1 “ The Basel Capital Requirement Ratio and Its Impact on Banks all over the world July , Conference Gala Dinner Computing in Economics and Finance (16 th ) Naoyuki YOSHINO Professor of Economics, Keio University, Japan Director, Financial Research & Training Center FSA (Financial Services Agency), Government of Japan Tomohiro HIRANO Research Fellow, Financial Research & Training Center FSA (Financial Services Agency), Government of Japan

Bank Loan/GDP Ratio (Bubble) USA JAPAN 2

Various Proposals for Minimum Capital Requirement exist 1, Adjustable minimum capital requirement ratio --->raise in good times and reduce in bad times 2, Boom country  higher capital requirement Sluggish country  Lower requirement 3, Adjustment Factors to the Basel Capital Requirement 4, Ryozo Himino (2009)  Ex. Stock Price Index 3

The Basel minimum capital requirement should be different from country to country since the economic structures are different from each other. A simple general equilibrium model suggests that the optimal minimum capital requirement ratio depends on the structure of the economy (i.e. Asset Price, GDP, Interest rate) 4

Bank’s Balance Sheet 5 Non Performing Loans (NPL) Bad Assets Bank Loans Good Assets Capital=A(q)

A Simple General Equilibrium Model 1, Objective of the Basel Minimum Capital Requirement  Stabilize bank lending (L) Minimize (L-L*) 2 [Capital / Risk Weighted Assets] > Minimum Basel Capital Requirement ( θ) 2, Banks: M aximize their profits 3, Macroeconomic variables (i) land price (q 1 ), (ii) Stock price (q 2 ), (iii) GDP (Y), (iv) interest rate (i B ) 6

Derivation of the Optimal Value for θ (θ =minimum capital requirement) Minimize Loss = (L-L * ) 2 sub to Bank’s Profits sub to Balance Sheet of Bank sub to A(q)/K(ρ e )>θ  The optimal minimum capital requirement is expressed as follows: θ t * = f (L*, q 1, q 2, Y, i B ) 7

8 Min(L t -L * )² Bank Profits 兀＝ i L （ L ） x L ＋ i B ×B － ρ e (q,Y,i B,q e )×L － i m (θ － θ*)×D － C （ L,B,D ） Balance Sheet Constraint L+B ＝ D+A( ｑ ) Capital Ratio = Capital / Risk Weighted Assets A(q) ≧ θ K[ ρ e (q,Y,i B,q e )]×L ≧θ≧θ

Banks are maximizing their profits  π e : Expected profit of Bank.) where i m (θ － θ*)  i l : interest rate on risky asset  L: Risky assets (bank loans etc.)  i B : interest rate on safe assets  B: safe assets (such as government bond)  ρ e : ratio of the expected default loan losses  D: deposits and funds absorbed from the short term market  i m : the rate of interest charged to deposits or short term borrowing from the market  C(L,B,q 1,q 2 ): various costs, q 1 =land price, q 2 =stock price 9

10 Supply of Bank Loans i ’ L (L)×L ＋ i Ｌ (L) － ρ e － C ’ L + λ 1 ＝０・・・（ １） Demand for Bank Loans L= ｄ ０ －ｄ １ i L +d 2 Y+d 3 q 1 +d 4 q 2 ・・・・・ ・（２） Loan Market Equilibrium L ＝ d 0 /2 ＋ d 2 /2 ・ Y ＋ d 3 /2 ・ q － 1/2( ρ e － C ’ L － i m － C ’ D )…..(3) Min(L t -L * )² sub. to (3) Total differentiation yields : d θ = α 1 dq 1 ＋ α 2 dq 2 ＋ α 3 dY ＋ α 4 di B

11 ・ Land Price （3）（3） ・ Stock Price （4）（4） ・ Bond Market （5）（5） ・ Goods Market （6）（6） A Simple Macroeconomic Model

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How much % would the Based Minimum Capital Requirement be adjusted in Japan? based on Japanese Data 1996Q1-2008Q4 land price (q 1 ), stock price (q 2 ), GDP(Y), interest rate (I B ) 13

1 Changes in Land price (dq 1 )  K (default risk) 2 Changes in Stock price (dq 2 )  K, A(bank’s cap.) 2 Changes in business condition (dY)  K 3 Changed in interest rate (di B )  K (default risk)  Risk Asset ratio (K) changes  Bank’s Capital (A(q 1 ))changes 14

15 =-2.20% 1998Q1-2008Q4

Empirical Results of Optimal Minimum Capital Requirement (1) Japan Estimation 1996 Q1 – 2008 Q4 θ = % (=5.80%) 1998Q1-2008Q4 (2) USA Estimation 1995 Q1 – 2008 Q4 θ = % (=12.42%) 2002 Q4 – 2007 Q4 θ = %(=7.884%) 2001 Q1 – 2002 Q4 (3) Canada θ ＝ ＋ 0.37% (=8.37%) 2003 Q1 – 2004 Q4 θ ＝＋ 0.96% （＝ 8.96%) 2006 Q1 – 2007 Q4 16

Conclusion 1 1 Adjustable minimum capital requirement ratio -->raise in good times and reduce in bad times 2, Boom country  higher capital requirement Sluggish country  Lower requirement 3, Adjustment Factors to the Basel Capital Requirement (i) Land Price (ii) Stock Price (iii) GDP (iv) Interest rate 17

1 Two country model (Cross-Border) 18 Country A Capital Requirement A% Country B Capital Requirement B% Bank should follow Each country’s minimum capital requirement ratio (A% or B%) 1 2

2, Two country model (Cross-Border) 19 Country A Boom Capital Requirement A% Country B Recession Capital Requirement B% Domestic Loans (1) Cross-border Loans (3) Capital Requirement A% Domestic Loans (2) Cap. Req. B%

Conclusion 2 Cross-border Case 1 Boom country – higher minimum capital (A) contracted country – lower minimum capital (B) 2 Different minimum capital requirement A% & B%. lending and asset management in each country should follow each minimum capital requirement 3 Regulator has to be able to monitor each country sources of absorbed assets  Asset management 20

Mitsubishi-Tokyo-UFJ Bank 21

Japanese Banks’ Behavior 22

Marginal Revenue = Marginal Cost 23

Profits of Japanese Banks 24

Estimates of Bank Loans, Japan 25

References Naoyuki Yoshino, Tomohiro Hirano, and Kakeru Miura, (2009), “ The Optimal Basel Capital Requirement to Cope with Pro- cyclicality: A Theoretical Approach”, (Financial Research and Training Center, Financial Services Agency (FSA), Government of Japan. FRTS Discussion papers, DP2009-6) Himino, Ryozo., (2009), “ A counter-cyclical Basel II, ” RISK magazine, 01, Mar 2009 Revankar N. and Yoshino, N., (2008) “ An Empirical Analysis of Japanese Banking Behavior in a Period of Financial Instability, ” Keio Economic Studies, Vol.45 No.1. Yoshino, Naoyuki and Tetsuro Mizoguchi (2010) “The Role of Public Works in the Political Business Cycle and the Instability of the Budget Deficits in Japan” (Asian Economic Papers, MIT Press). 26