The Macroeconomic Implications of Regulatory Capital Adequacy Requirements for Korean Banks

Abstract

The capital adequacy requirement, combined with the flight to quality, contributed to a drastic credit slowdown and a sharp recession in Korea in the aftermath of the financial crisis. Since most banks were placed under the strengthened capital adequacy constraints, they reduced loans to firms with high credit risks. As a result, bank‐dependent small and medium‐sized enterprises (SMEs) were badly hit, and eventually demand for bank loans fell. The reduction in loans was most visible among banks with poor capital adequacy, yet the overall change in bank portfolios had a disproportionately large negative influence on financial conditions for SMEs. In conclusion, the banks' response to capital adequacy requirements resulted in changes in the loan/bond ratio which, in turn, reduced loans to SMEs and caused a sharp cut in production. The resulting contraction in SME production created a polarized industrial structure and a chronic depression in the traditional sectors of the economy. The introduction of capital adequacy requirements (CARs) in the wake of financial crisis worsened conditions for SMEs and weakened the validity of the CARs that were mainly necessitated by successive failures among larger firms.

The importance of prudential regulations in the process of transmitting monetary policy to economy

“…Limiting the supply of loans on the basis of issuing capital regulations of the Basel Committee of Banking Supervision is observed also in developing economies. Choi (2000) confirmed that issuing regulations regarding capital adequacy in the 90's of the 20 th century in Korean banks caused the decrease of tendency for issuing loans. Chiuri, Ferri, Majnoni (2001) documented decrease in the supply of loans by analyzing 16 rising economies which implemented Basel I regulations in the 90's in the 20 th century.…”

The roles of domestic and foreign Islamic banks in Malaysian monetary transmission

“…Following the efficiency of this channel, extended research was carried out in a few countries such as Issing (1997) in Germany, de Bondt (1999) in Germany, Belgium and The Netherlands, de Haan (2003) in The Netherlands, Rich (1996) in Switzerland, Gambacorta (2005) in Italy and Ehrmann et al (2003) in France, Germany, Italy and Spain. The testing of this channel subsequently grew to Asian countries such as Agung (1998) in Indonesia, Choi (2000) in Korea, Ogawa (2000) and Hosono (2006) in Japan and Gunji and Yuan (2010) in China.…”

How Do Bank Capital and Capital Adequacy Regulation Affect the Monetary Transmission Mechanism?

“…8 Assume that there is no cash in the economy, so that the money supply consists of bank reserves, R, and the money demand consists of households' demand for deposits, D(y, δ), where y is the aggregate output, and δ is the spread between interest rates on bonds and deposits, δ = r B − r D . 9 Since the equilibrium interest rate on deposits is given by (7), δ * = τr B . Assume that ∂D ∂y > 0 and ∂D ∂r B < 0.…”

“…2 Peek and Rosengren (1997) also report that a decline in the capital-to-asset ratio of Japanese parent banks led to a fall in lending by their American branches. More recently, Choi (2000) finds evidence that the recent imposition of 8% capital adequacy requirement on Korean banks has led to a decline in bank lending.…”

“…Here, we will not consider the behaviour of capital markets; in effect, suppressing it by Walras' Law 9. Note that since there is no cash in the economy, the return on money is given by r D , so that δ is the return on bonds relative to that on money 10.…”