Give me more! Higher Capital Requirements and Loan Collateralisation

Sudipto Karmakar

How do banks adjust when faced with a sudden rise in capital requirements? The most frequent response, in the theoretical literature, is that they reduce lending or “deleverage” (see, e.g., Aiyagari and Gertler (1999); Gertler and Kiyotaki (2010). This is particularly true in crisis episodes when raising equity can be costly. However, in a new paper co-authored with Hans Degryse and Artashes Karapetyan, I show this is only part of the story. Banks may also ask borrowers to provide more collateral; collateralised exposures carry lower risk weights on average and hence enhance capital ratios. This requirement can adversely affect young and new borrowers that typically lack collateral to pledge and are also unlikely to have longstanding banking relationships.

Setting the Scene

On October 26, 2011 the European Banking Authority (EBA) conducted a Capital Exercise and announced that major European banks would have to strengthen their regulatory capital positions. First, banks were required to hold a new, exceptional and temporary capital buffer to cover risks linked to their holdings of sovereign bonds. Second, banks were also required to hold an additional temporary capital buffer, increasing their core tier 1 (CT1) capital ratios to at least 9 percent of their risk-weighted assets (RWA) by June 2012. The exercise was undertaken with the aim of building confidence in the ability of euro-area banks to withstand adverse shocks and still have sufficient capital. The buffer against the sovereign exposure would be based on the market prices of respective sovereign bonds, as of the 30th of September, 2011. The announcement came largely as a surprise for most of the banking groups, Gropp et al. (2018), which makes this a good quasi-natural experiment to study.

In the study, we focus on Portugal to understand the impact of the capital exercise on banks’ behaviour. Portugal offers extremely rich micro-data on the universe of firms and banks. Such granular information is crucial to study the channels of transmission of the effects of financial regulation to the real economy. And more generally, Portugal provides an excellent laboratory for this study because it has experienced large financial shocks in the last decade. The lessons derived from this study therefore have important implications for other countries.

In Portugal, four out of the eight biggest banking groups were required to increase their capital ratios in the EBA capital exercise. The total capital shortfall (after including the sovereign capital buffer) for all banks operating in Portugal stood at around 7 billion euros, which was roughly 6 percent of the aggregate shortfall in the euro-area. This shortfall was approximately equal to 22 percent of total capital or 30 percent of CT1 (as of the second quarter of 2011) of affected banks. Gropp et al. (2018) argue that exposed banks aimed to comply with the higher capital ratios without raising costly new capital. So how did the banks meet the stricter capital requirements? Did the affected banks behave differently than their unaffected counterparts? The quasi-natural experiment provides an ideal setting to answer these questions using a differences-in-differences approach.


We test whether banks would shift towards more collateralised lending. This makes intuitive sense because, on average, collateralised loans have lower risk weights (Degryse et al. (2018)). This means that loans secured by collateral require less regulatory capital than unsecured exposures. This observation is important as it makes it cheaper for the bank to extend collateralised loans relative to unsecured loans, where the bank has to exert effort (e.g. send a loan officer to assess the borrower conditions or regularly monitor the loan) to learn more about the quality of projects being financed. Something worthwhile considering is that we are only analysing collateral requirements in this piece and not other features of loan contracts like interest rates. We do so because we do not have access to loan level interest rate data.

The capital exercise should, therefore, increase banks’ incentive to require collateral on new loans. However, the effects are not likely to be similar across all borrowers. Banks typically have more information on their regular clients (relationship borrowers). Longer lending relationships lead to accumulation of soft information. Therefore it might not be as costly for a bank to predict the quality of projects being undertaken by such clients. Keeping this in mind, one should expect a differential impact on such borrowers i.e. relationship borrowers should have access to credit with conditions more favourable than their counterparts.

The discussion above is related to the issue of asking for collateral or not. The other issue of course is, conditional on collateral being pledged, is there increased usage of any specific type of collateral? It is known that not all types of collateral are equally beneficial regarding the reduction of risk weights on loans they secure. Certain kinds of “high quality” collateral like real estate and guarantees provided by financial institutions or the state aid in lowering the risk weights on the loans they secure. Focussing on the set of collateralised loans, we investigate if there was a shift to some specific types of collateral. Based on the discussion above, we formulate two hypotheses as follows:

H1: Following the capital exercise, the loans granted by constrained banks are more likely to be collateralised than those by the unaffected banks, but less so for relationship borrowers.

H2: Following the capital exercise, collateralised loans granted by constrained banks are more likely to have ‘high quality collateral’ than those by unaffected banks, but less so for relationship borrowers.

Data and Results

For this analysis, we use confidential data on loans granted by all Portuguese banks to the universe of firms in Portugal. This dataset was then merged with firm and bank balance sheet databases to create a comprehensive dataset showing the linkages between the banking sector and the real economy.

We find that affected banks are 6-10 percent more likely to require collateral than their unaffected counterparts. However, this increase in collateral requirements stems, mainly, from the newer borrowers (transactional borrowers). The relationship borrowers (long-term customers of the bank), also see an increase in collateral requirements but substantially less than the transactional borrowers. This shows that relationship banking can aid in easier access to credit in crisis times.

With regard to the type of collateral, we find that that affected banks were about 25-30 percent more likely to ask for ‘low risk weight collateral’ compared to unaffected banks following the EBA capital exercise. However, this effect is muted by approximately 20 percent for relationship borrowers. This result shows that the EBA capital exercise lead to a more intensive pledging of low risk weight collateral, but less so for relationship borrowers.

Our results document a novel channel through which banks adjust when asked to raise capital ratios in a relatively short horizon. It is important to mention that this is not the only channel though. The more conventional deleveraging channel also exists in our data and we also document this in the paper.

Discussion and Policy Implications

The results obtained have direct implications for the access to finance of young firms and start-ups during crisis times because such firms cannot have long standing banking relationships. Further, if they also lack sufficient collateral to pledge, they might experience reduced access to credit if banks engage in more collateral based lending. Therefore, it is important for policymakers to be aware of how banks are meeting stricter capital requirements and ensure that the viable firms have sufficient access to credit.

Sudipto Karmakar works in the Bank’s Financial Stability Strategy and Risk Directorate.

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3 thoughts on “Give me more! Higher Capital Requirements and Loan Collateralisation

  1. Hello – this is a very interesting study on the behaviour of banks to optimise their lending under various constraints.

    I have 2 questions:

    1. I know you only looked at the commercial sector impact but is the data sufficient to do a similar analysis on the lending impact on the consumer side? Would you have any insights or conjectures on the impact on the consumer side with respect to the increased use of collateralised lending products?

    2. The data that you outlined seems well suited to apply an ABM approach to simulate various impacts on the wider economy as well as a sector specific analysis. Do you see this data as being feasible to support building an ABM model for Portugal?

  2. How does a longer client relationship lead to a lower regulatory risk weight for a loan? I do understand that better information reduces effective risk but wasn’t sure how it featured in the RWA calc…

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