths

Model IDependent variable: asset growth rateVariables in levels

1973-75

1979-81

1984-86 1989-91A A

aA A

aA A A

INTERCEPTRINTb

N

R2RMSE

-29.83.31***

132.30

5.39

4.64.04

-42.60.45***

170

.376.82

5.40.04

-32.30.42***

160.38

13.11

5.14.04

-17.47.22***

126.30

8.03

3.19.03

Model IIDependent variable: change in asset growth rate

1979-81 1984-86 1989-91Aa

A6

A 0

INTERCEPTARINT'

N

R2RMSE

-1.48.27***

145

.12

6.89

.57

.06.01.40***

161

.3220.43

1.60.04

-1.00.26***

128

.2412.07

1.16.04

'The period 1989-91 is June 1989 to June 1991. All other periods are December to December.bRINT = (beginning-of-period equity + retained earnings)/(beginning-of-period equity).

RINT-RINT, 2*, **, *** significant at the .10, .05, and .01 levels respectively.

This is consistent with the basic findings fornonfinancial firms (for instance, Fazzari, Hub-bard, and Peterson, 1988).

The preceding analysis sheds little light onthe impact of capital requirements on bankgrowth. In Model III, asset growth is influencedby DUMO-DUM8, dummy variables tied both to

the bank's do-nothing capital ratio, as well asto the bank's internal capital generation rate,RINT. The estimation results for Model III arepresented in table 6. Taking account of banks'regulatory capital significantly increases theability to explain differences in bank assetgrowth in all time periods studied. In the 1973-75 period and the 1979-81 period, R2 increasesby .07 and .09 respectively. Results for 1984-86and 1989-91 are more dramatic; R2 increases by.19 for 1984-86 and by .15 for 1989-91. Thissuggests that capital levels have become moreimportant in determining bank growth. Thisconclusion is backed up by the variation incoefficients on RINT across different capital

categories. Low-capital banks have smallercoefficients on RINT which are generally notsignificantly different from zero. High-capitalbanks have larger, statistically significant coeffi-cients on RINT. The continued significance ofRINT, even after accounting for differences inthe level of capital, is further evidence that itssignificance is not simply due to differences inlong-run profitability.

Previous discussion indicated that we couldconsider bank behavior to be driven primarily byregulatory pressures at levels of capital forwhich the coefficient on RINT becomes zero. Ineach two-year period, the coefficient on RINTbecomes insignificantly different from zero oncethe do-nothing capital ratio falls below a criticallevel. The results presented in table 6 suggestthat the regulatory capital constraint has becomebinding at higher and higher capital ratios. Forthe 1973-75 period, variation in RINT began tomatter once a BHC' s capital ratio rose above 4percent. For the 1979-81 period, the cutoff point


11

TABLE 5

Relationship between changes in market capitalization and asset growthsDependent variable: asset growth rate

Variables in levels

1973-75 1979-81 1984-86 1989-91A

13A

aA A A

RA

aA

13A

Market model

INTERCEPT 7.96 .90 7.56 .75 6.48 1.55 4.82 .94DMCAP .16 .04 .22 .03 .32 .03 .10 .03

R2 .09 .29 .38 .07RMSE 6.19 7.23 13.01 10.31

Regulatorymodel

INTERCEPT -30.18 4.68 -42.36 5.39 -32.2 5.2 -26.6 3.86RINT .31 .04 .45 .04 .42 .04 .30 .03

R2 .30 .37 .37 .36RMSE 5.42 6.79 13.12 8.53

Joint model

INTERCEPT -26.35 5.38 -30.09 6.55 -17.54 5.22 -27.17 4.37RINT .28 .04 .33 .05 .24 .06 .30 .04DMCAP .06 .04 .10 .03 .19 .04 -.01 .03

R2 .30 .41 .44 .37RMSE 5.40 6.62 12.35 8.56N 130 169 158 122

The period 1989-91 is June 1989 to June 1991. All other periods are December to December.

was a capital ratio of 5 percent. For the 1984-86period, the cutoff point was an equity-to-assetratio of 6 percent. For the 1989-91 period, RINTbegan to matter only when the equity-to-assetratio exceeded 7 percent. The regulatory con-straint first appeared to slow growth rather thanhalt it. It is also interesting that regulatory pres-sures appeared to influence banks well beforetheir do-nothing capital ratio fell to the ostensi-ble regulatory minimum. For example, the 1991regulatory minimum equity-to-asset ratio wasostensibly in the 4 to 5 percent range. However,regulatory pressures appeared to become opera-tive once the equity ratio fell below 7 percent. Asimilar phenomenon appeared to be at work inthe 1984-86 period.

Table 7 presents data on the shape of theregulatory constraint. The asset growth rates ofbanks with do-nothing equity ratios below 3percent have declined steadily over the last twodecades.

The 1989-91 period is distinguished fromprevious periods by more than the apparent

tightness of the regulatory constraint. The linkbetween changes in regulatory capital and assetgrowth as reflected by the coefficients on RINTis much weaker than in any previous period.The coefficients on RINT during the most recentperiod were roughly half those of the previousperiod. These differences are statistically signif-icant for BHCs with do-nothing capital ratiosover 6 percent. 6 There are two possible explana-tions for this. First, it may reflect tight monetarypolicy by the Federal Reserve. This tighteningmade further growth by well-capitalized banksunattractive. However, two interest rate indica-tors of policy tightness-the term spread and thechange in rates-indicated a relatively loosepolicy stance, suggesting that the Federal Re-serve did not dramatically tighten its monetarypolicy. A second possible explanation for thesmall coefficients is that a tightening of theregulatory constraint drove every bank's optimalequity ratio above the current level. With theirequity ratios well below optimal, these banks


TABLE 6

Relationship between regulatory equity ratios, internally generated equity, andbank holding company asset growth'

Model IIIDependent variable: asset growthVariables in levels'

1973-750 1979-81d 1984-86° 1989-91fACS

A6

A0.5 11

A

INTERCEPT 9.13*** 1.26 15.35*** 1.24 28.16*** 2.03 10.93*** 1.24DUMO -10.62** 4.56 -22.91*** 4.72 -38.52*** 7.26 -23.39*** 3.49DUM3 -6.17*** 2.33 -8.27** 3.45 -34.95*** 7.26 -15.80*** 3.26DUM4 -5.92*** 1.83 -8.70*** 2.59 -27.66*** 7.26 -12.38*** 2.62DUM5 -5.09*** 1.73 -6.72*** 2.12 -19.66*** 3.79 -15.97*** 2.40DUM6 -3.53** 1.71 -3.17* 1.69 -14.18*** 3.04 -7.06*** 2.30DUM7 -3.84** 1.90 -1.70 1.74 -6.47** 2.90 -0.64 1.86

RINT* DUMO .066 .122 .138 .164 .139 .082 -.061 .142RINT* DUM3 .164 .122 -.332 .629 .194 .712 -.008 .191RINT* DUM4 .465*** .098 .062 .143 -.004 .349 .092 .154RINT* DUM5 .307** .119 .474*** .177 .182 .252 .018 .257RINT* DUM6 .113 .139 .583*** .125 .646*** .197 .081 .175RINT* DUNT7 .635*** .179 .207 .158 .759*** .181 .305** .147RINT* DUM8 .589*** .121 .713*** .087 .987*** .117 .217* .118

R2 .37 .46 .57 .454R2 vs. Model I .07 .09 .19 .15N 134 170 160 131

'The period 1989-91 is June 1989 to June 1991. All other periods are December to December.'Deviations from mean value of RINTfor each capital category. RINT= (beginning-of-period equity + retained

earnings)/(beginning-of-period equity).

'When the constraint pa = I3 is imposed, 115_3 is not significantly different from 0 at the .10 level.

'When the constraint pa = 11 3 =13 4 is imposed, 11 5_4 is not significantly different from 0 at the .10 level.

'When the constraint pa = p a = 116 = pa is imposed, (3 5_5 = .137 and 6005 = .075. 13, 0 is significantlydifferent from 0 at the .10 level.

i'When the constraint 130= 113 = 114 = 11 5 = p a is imposed, 115_6 is not significantly different from 0 at the.10 level.*, **,*** significant at the .10, .05, and .01 levels respectively.

chose to devote a large portion of their retainedearnings to rebuilding capital.

Regulation or the market?

The preceding results suggest that BHCs arebehaving as if it is costly to adjust to disturbanc-es in regulatory capital. However, these changesmay reflect creditor discipline not regulatorydiscipline. If it is costly to issue new shares andmarket discipline is driving bank growth deci-sions, we would expect that changes in the mar-ket value of a bank's capital would be positivelycorrelated to its asset growth. As was the casewith the regulatory model, we allow both the do-nothing market capital ratio and the percentage

change in market capitalization DMCAP to affectasset growth. We define do-nothing marketcapital as the sum of the end-of-period marketvalue of common equity plus the beginning-of-period book value of preferred shares. As in theregulatory model, BHCs are then classified bytheir do-nothing capital ratios, the ratio of do-nothing market capital to beginning-of-periodassets. Using this classification, we then generat-ed a set of dummy variables MDUM2-MDUM7.

In order to assess the relative importance ofmarket forces and regulatory forces, we thencompared the performance of various versions ofthe regulatory model specified in equation (4)


TABLE 7

Estimates of the regulatory constraintsAsset growth rate

Do-nothingequity ratio 1973-75 1979-81 1984-86

1989-91

< 3 -1.5 -7.6** -10.4* -12.5***

3 - 4 3.0 7.0*** -6.9 -4.8

4 - 5 6.6*** .5 -1.5

5 - 6 8.5*** -5.0*

6 - 7 3.8**

'The period 1989-91 is June 1989 to June 1991. All other periods areDecember to December.

",**,"*" significant at the .10, .05, and .01 levels respectively.

A =B. DUM.. + C. pum..,RINT„,

and a comparable market model

A.(5) = E a., MDUM. + /13 MDUM.. DMCAP

If RINT is merely proxying for changes inmarket value, we would expect regression esti-mates of (5) to have greater explanatory powerthan equations using RINT. Table 5 presentsresults including only RINT and DMCAP mod-els. In no case do market-based measures ofchanges in capital adequacy do a better job ofexplaining cross-sectional variation in assetgrowth. In three of the four time periods stud-ied, regulatory measures of changes in capitaladequacy are clearly superior. When RINT andDMCAP are included in the same equation,RINT is always highly significant, while DM-CAP is insignificant during both the 1973-75period and the 1989-91 period.

Table 8 compares the R's for models whichinclude do-nothing capital ratios (DUM orMDUM) and the internal rate of capital genera-tion (RINT or DMCAP). In the 1973-75 periodand the 1989-91 period, the regulatory modelsignificantly outperformed the market model. Inno case did the market model outperform theregulatory model. The results presented in ta-bles 5 and 8 support our contention that BHCbehavior between June 1989 and June 1991 wasdriven not only by declines in asset values, butalso by shocks to regulatory capital. The factthat regulatory variables continue to be signifi-cant even after inclusion of market variables

reinforces our contention that RINT is capturingregulatory effects rather than differences in longrun profitability.

The equivalence of asset recycling andcapital shocks

The dependence of banks on retained earn-ings to fund growth raises the possibility that theresolution of bank failures may have implica-tions for the behavior of the entire depositorysystem. When an institution fails, the ResolutionTrust Corporation (RTC) or the BIF generallysells its assets and liabilities to a well-capitalizedsurvivor. Undercapitalized but solvent institu-tions may also initiate the recycling of assetswhen they attempt to shrink their existing assetsand liabilities. We call this transfer of assets andliabilities recycling.

When assets are recycled to a well-capital-ized institution, its regulatory equity requirementincreases. This occurs even though aggregateassets and liabilities of the depository systemremain unchanged. If well-capitalized institu-tions engaged in recycling either choose or arerequired to maintain a capital ratio at or abovethe regulatory minimum, they may slow or evenreduce lending to other customers in order toavoid additional costly equity issues. Underthese circumstances, policies governing the saleand liquidation of failed institutions will affectreal economic activity through precisely thesame channels as innovations in capital require-ments or earnings.

For simplicity, consider an institution whichbefore the purchase had a capital ratio at theregulatory minimum and then purchases assetsfrom the RTC. To remain in compliance, theinstitution must either raise new equity or reduce

its assets and liabilities. Ourresults suggest that institutionsgenerally did the latter. In orderto reduce its assets and liabili-ties to the desired level, thepurchaser will in the first in-stance respond by raising theprice of credit and reducing thereturn on deposits. The distri-bution of the adjustment be-tween the cost of credit and thereturn on deposits will dependof course on their relative inter-est elasticities. As the spreadbetween loans and depositsrises, both old and new borrow-


TABLE 8

Explanatory power of regulatory measures of capitaland market-based measures of capitala

1973 -75 1979-81 1984-86 1989 -91

Regulatory modelb .45 .50 .59 .53

Market capitalizationmodel .35 .50 .58 .33

N 130 169 158 122

aThe period 1989-91 is June 1989 to June 1991. All other periodsare December to December.

b A „=I B„DUA /1„ t +EC„DUM

Att- ,

A

Au-1= Ear MDUM.. + Eik,MDUMivDMCAPij

ers will seek alternative sources of credit. Ifloans from other intermediaries are an imperfectsubstitute or other well-capitalized institutionsare also loaned up, borrowers and depositors willbe crowded out of the depository system and thedepository system as a whole will shrink.

Why would a well-capitalized institutionwillingly purchase a failed institution knowingthat it will need to shrink or issue new equity?Because the transaction is priced to offset anycosts of adjustment incurred by the purchaser,including the costs of running off assets andliabilities. These costs are ultimately borne notby the purchaser but by the seller in the form oflower bids on the failed institution.

Relatively little crowding out would beobserved if the transfer of assets and liabilitiesby the BIF, the RTC, and undercapitalized insti-tutions is price-sensitive. However, the RTCand the FDIC generally sell assets and liabilitiesat auction, which suggests that the supply isvery inelastic with respect to price. The otherimportant source of recycled assets—asset salesby solvent but capital-deficient banks—is drivenby efforts to avoid the high cost of issuing equi-ty. This means that the supply curve of assetsbeing sold by undercapitalized banks is alsohighly inelastic until the discount exceeds thelemons premium on new equity issues. If thedilution experienced by shareholders of industri-al companies is any indication, shareholderswould be willing to incur discounts up to 3.5percent on the value of assets sold to avoid issu-ing new equity.'

Assessing the financialshocks of the 1989-91period

The preceding analysissuggests that increased capitalrequirements, reduced earnings,and the recycling of assets andliabilities from poorly-capital-ized or insolvent institutions towell-capitalized institutions canaffect the supply of intermediat-ed credit and the size of thedepository system. Table 9presents estimates of theseshocks for the time periodscovered by our study.

We estimate that Er, theequity ratio at which banksbecome capital-hungry, was onepercentage point higher for the

period June 1989 to June 1991 than it was in thepreceding two year period. As a result of highercapital requirements and weaker earnings, theproportion of banks that behaved as if they werecapital-hungry rose to a new high. Figure 1shows the proportion of assets in our sample thatwere controlled by capital-hungry BHCs. As ofJune 1991, 66 percent of the assets in our samplewere being held by BHCs with equity ratiosbelow 7 percent—the point at which we foundbanks were behaving as if they were being driv-en by regulatory concerns.

However, to focus solely on those banksthat are capital constrained understates the de-gree of the shock. Heavily capitalized bankswill also be affected by an increase in capitalrequirements if they choose to maintain a bufferof excess capital. If a one percentage pointincrease in c' translates into a one percentagepoint increase in each banks' desired capitalratio, E *, the industry would have had to increaseits capital base by $22 billion-9.5 percent ofthe industry's total equity as of June 1991—toavoid shrinking. In addition, money-losingbanks experienced losses of roughly $10 billion.Finally, some banks began the period with equi-ty ratios below the 6 percent level, creating aneed for another $11 billion in equity.

Asset recycling also created major demandson the industry's supply of equity. During the1989-91 period, capital-deficient BHCs in oursample reduced their assets and liabilities by atotal of $82 billion. Insolvent banks and S&Lswith total liabilities of $235 billion were trans-


15

FIGURE 1

Proportion of assets held by capital-deficient banks

percent75

60

-

-

66%

54%51%

45 -

30 - 28%

15

012/75 12/81 12/86 6/91

TABLE 9

Shocks to the capital of depository institutionsa(billions of dollars)

(10)

Totalnew

equityneeded

(% ofequity)

(1)

Minimumdo-nothing

capitalratio°

(2)

Shrinkageat capital-deficient

BHCs'

(3) (4) (6)

Incrementalequity

required"

(7)

Impact ofincreased

capitalrequirement'

(8) (9)

Beginning-of-period

capitalLosses shortfall'

(5)

Totalassets

recycled

Assets Assets atat failed

failedbanks

S&Ls

1973-75 .04 $0.04 $4.2 $0.2 $4.4 $0.2 $0 $0.0 $1 1.8

1979-81 .05 3.5 5.0 1.9 10.4 0.5 11 0.2 3 12.8

1984-86 .06 20.1 15.6 18.0 53.6 3.0 18 2.3 5 14.35

1989-91 .07 82.8 58.6• 177.0') 318.4 22.0 22 10.0 11 28.7

The period 1989-91 is June 1989 to June 1991. All other periods are December to December.

°Based on results reported in table 6.

°Estimated using Compustat. BHCs with do-nothing capital ratios less than column (11 are considered undercapitalized.

°Column (1) multiplied by column (51.

°Based on results reported in column Ill, the minimum equity ratio is assumed to increase by .01 in the 1979-81, 1984-86, and 1989-91 period. This may overstate theextent of the increase for the 1979-81 and 1984-86 periods.

'Based on difference between beginning-of-period capital ratio and previous period's minimum equity ratio as reported in column (1).

°Estimated as one-half of the 1989 amount ($14.5 billion) plus the 1990 amount ($15.6 billion) -F one-half of the 1991 amount ($28.5 billion).

'Deposits transferred by the RTC through July 1991 as a result of resolution ($147 billion) and reduction in assets at S&Ls in conservatorship ($30 billion).

ferred to well-capitalized banks and thrifts. Lia-bilities totaling $318 billion were recycled dur-ing this period. Assuming that most well-capi-talized banks in the system began the periodwith an equity ratio near their desired level E a ,total equity in the banking industry would havehad to be at least 9.7 percent above its June 1991level for the banking system to reabsorb theentire $318 billion in assets and liabilities.'

The magnitude of these deposit transferscalls into question the assertions of some ana-

lysts, for instance, Feldstein (1992) and Keran(1992), who have argued that tighter capitalstandards have been the primary cause of theprolonged sluggishness in both bank lendingand real GNP following the onset of the reces-sion in July 1990. By contrast, our analysissuggests that the most recent increase in bankcapital requirements can explain only a portionof the slowdown in the growth of bank assetsand liabilities. If capital requirements had beenkept at 1986 levels, we estimate that the equityshortfall for the banking system as a wholewould have been only 33 percent less. Theremainder of the equity shortfall was accountedfor by the recycling of assets from failed institu-tions (33 percent), capital shortfalls predating the1989-91 period (15 percent), and banks thatwere capital-deficient at the beginning of theperiod (17 percent).

Effects on real economic activity

Whether the resulting decrease in the supplyof intermediated credit had a significant impacton real economic activity depends on two fac-tors: the amount of earning assets transferred,and the ease with which bank borrowers canreplace credit from banks with credit from othersources.

To date, there have been few attempts toestimate the extent to which the poor perfor-mance of the economy since 1989 has been dueto shocks to the banking system. Seeking to


assess the macroeconomic impact of bank capi-tal deficiencies, Bernanke and Lown (1991)measured the relationship between interstatevariation in bank capital ratios and interstatevariations in unanticipated employment growth.They found that variation in bank capital ratiosexplained little of the variation in employmentgrowth across states, and therefore concludedthat the capital crunch had not had importantmacroeconomic consequences.

Two assumptions underlie Bernanke andLown's interpretation of their results. One isthat banks operating in states with relativelyhigh capital ratios are freer to lend to their cus-tomers than are banks operating in low-capitalstates; the second is that the losses are the onlyshock to the banking system. However, ouranalysis suggests that capital deficiency as mea-sured by Bernanke and Lown accounts for onlyone-third of the banking system's increased needfor capital.

When banks find it costly to raise capital,higher capital requirements and asset recyclingcan be as disruptive to bank growth as actualdeclines in bank capital. Unlike earningsshocks, higher capital requirements and assetrecycling tend to equalize the level of stressacross the banking system. If, as our resultssuggest, banks willingly hold a buffer of capital,even banks with capital ratios above the regula-tory minimum will choose to slow growth in theface of increased capital requirements as theyseek to boost their capital positions. Heavy assetrecycling will further equalize credit conditionsacross banks with different capital ratios. Poor-ly-capitalized banks will be unwilling to lend tonew borrowers because they are trying to satisfyregulatory capital requirements. Well-capital-ized banks will be reluctant to lend to new bor-rowers because they are purchasing assets andliabilities of failed institutions and trying torebuild their buffer of regulatory capital.

Under these circumstances, cross-sectionaldata cannot indicate the macroeconomic impor-tance of supply-side shocks to the financialsector. However, if financial sector supplyshocks are important, then we would expect thegrowth of depository system assets to be corre-lated with shocks to the system. If these aretruly shocks to the supply of credit and notshocks to demand, we would also expect theprice of intermediated credit to rise relative tothe price of credit paid by borrowers with directaccess to the capital markets.

Studies by Duca (1992) and Kasriel andLaurent (1992) report findings consistent withour contention that resolution activity slowed thegrowth of the depository system. Both papersfind that changes in money supply growth arehighly correlated with the resolution activities ofthe RTC.

Some believe that if asset recycling causedmovements in the money supply, this implies animpact on output. Others argue that unless theresult is significantly more expensive credit forborrowers, the implications for output will beminimal. However, evidence on loan pricingsuggests that the shocks to the capital positionsof depositories have indeed made bank creditmore expensive. The spread between the primerate and the commercial paper rate provides onemeasure of the relative costs of bank credit.Vector autoregression analysis reported by Kutt-ner (1992) indicates that unanticipated changesin the prime-paper spread have persistent nega-tive impacts on real GNP. In a related study,Corcoran (1992) reports that unanticipatedchanges in the spread between rates on publicly-placed and privately-placed bonds have negativeimpacts on real GNP.

Figure 2 shows the history of the prime-paper spread. 9 Two points are worth noting.First, it is below the peak levels of the early1980s. However, the figure also suggests thatthis spread usually falls when the level of inter-est rates falls and rises when the level of ratesrises. This is to be expected, since banks bear adisproportionately large part of the burden ofany contraction in the supply of bank credit.That is because when monetary policy tightens,the cost of bank credit must rise faster than thecost of credit from other intermediaries. Theprevious exception to this rule was the 1973-74period, when the prime rate was subject to pricecontrols.

In 1990 the prime-paper spread began torise even though interest rates were falling.Since that time it has held more or less steadydespite a fairly sharp decline in rates. The initialrise in the spread despite declining rates suggeststhat during the last half of 1990 and the first halfof 1991, the supply of bank credit was reducedby more than the demand. Since mid-1991, theprime-paper spread has remained relatively flat.The subsequent failure of the spread to declinein the face of large rate declines suggests that thesluggish growth of bank assets during the last


FIGURE 2

The behavior of the adjusted spread between theprime rate and the commercial paper rate

percent30 —

25

20

1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 15 1971 '74 '77 '80 '83 '86 '89 '92

two years is not merely a result of weak creditdemand, but also of weak supply.

Conclusion

In this article we add several findings to theliterature on bank asset growth. First, wepresent evidence that banks find it costly to issuenew equity in response to a deterioration in theircapital position. Second, we show that regulato-ry capital appears to play a greater role in bankgrowth than does stock market valuation. Third,we suggest that changes in bank capital require-ments have changed bank behavior. Fourth, weargue that when it is costly for banks to issuenew equity in order to maintain their regulatoryequity ratios, then the recycling of assets andliabilities from insolvent to solvent institutionswill have much the same effect as a capitalcrunch. Finally, we develop measures of the

shock to the depository system'scapital position. We find thatbetween June 1989 and June 1991,nearly two-thirds of the assets inour sample were controlled byinstitutions which seemed to beresponding to regulatory con-straints—the highest proportion inthe periods covered by our sample.Taking into account higher capitalrequirements, beginning-of-periodcapital deficiencies, losses, andasset recycling, we estimate thatthe depository system would haveneeded an additional $65 billion inequity to remain in equilibrium.This represents 28 percent of theindustry's June 1991 equity. Weestimate that asset recycling andhigher capital requirements each

accounted for one-third of the shortfall Finally,we note that research on the link between thebehavior of the RTC and monetary aggregates isconsistent with our hypothesis about asset recy-cling, while the behavior of the prime rate isconsistent with a tightening of the supply ofcredit unrelated to monetary policy.

These findings suggest that policymakersshould view with great skepticism proposals toweaken capital requirements. They also castfurther doubt on policies like forebearancewhich have the effect of allowing the inventoryof unresolved institutions to accumulate, therebyconverting a number of relatively small capitalshocks into one large capital shock Finally, ourfindings suggest that when the FDIC sells off alarge number of insolvent institutions in a shortperiod of time, the result will be more expensivebank credit and slower economic growth.

FOOTNOTES

'See Paul Asquith and David W. Mullins, "Equity issuesand offering dilution," Journal of Financial Economics,January/February 1986.

'See Wall and Peterson (1991), Isberg and Brown (1987),and Bishop and Lys (1992).

'Other papers have used measures of market attractivenessto control for cross-sectional variation in growth opportuni-ties. There are several reasons why we do not take thisapproach. First, many of the banking organizations in our

sample are active nationally and internationally, making itdifficult to measure market attractiveness. Second, evenbanks operating in relatively unattractive markets may havesignificant growth opportunities if other competitors be-come acquisition targets. Several recent examples of thisphenomenon include Fleet's acquisition of Bank of NewEngland, BankAmerica's acquisition of Security Pacific,and Bank of Boston's aborted bid for Shawmut.

'Only those firms filing with the SEC are included in theCompustat database Firms may cease to file with the SECif they are acquired, are taken private, or cease operations.


5Barro(1990) compares this measure of future profitability tochanges in Tobin's Q and finds that the former measureoutperforms Q in investment equations.

6Equality of the coefficients on R1NT was tested by poolingdata for the 1984-86 period and the 1989-91 period. Thehypothesis that the coefficients on RINT were indeed equalacross time periods was rejected at the .03 level for bankswith do-nothing capital ratios between 6 and 7 percent, .05level for banks with do-nothing capital ratios between 7 and 8percent, and at the .001 level for banks with do-nothingcapital ratios greater than 8 percent.

This assumes an offering dilution rate of 30 percent on newshare issues, a marginal tax rate of 40 percent, and a desiredcapital ratio of 7 percent.

'The $318 billion reported for the thrift industry overstatesthe likely impact of thrift resolutions on credit markets. Incontrast to usual practice with bank resolutions, the RTC hastended to transfer only a small proportion of a failed institu-tion's noncash assets. Noncash assets have typically beensold off separately or warehoused by the RTC. To theextent they are sold off either to banks or to purchasers who

rely on the banking system for funding, the effect is stillthe same.

9It is not entirely clear how best to measure the spreadbetween the prime rate and the commercial paper rate.Macroeconomic studies of interest rate spreads typicallyfocus on the absolute spread However, it is by nomeans clear that a spread of 100 basis points has the samebehavioral implications when riskless rates of interest are20 percent as when they are 4 percent. Indeed, price theorytypically suggests that behavior is affected by relativeprices. Discounting payment flows for a prime rate loan atthe commercial paper rate r p , the price of prime rate loanmaturing in M years is

1

t=1 (1+0' (1+0"

Discounting payment flows for a commercial paper trans-action at the commercial paper rate yields a price of 1. Thespread estimates presented in figure 2 assume a maturity of5 years.

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