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Number 94-35, October 14, 1994

Risk-Based Capital Requirements
and Loan Growth
When the new risk-based capital-to-asset ratio
requirements for U.S. banks were announced in
early 1989, some banks and bank holding companies (BHCs) found themselves undercapitalized. A number of these institutions met the new
requirements by decreasing their risky assets, including loans. This has led some observers to
argue that the new standards contributed to the
slowdown in bank loan growth in the early 1990s.
Furlong (1992) and others have found evidence to
support this view.
But, slower loan growth is not the inevitable
consequence of tighter capital standards: Banks
could have met the new requirements by issuing
additional new capital. The question is: Why
didn't many of them? In this Weekly Letter, I
consider the negative wealth effect of common
stock issuance as one possible incentive for undercapitalized BHCs to choose to decrease loan
growth rather than issue capital, and discuss
whether this incentive was important enough
to playa determining role in banks' lending

Risk-based capiial requiremenis
Risk-based capital requirements for banks and
BHCs were announced in 1989 and phased in
over a period ending in December 1992. The
new risk-weighted asset portfolio was calculated
by applying different weights to different types
of assets, according to their perceived riskiness.
For example, commercial loans received the
highest weight and u.s. government securities
the lowest.
The risk-based capital requirements specify that
banks hold certain proportions of certain types
of capital. Banks and BHes now have to hold at
least 4 percent of their risk-weighted assets in socalled Tier 1 capital and 8 percent of their riskweighted assets in Tier 1 plus supplementary
(Tier 2) capital. For BHCs, the bulk of Tier 1 capital must be common shareholders' equity plus
retained earnings, while Tier 2 capital includes
some types of preferred stock, mandatory con-

vertible debt, and subordinated debt. In addition
to the new risk-based requirements, banks and
BHCs must meet an effective new 4 percent
minimum ratio of Tier 1 capital to unweighted
assets (leverage ratio).

Wealth effects of common stock issuance
The separate requirements for Tier 1 capital
meant that some BHCs were potentially deficient
in common shareholders' equity but not necessarily in other types of capital. It has been wellestablished that, for a variety of types of firms, an
announcement of the intention to issue common
stock tends to decrease a firm's stock value. However, the announcement of the issuance of most
other types of securities does not tend to affect
stock value, although a few studies also find such
negative wealth effects for convertible debt, debt
that can be converted into stock.
One explanation for these findings is that managers of firms have an incentive to issue equity
(common stock) when the firm's stock is overvalued and straight debt (debt that cannot be
converted into common stock) when its stock is
undervalued. This is because when a firm issues
equity, it sells a portion of its existing assets but
acquires, for its existing stockholders, a share in
the value of the new project to be undertaken
with the funds raised. If the firm's existing assets
are significantly undervalued by the market, the
dilution suffered by existing stockholders can be
greater than any gains they receive from undertaking the new project, in which case managers
would opt to issue debt rather than equity. On
the other hand, if a stock is overvalued, stock issuance rather than debt issuance begins to look
more beneficial to stockholders. The market realizes that managers have these incentives. If
managers have inside information regarding the
value of the firm that market participants do not
have, then the issuance of equity will impart new
information to market participants. In particular,
investors, knowing managers' incentives, will interpret the issuance of new equity as a signal that
the stock is overvalued, and the price will fall.

In contrast, investors will interpret the issuance
of new debt as a signal that the stock is undervalued, and the price will rise.
This explanation, however, does not accord with
the empirical findings indicating the general lack
of any wealth effect, positive or negative, from
the issuance of straight debt. One explanation is
that market participants think that if a firm seeks
external financing by issuing stock or debt, it
must be expecting lower earnings. This is because, usually, financing through the retention of
earnings is less expensive than financing through
issuing securities. Thus, under this explanation,
issuance of debt also might be a signal that a
firm's stock price is "too high."
A synthesis of these two theories would say that
an equity issuance announcement would have a
negative effect, while a debt issuance announcement would have an ambiguous effect on stock

Evidence for banks
Several studies indicate that, in the past, banking
organizations experienced negative wealth effects in connection with their common stock issuances. However, some have argued that this effect may have diminished or disappeared in the
early 1990s, with the phasing in of risk-based
capital requirements. The reason is that market
participants who observe a bank issuing new equity in a tighter regulatory environment may not
conclude that the bank's managers think the
stock is overvalued. Instead, they may think that
the bank simply is under regulatory pressure to
raise capital.
But this reasoning overlooks a capital deficient
bank's option to decrease asset growth relative to
the growth in capital achieved through retained
earnings. Thus, by issuing new equity instead of
reducing asset growth, a bank may still signal
that its stock is overvalued.

To investigate vvhethei the negative vvealth effect of
common stock issuance may still have been at
work among banks in the early 1990s, I looked
at the stock market's response to BHCs' announcements of upcoming common stock issuances
during the period. I found that, on average, a
BHC's announcement of an impending issuance
of new common stock decreases its common
stock returns by about 1.6 percentage points (see
Laderman 1994). The size of this effect is very
similar to what others have found for other types

of firms and for BHCs in earlier periods. In contrast, I found that announcements concerning the
issuance of other types of securities that are included in Tier 2 capital do not decrease stock

Consequences for loan growth
If BHCs witness a decrease in the value of their
outstanding stock when they announce that they
will issue new stock, then they may avoid issuing
new stock unless they have sufficiently attractive
lending opportunities. Therefore, BHCs trying to
raise their risk-weighted Tier 1 capital ratios or
leverage ratios to meet the regulatory minima may
have strongly favored decreasing asset growth
over issuing new common stock. On the other
hand, if the stock price impact is a decisive factor, BHCs that could meet the requirements by
issuing Tier 2 capital (given their asset size)
might not have had as strong an incentive to
decrease asset growth.
Of particular interest is the effect that the new
risk-based capital requirements might have had
on loan growth. Among all bank assets, commercial and consumer loans receive the highest risk
weight. Therefore, a reduction in loan growth will
decrease growth in risk-weighted assets more
than will reductions in growth in other types of
assets, like government securities. For this reason, we might expect loan growth to have been
particularly affected by the new capital requirements. In addition, we want to examine loan
growth because of its potential to affect economic growth generally.
To investigate whether the negative effect of
common stock issuance might have resulted in
reduced loan growth, I compared loan growth
across three groups of BHCs (Laderman 1994).
The first group, "unaffected" BHCs, included
those with enough of the various types of capital
in December 1990 that they already met all three
capital ratio minima that were due to be fully
phased in in December 1992. The second group,
"Tiei 2 deficient" BHes, included those with
the choice of issuing either Tier 1 capital (common stock) or Tier 2 capital or decreasing asset
growth. The third group, "Tier 1 deficient" BHCs,
either had to issue new common stock or decrease asset growth.
The difference in average loan growth rates between unaffected and Tier 2 deficient BHCs on
the one hand and Tier 1 deficient SHCs on the
other hand was striking. Unaffected and Tier 2

deficient BHCs both showed positive average
loan growth between December 1990 and December 1992, and the loan growth rates were
similar: 10.3 percent for unaffected BHCs and
11.5 percent for Tier 2 deficient BHCs. In sharp
contrast, on average, loans at Tier 1 deficient
BHCs shrank by 12.6 percent over the same
I investigated the possibility that other factors
affected relative loan growth rates at Tier 2 deficient and Tier 1 deficient BHCs. For example,
Tier 1 deficient BHCs may all have faced unusually weak loan demand. Or, perhaps BHCs
avoided issuance of any type of capital, and
Tier 1 deficient BHCs' reduced loan growth was
simply because they were more severely undercapitalized. However, even after controlling for
loan demand and the size of the BHC's largest
capital deficiency (taking into account all three
types of capital ratios), the sharp difference in
loan growth rates remained. Also, the size of
the difference was found to be statistically

After the announcement of the new risk-based
capital requirements in 1989, bank loan growth
decreased for a period. Previous researchers have
found some evidence to link the two events, essentially arguing that numerous banks and BHCs
anticipated being undercapitalized and raised
their capital-to-assets ratios by decreasing loan
What has been missing from this story is an explanation of why banks should have avoided new
capital issuance. In this Weekly Letter, we have
seen that BHCs, as well as other types of firms,
appear to experience a drop in their stock prices
when they announce new issuances of common
stock. Such an effect may help to explain a pref-

erence for decreasing loan growth rather than
issuing new equity. BHCs with inadequate common shareholders' equity experienced a sharp
drop in loans between year-end 1990 and yearend 1992. On the other hand, no negative stock
price effects seem to follow from announcing issuances of non-common stock regulatory capital.
And, indeed, capital deficient BHCs that were
not short on common shareholders' equity in particular experienced loan growth comparable to
that of BHCs that had no capital deficiency at all.
One interpretation of these results is that, had the
risk-based capital rules not included a requirement for a certain level of common shareholders'
equity, loan growth for the Tier 1 capital deficient
BHCs would have been considerably higher. But,
this does not necessarily mean that requirements
for common shareholders' equity should be reduced or eliminated. This type of capital arguably provides the best protection to the deposit
insurance fund in case of bank failure. However,
it does mean that if we are concerned about the
flow of bank credit to the economy, we might
want to take these results into account in weighing the likely costs and benefits of the design
and enforcement of capital regulations.

Elizabeth Laderman
Furlong, Frederick T. 1992. "Capital Regulation and
Bank Lending:' Federal Reserve Bank of San Francisco Economic Review (Number 3) pp. 23-33.
. Laderman, Elizabeth S. 1994. "Wealth Effects of Bank
Ho!ding Company Securities Issuance and Loan
Growth Under the Risk-Based Capital Requirements." Federal Reserve Bank of San Francisco
Economic Review (Number 2) pp. 30-41.

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.... Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.

Research Department

Federal Reserve
Bank of
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P.O. Box 7702
San Francisco, CA 94120

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Index to Recent Issues of FRBSF Weekly Letter





A 1'"11

nA 1r







Industry Effects: Stock Returns of Banks and Nonfinancial Firms
Monetary Policy in a Low Inflation Regime
Measuring the Gains from International Portfolio Diversification
Interstate Banking in the West
California Banks Playing Catch-up
California Recession and Recovery
Just-In-Time Inventory Management: Has It Made a Difference?
GATS and Banking in the Pacific Basin
The Persistence of the Prime Rate
A Market-Based Approach to CRA
Manufacturing Bias in Regional Policy
An "Intermountain Miracle"?
Trade and Growth: Some Recent Evidence
Should the Central Bank Be Responsible for Regional Stabilization?
Interstate Banking and Risk
A Primer on Monetary Policy Part I: Goals and Instruments
A Primer on Monetary Policy Part II: Targets and Indicators
Linkages of National Interest Rates
Regional Income Divergence in the 1980s
Exchange Rate Arrangements in the Pacific Basin
How Bad is the "Bad Loan Problem" in Japan?
Measuring the Cost of "Financial Repression"
The Recent Behavior of Interest Rates

The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.