On the Behaviour and Determinants of Risk-Based Capital Ratios: Revisiting the Evidence from UK Banking Institutions

Abstract

Using bank-level panel data from the United Kingdom, this paper investigates the factors that influence banking institutions' choice of risk-based capital ratios. Special focus is placed on evaluating whether and how institutions respond to changes in regulatory capital requirements and if these responses vary across the economic cycle. This issue is of particular interest to policymakers that rely on capital regulation in conjunction with other supervisory tools to affect bank behaviours and maintain market confidence and financial stability more broadly. The paper also explores the extent to which UK banks’ capital management practices were procyclical under Basel I. Understanding whether such practices existed under this less risk-sensitive (and potentially, less procyclical) regulatory capital regime is a useful first step towards determining if banks, in their capital management practices, consider swings in economic conditions on their capital positions and lending capacities, which may, in turn, impact on the severity and duration of such economic cycles.We find a statistically significant association between banks' risk-based capital ratios and individual capital requirements set by regulators in the UK. We also find that the rate at which banks respond to changing capital requirements depends significantly on certain characteristics of the bank (e.g., size, exposure to market discipline, nearness to regulatory threshold) as well as the direction of the economic cycle. We find a (marginally statistically significant) negative association between capital ratios and the economic cycle, but no association when we focus only on the largest banks in the UK, suggesting that systemically important banks tend to maintain risk-based capital ratios over the cycle (although we note that this finding is based on a sample period which does not contain a significant downturn). Further, we note a positive association between capital ratios and capital quality, suggesting that reliance on capital with relatively higher adjustment costs (e.g., tier 1 capital) may raise the profile of that consideration in capital management practices and lead cost-minimizing banks to maintain higher total risk-based capital ratios overall. Finally, we find a positive marginal effect of market discipline on total risk-based capital ratios held by UK banks. We interpret this result as suggesting that banks mitigate expected market reactions (e.g., on their funding costs or ability to access certain capital markets activities) to their business decisions by holding higher capital ratios.