Theories of bank behavior under capital regulation

This paper reviews academic studies of bank capital regulation in an effort to evaluate the intellectual foundation for the imposition of the Basel I and Basel II systems of risk-based capital requirements. The theoretical literature yields general agreement about the immediate effects of capital requirements on bank lending and loan rates and the longer-term impacts on bank ratios of equity to total or risk-adjusted assets. This literature produces highly mixed predictions, however, regarding the effects of capital regulation on asset risk and overall safety and soundness for the banking system as a whole. Thus, the intellectual foundation for the present capital-regulation regime is not particularly strong. The mixed conclusions in the academic literature on banking certainly do not provide unqualified support for moving to an even more stringent and costly system of capital requirements. These widely ambiguous results do suggest, however, that assessing the implications of capital regulation for balance-sheet risk and monitoring effort in diverse banking systems is an important agenda for future theoretical research in the banking area.