Do Regulatory Bank Capital Adjustments actually work?
This recent social science research network paper (A primer on regulatory bank capital adjustments) examines regulatory adjustments. These are adjustments that banks apply to book equity to calculate Tier 1 regulatory capital.
The paper, relying on U.S. data, documents a decreasing relation between regulatory adjustments and bank solvency. Specifically, low solvency banks benefit from regulatory adjustments. These banks report values of Tier 1 regulatory capital that exceed book equity. These banks rely on regulatory adjustments to inflate important regulatory solvency ratios, such as the Tier 1 leverage ratio and the Tier 1 risk-based capital ratio.
In contrast, highly solvent banks report Tier 1 capital that is lower than book equity. These banks are required to adjust their solvency ratios downward for prudential reasons, despite their resilient solvency levels.
I always thought that regulatory adjustments disciplined (or chastised) weak banks, and leave strong banks alone. In practice, it works the other way around. These results weaken the case for regulatory adjustments.
Perhaps something for the Basel Committee on Banking Supervision to look at when discussing the regulatory framework.