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Journal of Applied Finance & Banking, Vol. 10, No. 5, 2020, 105-128 ISSN: 1792-6580 (print version), 1792-6599(online) Scientific Press International Limited Do the Capital Requirements Affect the Effectiveness of Monetary Policy from the Credit Channel? Xiaoqiong Diao1 Abstract This paper examines weather the capital requirements affect the effectiveness of monetary policy from the credit channel. According to the penal data of commercial banks listed on the A-share stock market in China from 2007 to 2017, I find that the capital requirements to the commercial banks affect the bank loans through the credit channel of monetary policy transmission, which is more obviously on the smaller banks. I further use issuance of preferred stocks of commercial banks instead of IPO to confirm the results again. Moreover, I compare the two kinds of monetary policy instruments in my results, which document that the price-based monetary policy instruments are more sensitive than the quantitative ones. Keywords: Credit channel, monetary policy, transmission channel of monetary policy, capital adequacy ratios (CAR), preferred stocks. 1 PBC School of Finance, Tsinghua University, Beijing 10083, China. Article Info: Received: April 7, 2020. Revised: April 21, 2020. Published online: June 1, 2020. 106 Xiaoqiong Diao 1. Introduction “Banking plays a crucial role in China’s financial system.”Zhu, Chen, Zhou, Gai and Xiong (2020) said in their new book, The Jingshan Report: Opening China’s Financial Sector. Because commercial bank is not only the crucial part of financial system in China, but also a carrier of monetary policy. Credit channel is considered to be the main transmission channel of monetary policy in China. “Monetary policy transmission mechanism must coordinate with the national financial system. There are two different kinds of financial system, one is marketoriented, and the other is bank-dominated. Running in a typical bank-dominated financial system, Chinese commercial banks play a pivotal role in the transmission of monetary policy. Afterall, the behavior of commercial bank is the decisive factor to make sure that the monetary policy is smoothly transmitted.” Sun Guofeng, head of the monetary policy department at the People’s Bank of China (PBOC), said earlier 2019. The credit availability doctrine began to show the Credit Transmit Channel of Monetary Policy in 1950s. As Roosa said in his book, the central bank uses interest rate as a tool to adjust the behavior of the commercial banks. When the central bank changes the interest rate, as a lender, the commercial bank will change its capital structure as well. As a result, the credit available to the enterprises and households are finally changed. Bernanke (1986) use a SVAR modal to document how the behavior of American commercial banks can affect the aggregate demand of a country, this is theorized as the credit transmission of monetary policy. Oliner and Rudebusch (1996) showed the borrowers will reduce their investments after the central bank tighten the monetary policy. Similar evidence has also been found in bank level data Kashyap and Stein (2000). Wang and Wang (2000), Suo and Fan (2007) focus on the Chinese monetary policy, and they all documented the credit channel of monetary policy exists in China. Rao and Jiang (2013) investigated monetary policy effects on the relationship between bank loans and business credit. They also provided micro evidence on Chinese monetary policy's credit transmission mechanism. Although the proportion of direct financing increased, indirect financing still occupied a leading position in China. The Jingshan Report said, “In the future, the banking industry will continue to dominate Chinese financial system.” According to the PBOC, the amount of social financing including credit financing, securities financing, insurance and other financing forms, increased by 22.5 trillion RMB yuan in the year of 2019. The new yuan loans increased by 16.8 trillion, which account for approximately 66 percent of the amount of total social financing. The new yuan loans have reduced from over 91% of the amount of social financing in 2002 to 66 % in 2019, but they still make up no less than 50 percentage of the total social financing. In the last three years, loans accounts for over 60 percent of the assets in the balance sheet of financial institutions in China, other include portfolio investments, shares and other investments, foreign exchanges. Although the amount of loans is Do the Capital Requirements Affect the Effectiveness of Monetary Policy… 107 decreasing in the past ten years, the loans always make the biggest and irreplaceable contribution to the financial institution’s returns. As a country in the economic transition period, China's capital market, which is different from those of western countries, is immature. The loans of China’s financial institution, especially for commercial banks, cannot be substituted with other kinds of assets. Even the commercial banks can sale the securities to increase liquidity, the amount of loans is far greater than their other securities. As an important finance intermediary, the commercial bank has become the main center of economic activity. Its antenna widely penetrates in each department and corner of the modern economy and society. On the one side, the commercial bank implementing the monetary policy, which made by the central bank. On the other side, the commercial banks provide money for enterprises and households at a price which pursue monetary policy objectives. As a monetary policy instrument, the credit always plays a leading role in the transmission channel of monetary policy in China. Sheng and Wu (2008) According to the balance sheets of China’s financial institutions, the deposits are made up around 85 percent of the total fund sources in the recent three years, which is far more than the other items including financial bonds, currency and other liabilities. “Unlike other large global banks, Chinese banks continue to rely on savings and loan business. Consequently, interest remains the major source of income for Chinese banks.” The Jingshan Report said. Based on the macro time series data and micro survey data from January 2008 to June 2017, Guo, Dai and Peng (2018) examined the efficiency of China’s monetary policy interest rate transmission to loan interest rates. In general, the benchmark interest rate is the main factor that affects the loan interest rates. Last year, China’s central bank officially announced that the traditional benchmark lending rate was instituted by the loan prime rate (LPR) in Jan 1st 2020. This is considered a milestone in the 25-year process of market-oriented interest rate liberalization reform. The LPR will become the only benchmark rate for banks' new lending, which allows the financial institutions and their clients negotiate a floating rate higher or lower than the benchmark. The regulators expect that the reformation will make the companies able to get cheap loans to counter economic downside pressure. And the behavior of commercial banks is changed correspondingly. In addition, the reserve requirement ratio framework is always considered to be the most important and direct monetary policy instrument for the PBOC, which directly change the commercial bank’s behavior. During 2019, China’s central bank cut commercial banks’ reserve requirements ratio for three times, which unleashed 2.7 trillion RMB yuan long-time capital to maintain the liquidity at a reasonable and ample level. When the reform of loan prime rate (LPR) is officially introduced, the PBOC is also need to cut the reserve requirement ratio to inject the liquidity in the financial system. The transmission channel of monetary policy depends on the monetary policy tools, the credit decision of commercial banks and the investment decision of enterprises and households. Therefore, how the commercial banks manage their balance-sheet have significant impact on the effectiveness of monetary policy. For example, the 108 Xiaoqiong Diao central bank will loosen monetary policy, but the commercial banks are striving to repair their overstretched balance-sheets, which make the banks reluctance to lend. That impair the effectiveness of monetary policy. In modern economy, the bank's operating pressure, earnings pressure, lending risk are growing day and day. Besides, the commercial banks face more supervision in China, and this cause the credit decision-making of banks are more complicated and highly variable. Despite the reforms over the past 30-plus years, the banking sector in China is still heavily regulated and inefficient. Song and Xiong (2018) For commercial banks, the regulators are concerned most about their capital adequacy ratios (CAR), which play a significant role in mitigating bank solvency problems. It is considered to be a barometer of financial healthiness, which measures the proportion of a bank's capital to its risk-weight assets. Since the late 1980’s G-10 and some other economies all over the worlds have begun to concentrate on bank adequacy ratios of their own banking sectors. In March 2004, Chinese Banking Regulatory Commission (CBRC) promulgated "Commercial Bank Capital Adequacy Ratio Management Method" according to The Basel Accord, which built up the capital regulatory framework of China’s commercial banks. At that time the CAR of most commercial banks in China are far less than 8 percent. Towards this end, most studies pertain to the ways to improve the commercial banks CAR conforming to the new regulatory. The commercial banks are required to increase their capital to meet the regulatory, which can improve the soundness and safety of the banking sector. Benston and Kaufman (1996) and Dowd (2000) both argued that capital adequacy regulation might help to counter the effects of other given interventions such as the moral hazard created by the regulatory authorities. Furthermore, the CAR regulation is considered to increase market transparency, thereby enable the markets reward the well capitalized banks and punish the banks with low capital levels. Genschel and Plumper (1997) According to the China Banking and Insurance Regulatory Commission (CBIRC), commercial banks are obliged to meet their capital ratio requirements by the end of 2018. They will need to maintain a minimum CAR of 9.5 percent and a core tier-1 CAR of 8.5 percent. At the end of 2019 the commercial banks’ CAR inched up to 14.64 percent in China, which is above the minimum capital requirement ratio. Chinese banks’ capital adequacy ratio and non-performing loan ratio were all kept within a safe limit, said by CBIRC. Although the CAR of commercial banks in China have met regulatory requirement the banks still face pressure in the long term. According to the 2019 semi-annual reports of the 33 listed commercial banks, the tier-one capital ratio of 19 listed banks declined compared to the same period last year. Moreover, 23 listed commercial banks with a declined core tier-1 capital ratio. The core tier-1 CAR and the tier-1 CAR both declined in the five large-scale stateowned commercial banks. Furthermore, the CAR and the core tier-1 CAR of the three main joint-stock commercial banks in China, are both lower than the last year, let alone the small banks. In addition, since the CAR of international leading banks is between 15 and 20 percent, the commercial banks in China still have the space to improve. It is also said that the risk of Chinese banking system is concentrated on Do the Capital Requirements Affect the Effectiveness of Monetary Policy… 109 the rural and small banks, whose assets account for 10 percent of total assets. During recent three years, 60 percent of the profits of commercial banks listed in A-share stock market is used to replenish capital, compared that 17 percent for tax and 23 percent for their stock dividends. The market value of commercial banks listed on the A-share stock market take occupied about 16.56 percent of the whole value of Shanghai stock exchange market, and the profits of commercial banks make up about 39.01 percent of the whole market by the end of the third quarter of 2019. It documents that the profits using for replenishing bank’s capital are earning from the real economy, which in turn to feed back to the real economy with more expanding loans by means of the capital leverage. This virtuous circle promotes the economy develop steady and rapid. Toward this end, the commercial banks devote themselves to improve their capital both from the internal channels and external channels. The major internal channels available for commercial banks to replenish their capital are retaining earnings, but they are facing a serious problem of the growth of profits slowing down. Comparatively, the external channels for capital supplement of commercial banks are more immediate and effective, such as stock issuance, preferred stocks, convertible bonds and tier-2 capital bonds. From the 2003, the State Council injected US$45 billion from the foreign exchange reserves as capital supplement into the Bank of China (BOC) and the China Construction Bank (CCB) in order to make them prepare to list in the stock markets. After that, other stated-own commercial banks, joint-equity commercial banks and city commercial banks are successively reformed so that the CAR reported by more and more Chinese commercial banks are increased to exceed the regulatory threshold at that time. But the regulatory level of CAR is increased year by year. In the year 2011, the CBRC’s new standards set the minimum capital adequacy ratio for banks of systematic significance are at 11.5 percent, while those for banks with non-systematic significance at 10.5 percent. After the year 2016, Macro Prudential Assessment (MPA) as a new regulatory framework on commercial banks are launched by PBOC in order to prevent systemic financial risks. According to the MPA framework, the regulator assesses seven aspects of banking financial institutions quarterly, including capital adequacy and leverage, assets and liabilities, liquidity, pricing, asset quality, foreign debt risks and policy implementation. The primary parameters of the MPA framework is capital adequacy. Along with the increasing market competition and the strengthening of financial supervision, the commercial banks are eager to launch their IPO plans. By the end of 2019, 48 commercial banks have landed in the capital market, including 34 IPOs on the A-share stock market and 14 IPOs on the Hongkong stock market. Furthermore, the primary purpose of IPOs of these commercial banks is to replenish their capital disclosed by their prospectus. As more related policies are being put into play China will have an increasingly sound mechanism to supplement commercial banks capital and the banking industry will have more ability to support the real economy. Another important reason for commercial banks to replenish capital is that 110 Xiaoqiong Diao alleviating the capital pressure of commercial banks is important to ensure a smooth transmission of the monetary policy, thus makes the policy more effective and better serve the real economy. The financial system mainly relies on indirect financing where commercial banks play a major role. After the central bank loosing monetary policy, if commercial banks fail to transfer the liquidity into credit granted to the real economy the monetary policy would not be as effective as desired. Narmeen, ISaba, Kouser and Khurram (2018) using panel data methodology documented CAR has impact on change in capital and change in loans. Jin, Zhang and Gao (2014) suggested that the central bank should take counter-cyclical capital regulation policy to offset the effect of monetary policy on the excessive risk-taking behavior of banks. But they only concerned about the risk-taking of banks. Ma and Ji (2016) elaborate that the loan-to-deposit ratio, loan limitation and the interest rate regulation are the main factors blocked the monetary policy transmission mechanism. They did not mention the effects of CAR. Liu, Yu, Yang and Zhu (2017) documented that capital adequacy ratios mostly affect the efficiency of small banks credit structure adjustment. Feng and He (2011) using the data of banks from 2003 to 2010 showed that the lending behavior of banks are significantly affected by the public financing of banks and the effectiveness of bank credit channel of monetary policy transmission mechanism is limited. But they didn’t tell the differences between big banks and small banks hampered by a lack of enough quantitative data. Moreover, they experimented that the quantitative monetary policy instruments were more sensitive than the price-based ones in their article. But after these years interest rate liberalization reform, I find the opposite result according to the updated data. Besides, there are more other ways for the bank replenishing their capitals such as preferred stocks, which were not discussed in their article. After modification of Feng and He (2011) model, this paper uses monetary policy proxy variables to analyze that the capital supplement of commercial banks can impair the effectiveness of monetary policy through the credit channel, which is more obviously on small banks. I also compared the two kinds of monetary policy instruments in my results, which document that the price-based monetary policy instruments are more sensitive than the quantitative ones. Then I use the issuance of preferred stocks instead of IPO as dummy variable to do the robust check. The results prove my point of view again. Furthermore, I also compared the results before and after 2016, when the MPA framework is implemented to increase the capital requirement of commercial banks. The paper is organized as follows. Section 2 describes a theoretic model to experiment how the capital requirement of commercial banks can jam the credit channel of monetary policy transmission, while section 3 shows the data. In section 4 I present the empirical results and the conclusion is in section 5. Do the Capital Requirements Affect the Effectiveness of Monetary Policy… 111 2. Theoretical Model Following the finance literature Kopecky and Hoose (2004), I use a typical bank profit maximization model to examine the impact of deposit reserve as a monetary policy shock on bank credit behavior under the requirements of capital adequacy ratio. Furthermore, I take inter-bank entrusted loans and debts separately analyzed. Because the interbank loans are different with the other loans thus attributed to the shadow banks in China. According to the commercial bank’s balance sheet, the model is given by the following equation: 𝐿𝑆 + 𝑅 + 𝐿𝐶 + 𝑆 = 𝐷 + 𝐸 + 𝐵 (1) R is the bank reserve, which represents the reserves on the commercial bank’s balance sheet. If the central bank loose the monetary policy, the reserve requirement is decrease while R will increase. 𝐿𝐶 are the loans of the commercial bank. S shows the securities the commercial bank purchased including the treasury bonds and other risk-free securities, whose risk weight is 0%. 𝐿𝑆 are the interbank loans, and B is the interbank debts. D is the deposit, and E is the bank’s equity. For simplicity, I set the risk weight of all loans to 100%. As the model of Kopecky and Van Hoose (2004), I assume the reserve interest rate to 0. The deposit interest rate 𝑟𝐷 , the loan interest rate 𝑟𝐿 and the return of securities 𝑟𝑆 are all exogenously given. The return of the capital is 𝑟𝐸 . All kinds of the assets on the bank’ balance sheet have administrative cost, which are assumed as the quadratic function of the assets, that is, the administrative cost of securities 𝑠 𝑒 𝐶𝑆 = 2 𝑆 2 , the capital cost 𝐶𝐸 = 2 𝐸 2 . The quadratic function is easier to be solved than other forms of function. Moreover, it is also consisted with the economics interpretation. That is, the banks not only face more higher funding costs but also more expensive management costs along with the growing scale of loans. The marginal cost of loans is increasing when the loans have reached a certain scale, which is discussed by Dai (2006). For Chinese commercial banks, assets and debts are managed by the same department so that the management factor of loans and inter-bank loans is the same l, while the management factor of interbank debts and 𝑙 deposit is the same d. Accordingly, the costs of loans are 𝐶𝐿𝑆 = 2 𝐿𝑆 2 and 𝑙 𝑑 𝑑 𝐶𝐿𝐶 = 2 𝐿𝐶 2 , the deposit and inter-bank debts costs are 𝐶𝐷= 2 𝐷2 and 𝐶𝐵 = 2 𝐵 2 . Besides, the commercial banks face required reserve constraint, 𝑅 ≥ 𝜌(𝐵 + 𝐷), where 𝜌 is the required reserve rate. 112 Xiaoqiong Diao For the hypothesis of rational economic man, the commercial bank maximize its profits π, 𝑙 𝑙 𝑠 𝑑 𝑒 𝜋 = 𝑟𝑂 𝐿𝑆 + 𝑟𝑆 𝑆 + 𝑟𝐿 𝐿𝐶 − 𝑟𝐷 𝐷 − 𝑟𝐵 𝐵 − 𝑟𝐸 𝐸 − 2 𝐿𝑆 2 − 2 𝐿𝐶 2 − 2 𝑆 2 − 2 (𝐵 + 𝐷)2 − 2 𝐸 2 (2) s. t. 𝐿𝑆 + 𝑅 + 𝐿𝐶 + 𝑆 = 𝐷 + 𝐸 + 𝐵 𝑅 ≥ 𝜌(𝐷 + 𝐵) (3) Without the capital constraint requirement, the bank choose 𝐿𝑆 , 𝐿𝐶 and S to maximize 𝜋 subject to the reserve requirement constraint and equation (1). From the bank’s optimization problem, they are given by 1 1−𝜌 1 𝜌 1−𝜌 𝐿𝐶 ∗ = 𝛿𝑙 [𝑒𝑠𝑙 𝐿𝑆 ∗ = 𝛿𝑙 [𝑒𝑠𝑙 1 𝑆 ∗ = 𝛿 [𝑙𝑒 1 𝜌 1−𝜌 𝜌 𝐸 ∗ = 𝛿 [−𝑙𝑠 𝑅 + (𝑠𝑙 + 𝑒𝑠 + 𝑙𝑒)𝑟𝐿 − 𝑠𝑙𝑟𝐸 − 𝑙𝑒𝑟𝑆 − 𝑒𝑠𝑟𝑂 ] 𝑅 + (𝑠𝑙 + 𝑒𝑠 + 𝑙𝑒)𝑟𝑂 − 𝑙𝑠𝑟𝐸 − 𝑒𝑠𝑟𝐿 − 𝑒𝑙𝑟𝑆 ] 𝑅 + (2𝑒 + 𝑙)𝑟𝑆 − 𝑒𝑟𝑂 − 𝑒𝑟𝐿 − 𝑙𝑟𝐸 ] 1−𝜌 𝜌 𝑅 − (2𝑠 + 𝑙)𝑟𝐸 + 𝑠𝑟𝑂 + 𝑠𝑟𝐿 + 𝑙𝑟𝑆 ] where 𝛿 = 2𝑒𝑠 + 𝑒𝑙 + 𝑠𝑙 From these equations I get： 𝜕𝐿𝑐 𝜕𝑅 >0 𝜕𝐿𝑆 𝜕𝑅 >0 𝜕𝑆 𝜕𝑅 >0 𝜕𝐸 𝜕𝑅 <0 In the absence of capital constraints and keep the other conditions remain unchanged, once the central bank decreases the reserves requirement, the R increases accordingly so that the optimal size of loans is increased as well. That shows the monetary policy transmission mechanism. When R is increased, the banks will reduce their optimal capital scale E. Without capital constraints, commercial banks will constantly reduce their capital adequacy level to meet the goal of maximizing profits, which enables commercial banks to choose many risky loans or securities assets. Finally, the expansionary monetary policy brings a rapid expansion of credit scale. But in the real economy, the commercial banks not only comply with the reserve constrain, but also face the capital adequacy constrain. According to the CAR rules， the capital adequacy constraint must hold: 𝐸 ≥ 𝜃(𝐿𝑆 + 𝐿𝐶 ) (4) Do the Capital Requirements Affect the Effectiveness of Monetary Policy… 113 I plug the equation (4) into the model, the 𝐿𝑆 , 𝐿𝐶 , 𝐸 and 𝑆 is now: 1 1−𝜌 𝐿𝐶 ∗ = [𝑠(1 − 𝜃) 𝑅 − (𝑠𝜃 2 − 2𝜃𝑠 + 𝑠 + 𝑒𝜃 2 )𝐿𝑆 ∗ + 𝑟𝐿 − (1 − 𝜃)𝑟𝑆 − 𝜃𝑟𝐸 ] 𝜇 𝜌 1 1−𝜌 𝐿𝑆 ∗ = [𝑠(1 − 𝜃) 𝑅 − (𝑠𝜃 2 − 2𝜃𝑠 + 𝑠 + 𝑒𝜃 2 )𝐿𝐶 ∗ + 𝑟𝑂 − (1 − 𝜃)𝑟𝑆 𝜇 𝜌 − 𝜃𝑟𝐸 ] 1 1−𝜌 𝐸 ∗ = [𝑠𝜃(1 − 𝜃) 𝑅 + 𝑟𝑂 𝜃 + (2𝜃 − 𝜃 2 )𝑟𝑆 − 𝜃 2 𝑟𝐸 ] 𝜇 𝜌 1 1−𝜌 𝑆 ∗ = [(𝑒𝜃 2 + 𝑙) 𝑅 + 𝑟𝑆 (1 − 𝜃)2 − 𝑟𝐸 𝜃(1 − 𝜃) − 𝑟𝑂 (1 − 𝜃) − 𝑟𝐿 (1 − 𝜃)] 𝜇 𝜌 where 𝜇 = 𝑙 + (1 − 𝜃)2 𝑠 + 𝑒𝜃 2 Then I check the results again: 𝜕𝐿𝐶 𝜕𝑅 > 0, 𝜕𝐿𝑆 𝜕𝑅 > 0, 𝜕𝐸 𝜕𝑅 > 0, 𝜕𝑆 𝜕𝑅 >0 Under the constraint of CAR rules, when the central bank implements an expansionary monetary policy with the expanded supply of reserve R, the optimal loans and securities scale of the bank expands. Furthermore, the optimal capital level of commercial banks increases, which is the opposite of the case without capital adequacy constraints. Accordingly, the CAR constrain has an impact on the transmission mechanism of monetary policy. When the central bank eases the monetary policy, the commercial banks seek the maximized profits constraining by the CAR rules. As a result, the commercial banks will choose smaller scale of loans than the situations without the CAR constrains. However, once the central bank tightens the money supply, the commercial banks will reduce their capital and loans correspondingly. But to meet the CAR rules, the capital scale of commercial banks can-not be reduced less. Therefore, the scale of loan must be reduced more than the situations without the CAR regulations, which result in a greater credit crunch effect. I do the comparative static analysis again to explore the indirect effects on the monetary policy by the minimum CAR θ, and I get the results at a certain parameter level: 𝜕𝐿𝐶 <0 (5) 𝜕𝑅𝜕𝜃 𝜕𝐿𝑆 <0 (6) The equations (5) and (6) document that once the CAR is increased, the elasticity of commercial banks loans to the monetary policy is decreased, which indicates that the effectiveness of monetary policy will be affected by the capital requirements. 𝜕𝑅𝜕𝜃 114 Xiaoqiong Diao 3. Data and sample selection There are 28 commercial banks listed on the A share market by the end of 2017, which include the five state-owned commercial banks, the joint-equity commercial banks, city commercial banks and rural commercial banks. According to the prospectus, the cashes financing from the IPOs are all used to replenish the capital of commercial banks. Since 2005 all the five Chinese state-owned commercial banks have gone public. For example, China Construction Bank raised 58.05 billion RMB in September 2007, while Bank of China priced its 20 billion RMB IPO in July 2006. Among listed state-owned commercial banks, the ICBC ’s capital adequacy ratio increased significantly, from 9.89% before listing to 14.05% after listing, followed by China Communication bank from 10.83% to 14.44%. I summarized these on table 1. All the data comes from Wind database and I use interpolation method to estimate the missing data.