Saat C. hal (India ans and an Systems, Volume 5, Issue 2, 200 Regulatoy equiements and commecial bans' lending ate: some theoetical pespectives Abstact This pape demonstates theoetically how the egulatoy equiements could impinge on bans balance sheet and thus, influence thei optimal lending ate esponse to the policy inteest ate. In such a situation, fo the policy ate to be effective in the tansmission mechanism, a calibated appoach may be equied; changes in the policy ate to be accompanied by changes in the egulatoy paametes to achieve desied changes in the bans lending ate. In the couse of analysis, thee citical insights emeged. One, thee can be a tade-off between egulation and effectiveness of tansmission mechanism and competitiveness of the loan maet. Two, thee can be a situation fo bans to engage in subsidization of loans against investment in is fee govenment secuities. Thee, the capital maet could be lined to monetay tansmission mechanism if bans wee subject to a equied etun on thei capital base. Theoetical insights of the pape have implications fo ban egulation and policy puposes. Keywods: money, inteest ate, cedit, monetay policy, fim objective, mico theoy of picing, mathematical economics, financial economics. JE Classification: E4, E5, 2, 4, C,. Intoduction Fo an effective tansmission mechanism fo monetay policy though the inteest ate channel, it is necessay that commecial bans in a county should adjust thei inteest ates on loans (o the lending ates in tandem with the cental ban s policy shot-tem inteest ate (o the policy ate. Howeve, it is not uncommon to find commecial bans not esponding to policy signals in many counties. Numeous studies have explained the igidity in bans lending decisions due to maet impefection and non-picing objectives (ingle, 974; Hancoc, 986, capital decisions (ingle, 974; Taggat and eenbaum, 978, cedit ationing due to infomation asymmety and moal hazad (Stiglitz and Weiss, 98; Hannan and ege, 99; Neuma and Shape, 992, poduct divesification (Hanwec and Ryu, 2005; Allen, 988; Saundes and Schumache, 2000, elationship baning (Maye, 988; Shape, 990; oot et al., 993; Aoi, 994, ban specific chaacteistics such as size and owneship (emguc-kunt and Huizinga, 990; Angbazo, 997 and monetay tageting (Thao, 996. Some ealy studies also focused on inteest ate egulation and the capital constaints faced by the bans (Mingo and Wolowitz 977; oldbeg, 98; am and Chan, 985. Ove the yeas, the egulatoy envionment has changed significantly. In developed economies, bans ae fee to pice assets and liabilities due to inteest ate deegulation and monetay policy wos though the inteest ate channel. evelop- Saat C. hal, 200. I declae that this is my oiginal eseach wo. The views expessed in the pape ae of the autho only and the oganization to which the autho belongs is not esponsible fo the autho s views. The autho is gateful to an anonymous efeee fo valuable suggestions to impove the pape by incopoating citical policy insights. ing and emeging maet economies have embaced financial efom and feed bans to pice thei assets and liabilities. At the same time, bans in the latte economies have to contend with vaious quantitative egulatoy and pudential noms petaining to eseve equiement, statutoy liquidity, deployment of cedit to cetain sectos, is weighted capital atio and loan loss povisioning. It is not nown, eithe theoetically o empiically, how these egulatoy paametes could affect bans optimal lending ate esponse to the policy ate. Thus, the study is motivated fo a theoetical analysis on the subject. eiving fom the standad theoy of baning fim (Matthews and Thompson, 2005; Santomeo, 984; Slovin and Susha, 983; Sealey and indley, 977; Wood, 975; altenspege, 980, Mingo and Wolowitz, 977, oldbeg, 98; Klein, 97; Zau and Madua, 992 among othes, we demonstate that the egulatoy equiements could impinge on bans balance sheet and thus, complicate optimal decision elating to thei lending ates. Cuently, thee is a geat deal of discussion going on whethe to egulate bans moe o less deiving fom the lessons of the ecent global cisis. In this context, these theoetical insights of the pape will contibute to the liteatue and povide insights fo policy puposes. The est of the pape compises theoetical analysis followed by the conclusion.. Theoetical analysis et a epesentative ban has a simplified balance sheet as postulated in equation (. eposits ( cost inteest ate ( and loans ( and investment ( fetch inteest ate ( and yield (, espectively. The ban maintains eseve balances (R with the cental ban and statutoy liquidity (SR by investing in govenment secuities ( as fac- 24
ans and an Systems, Volume 5, Issue 2, 200 tions of deposits and s, espectively. The ban complies with pudential noms such as the capital to is weighted asset (oans atio (. Unlie the govenment secuities, loans involve cedit is due to loan defaults at the ate of on its advances and mae povisions fo default loans, ( ; 0 set by the egulato. The ban teats povisions as a cost item. The ban can boow fom the cental ban and the inte-ban maet to manage shot-tem liquidity needs costing the inteest ate. Such boowing could be subject to a limited amount and we assume it popotional to deposit (. It is assumed that the ban incus fixed opeating costs. The ban s balance sheet constaint entails that R K. ( Incopoating the egulatoy paametes, s, and, we have b s. (2 The paametes, s, and satisfy the condition 0, s,,. Unde nomal cicumstances, a ban cannot boow as much as its deposit liabilities and thus, 0 b. The objective function of the ban, i.e. maximize pofit, can be specified as: Max( (. (3 Afte incopoating (2 and the egulatoy paametes and boowing nom in the objective function (3, the latte solves to a function of : Max( ( (. b s b s (4 Fom the fist ode condition with espect to, we can deive bs e b s.(5 The vaious assumptions in ou analysis could elate to the eal wold in some developing and emeging maet economies. Illustatively, in a leading emeging maet economy lie India, bans ae equied to have cash eseves and statutoy liquidity in tems of investment in is fee govenment and othe appoved secuities and comply with pudential noms elating capital, povisioning and is weights to loans as stipulated by the authoities. At the same time, bans ae also subject to limits on boowing. In the inteban maet, on a fotnightly aveage basis, bans boowing should not exceed 00% of Tie I and II capital. Howeve, on any paticula day, bans can boow 25% of thei capital. In equation (5, the tems (, ( and ( b s ae positive but less than unity. Fo optimal solution to the lending ate (, loan demand should be downwad slopping and the inteest elasticity of loans (e should be geate than unity in line with the second ode condition 2. Howeve, fo the lending ate to be positive, the tem b s should be positive. If this tem is negative, then the tem ( elating to povisioning equiement of loans should outweigh the tem elating to b s. Othewise, we can elax the assumption of fixed opeating cost to bing in the tem maginal cost of loans to mae the lending ate positive 3. Howeve, the assumption of maginal opeating cost will not affect the maginal esponse of lending ate to the policy ate, which is ou main concen. Fo ou pupose, the linage between the and the policy inteest ate ( can be established by lining the latte to deposit inteest ate and govenment secuities yield: a, (6 a. (7 Assuming that bans boow only fom the cental ban at the policy ate,, and using (6 and (7, the maginal esponse of the lending ate can be deived as: b s. (8 b s e In equation (8, (, ( and ( b s tems ae positive but less than unity. Thus, fo 2 2 The second ode condition entails that d. This will be satisfied 0 2 d if d, fo a downwad slopping loan demand function, i.e., d 0 and inteest elasticity of loan demand e. 0 d e d 3 This assumption about opeating cost will not affect theoetical insights. Illustatively, let this assumption is elaxed by postulating that opeating costs as a linea function of the ban s coe business activities defined as the sum of loans, investments and deposits; C a c. The cost function can be simplified to a function of such as s C a c using the balance sheet b s constaint and thus, the lending ate equation will have anothe tem maginal cost, s in the ight side. Since the maginal cost is c b s not dependent on the policy ate, the will not be affected. 242
ans and an Systems, Volume 5, Issue 2, 200 0 the tems ( b s and the loan demand condition eflected in the inteest elasticity of loan (e will play a cucial ole. Seveal inteesting insights aise hee. Fist, let paametes, s, and and and ensue the second, thid and fouth tems in (8 to be positive. Howeve, fo a positive, the paamete e should exceed unity. Othewise, a negative can occu due to inelastic loan demand, i.e., 0 e. Inteestingly, fo e, the will be indeteminate and fo e 0, will be zeo. efect inteest elasticity of loans e will lead to a positive when the b s 0. Second, conside the case with no boowing ( b 0 and e. The sign of will depend upon s. One scenaio could be ( ; the pefect adjustment of and in tandem with. Then, changes in can bing about a positive. The magnitude of will depend upon the egulatoy paametes, s,, and loan elasticity (e. Altenatively, unde impefect maet conditions, the could adjust sluggishly than the, i.e., so that positive occus. If, thee may not be a positive. If, then the SR paamete (s could be adjusted to a lowe level to ensue that ( s is positive. Othewise, bans may engage in coss-subsidization in tems of educing and aising the. Anothe citical situation may aise when. In this scenaio,, the maginal esponse of the deposit ate to the policy ate, should be geate than s fo to be geate than zeo. Anothe impotant insight is that could be, ceteis paibus, lowe fo pefectly elastic loan demand condition, e =, than fo less than pefectly elastic loan situation e <. Thus, a tade-off could exist between effectiveness of egulation and tansmission mechanism and the competitiveness of the loan maet. Thid, the sign of maginal esponse of to the povisioning equiement ( will also depend upon the paamete e :. (9 e Since is non-zeo positive, will be non-zeo only when e. Howeve, the povisioning equiement (, ceteis paibus, can affect the level of lending ate but not the maginal esponse of lending ate to the policy ate,. Fouth, an incease (decease in will induce a simila adjustment in the lending ate, povided we have 0 e o a negative b s since ( b s e and b s e b s. (0 ( Thus, the loan maet impefection and the spead between the esponse of deposit and investment ates to the policy ate, ceteis paibus, could play a citical ole in detemining the impact of pudential egulation on bans optimal lending ate decisions. Fifth, we can simplify the lending ate equation as y( c s (2 ( g s and deive the maginal esponse of the lending ate to changes in s as 243
ans and an Systems, Volume 5, Issue 2, 200 y( c g. (3 2 s ( g s The sign of will depend upon y and ( c g ; s y can be positive if e, and the sign of ( c g will depend upon the esponses of deposit and boowing inteest ates to the policy ate. Futhemoe, let us addess some issues fo policy puposes. Fist, commecial bans may not face the boowing constaint. Second, how will the cental ban set the policy ate in line with the optimization poblem of the commecial bans? What paametes should affect the cental ban s decision in this egad? These issues could be addessed as follows. In the absence of boowing constaint, the balance sheet constaint faced by the ban could be expessed as ( (4 s and allowing fo eseve and liquidity constaint, the objective function could be expessed as a function of and : Max( s s. (5 Fom equation (5, the two fist ode conditions with espect to and can be solved fo the lending ate : e s s (6 and the boowing inteest ate, equal to cental ban s policy ate, as s. (7 s Fom equations (6 and (7, we can have e (8 and the maginal esponse of with espect to as e. (9 Thus, the changes in the policy ate could be detemined in tems of thee paametes, the inteest elasticity of loans (e, the loan default ate ( and the capital equiement (. Futhemoe, since and ae positive, we will have 0, fo e. Fo pefect inteest elasticity of loans, e, we will have and, povided (20. Othewise, as long as is lowe than, the will have to incease at a faste ate than the. Fom equation (9 we can also infe that a highe maginal esponse of the policy ate with espect to the changes in the lending ate will entail highe capital equiement and/o lowe loan default. Moeove, if we allow the boowing to be inteest elastic, then we will have e e b In equation (2,. (2 will be positive fo e and e b. Othewise, altenative scenaios will emege fo diffeent values of these paametes. The above analysis can be complicated futhe by postulating that the ban has to engage in financial intemediation objective and satisfy the shaeholde with a etun ( on thei capital ( K. The objective function with the boowing constaint scenaio will be Max( V ( s s K (22 K fo which the two fist ode conditions with espect to and will solve fo s. (23 s e K, (24 K 244
Some inteesting insights emege if we set and allow the ban to adopt the capital asset pice model, i.e. the etun on capital ( K as a function of is fee ate ( and the maet is pemium ( m : K (, (25 m e + + K. (26 e In equation (26, the fist tem will be positive fo e. Howeve, the second tem will be positive fo and negative fo. Fo the scenaio, the fist tem should outweigh the second tem fo to be positive. A notable thing hee is that the capital maet can play a ole in the tansmission mechanism. Thus, we have poved how the alignment between the lending ate and the policy ate could entail complications in the pesence of vaious egulatoy equiements. Conclusion This pape attempted a theoetical analysis of how vaious egulatoy paametes impinging on the bans balance sheet could influence optimal lending ate esponse to the policy ate. The policy ate alone can not bing about the desied changes in the bans lending ates. Seveal othe factos such as the inteest elasticity of loans, the deposit inteest ate, govenment secuities yield, Refeences ans and an Systems, Volume 5, Issue 2, 200 loan defaults and egulatoy and pudential noms such as capital equiement and povisioning could play an impotant ole. Theoetically, it could be possible fo the bans to subsidize loans and adjust loan inteest ate in the opposite diection to the policy ate unde cetain conditions. Fom policy pespective, the pape also demonstated that in line with optimal poblem faced by the bans, the alignment of the policy ate with the lending ate could be detemined by paametes such as the inteest elasticity of loan, the loan default is, the pudential capital equiement, and the esponse of yield on govenment secuities to the policy ate. Additionally, fo a stoc exchange listed ban, the paamete beta measuing the esponse of ban stoc etun to the maet is could also affect lending ate esponse to the policy ate. Accoding to the liteatue, the inteest elasticity of loans could depend upon the competitiveness of cedit maet and macoeconomic developments. efault is could depend upon macoeconomic conditions and the institutional mechanism fo debt esolution. Thus, we conclude that a calibated appoach fo monetay tansmission mechanism may be equied, i.e., changes in the policy ate could be accompanied by appopiate and adequate egulatoy and pudential paametes to achieve desied changes in the bans lending ates. At a time when a geat deal of discussion is going on whethe to egulate bans moe than eve befoe, theoetical insights of the pape will contibute to this discouse. This pape confined to standad compaative static analysis. Such a simplistic famewo could be justified when commecial bans, especially in developing economies, might not be well vesed with o pefe complicated balance sheet management. Nevetheless, fo futue eseach, the analysis of bans behavio in tems of dynamic optimization, altenative is picing, financial innovations and endogenous default is appoaches incopoating egulatoy equiements may povide futhe insights fo policy puposes.. Allen,. (988, eteminants of an Inteest Magins: A note, Jounal of Financial and Quantitative Analysis, 23. 2. altenspege, E. (980, Altenative Appoaches to the Theoy of the aning Fim, Jounal of Monetay Economics, 6. 3. oot, A.W.A. (2000, Relationship aning: What o We Know?, Jounal of Financial Intemediation, Vol. 9. 4. oot, A.W.A., eenbaum, S.I. and Thao. A.V. (993, Reputation and iscetion in Financial Contacting, Ameican Economic Review, 83. 5. Campbell, T. (978, A Model of the Maet fo ines of Cedit, Jounal of Finance 33 (Mach 978. 6. emigüç-kunt, A. and Huizinga, H. (999, eteminants of Commecial ans Inteest Magins and ofitability: Some Intenational Evidence, Wold an Economic Review, 3. 7. oldbeg, M.A. (98, The Impact of Regulatoy and Monetay Factos on an oan Chages, Jounal of Financial and Quantitative Analysis, Volume XVI, No. 2, June. 8. Hancoc,. (986, A Model of the Financial Fim with Impefect Asset and eposit Elasticities, Jounal of aning and Finance, 0. 9. Hancoc,. (986, Testing ice Taing in oan and eposit Maets, Financial Review, 2. 245
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