Financial Update (January-March 1997)

Are Banks' Responses to Capital Regulations 'Cosmetic'?

S ince the early 1980s, U.S. bank regulators have focused increasingly on the adequacy of banks' capital ratios. An article in the Atlanta Fed's Economic Review looks at changes to U.S. capital regulations and theoretical models for determining banks' capital strategy; the article then examines banks' responses (and the costs associated with their responses) to these regulations.

Authors Larry D. Wall, an Atlanta Fed research officer, and Pamela P. Peterson, a professor at Florida State University, categorize banks' responses into two primary types. One type of response a bank may make is to effectively increase its capital cushion either by reducing its risk exposure or by increasing its capital levels.

The other type of response (which Wall and Peterson term cosmetic changes to the capital ratio) occurs in one of two ways: a bank may reduce its total and risk-weighted assets while increasing its proportion of risky assets, or it may exploit differences between capital as measured for regulatory purposes and the bank's true economic capital. Such cosmetic changes may bring a bank's capital ratio within regulatory guidelines without reducing the probability that the bank will fail and without reducing the losses to depositors and the deposit insurance agency if the bank does fail.

Wall and Peterson point out that regulators, when formulating new regulations, need to consider which response they want to elicit: if the regulations are intended to reduce the risk of a systemic problem and the expected losses of the deposit insurance agency, then regulations that encourage cosmetic responses are unlikely to accomplish these goals.

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