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\section{Literature Review}
The benefits and costs of higher capital requirements in banks has been a
highly debated topic after the financial crisis of 07-09. The main elements
of the debate concerns the transmission channel of higher capital capital
requirements to the real economy:
\begin{itemize}
\item Do higher capital requirements strenghten banks' resilience and create
a more stable financial system?
\item Do higher capital requirements increase banks' funding costs and does
this imply lower lending from banks to households and firms?\bigskip
\end{itemize}
Our paper seeks to answer these two important policy questions by
investigating how banks adjust their balance sheets when their capital
requirement. by exploiting a unique implementation in Denmark of the Pillar\
II\ requirement in Basel II \cite{RefWorks:3}
\bigskip
\subsection{The impact of capital requirement on bank resilience}
Bank capital creates a cushion that helps banks to cope with shocks that
creates losses. Capital can be viewed as "breaking distance" - More capital
means that banks are able to weather losses of a greater magnitude before
their solvency\ is called into question \cite{RefWorks:2}. In the context of
capital requirement an important question is whether they are binding for
banks i.e. do banks adjust their behavior when the regulatory minimum
capital ratio changes. . If capital requirements were to rise, will banks
raise their own capital targets by a like amount,\ or will they simple
reduce their capital cushions and leave their capital targets unchanged.
Empirical research has identified substantial heterogeneity with respect to
bank responses to capital requirement, and particularly, the extent to which
capital requirements bind on banks\o\ choices of capital ratios. In many
studies, actual capital ratios respond strongly to changes in capital
requirements, but in other studies, there is little observed response, which
indicates that in some circumstances market discipline may be the dominant
influence on variation in capital ratios \cite{RefWorks:8}
For our sampple of UK banks, there have been studies examining the extent to
which changes in bank-specific capita lrequirements affected actual capital
ratios. Theses studies find a substantial impact, and both conclude that
capital requirements were binding on capital ratio choices.
iterature demonstrates that banks have an incentive to target a level of
capital of capital above the regulatory minimum, a so called voluntarly
capital buffer.\
Banks hold capital buffers as insurance against costly supervisory action in
the event of unexpected events causing the capital ratio to fall below the
regulatory minimum. Other reasons for holding capital buffers identified by
past literature include market discipline, to target an external credit
rating, to weather economic downturns, to secure access to wholesale
deposits and money markets, and for long-term growth and acquisitions
strategies
\bigskip
\bigskip
If market discipline motivates banks to maintain ratios of capital
sufficiently far in excess of those required by regulators, then changes in
regulatory requirements might have no effect on bank capital choices, and
therefore, no effect on bank loan supply
The theoretical bankin literature is in agreement that banks target an
optimal capital ratio which satisfies a trade-off between the costs of
holding too little or too much capital. In the event that conditiond change
such as a differene in per ceived risk or a change to creditors' risk
aversion, a bank will adjust its preferred level of capital (Flannery and
Rangan, 2008). Since, raising capital is costly, Berger et al.(1995)\ argue
that a bank may hold additional capital as financial slack to take advantage
of future potential profitable opportunities or to guard against unexpected
losses. Banks may also hold additional capital through market discipline, or
to increase confidence of shareholders, rating agencies and depositors.
Finally, banks may decide to hold additional capital to protect against
going-concern value if they view regulatory cpital to be insufficient.
Banks have a number of motives for holding "extra" capital. A bank might
stockpile more capital than it currently needs as a hedge against having to
raise new equity on short notice.\ If capital becomes low, a bank can only
raise capital quickly by selling new shares, \ which may entail significant
transaction costs or share price reductions.
The existence of voluntary capital cushons also has implications for the
efficacy of bank capital regulation.
\subsection{The impact of capital requirement on banks loan supply}
The discussion is often based on whether the Modigliani and Miller\ (1958)
theorem do apply to banks. The seminal article by Modigliani and Miller
implies that in the absence of frictions, the value of a bank is independent
on how it is funded between equity and debt. However, there may be various
frictions which cause changes in the funding structure of banks to have real
effects. These frictions can be divided into short term flow costs related
to the proces of raising new external equity, and longer term stock costs
that creates a permanent wedge in banks funding costs when equity levels are
increased \cite{RefWorks:5}.
Flow costs are factors like transactions costs associated with initiating
seasoned equity offering\ (SEO) and Myers and Majluf (1984) pecking order
theory, where firms do not like to issue new equity because this can be
interpreted by the market as a negative signal. If capital requirements are
increased these frictions may - in a transition phase - create a temporary
increase in banks funding costs. Longer term stock costs that implies that
equity is more expensive than debt on a ongoing basis, can mainly attributed
to the preferential tax treatment of debt and acess to (formal and
informal)\ government gurantees that protect the banks' creditors from
losses in the case of bankruptcy.
\bigskip
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