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.

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