Risk-sensitive Basel regulations and firms’ access to credit: Direct and indirect effects

Abstract

This paper examines the impact of risk-sensitive Basel regulations on debt financing of firms around the world. It investigates how firms cope with the impact through adjustments to their financing sources and capital investments. We find that the implementation of Basel II regulations is associated with reduced credit availability for lower-rated firms. Such firms mitigate the shortage in bank credit through increased reliance on accounts payable, lower payouts to shareholders, and reduced capital investments. The impact of the capital regulation is lower in countries that rely on the internal ratings-based approach. The key results are robust to controls for banking crises, bank-specific controls, and the inclusion of loan-level information. The findings of this paper substantially contribute to the understanding of the real effects of risk-sensitive bank capital regulations.

Introduction

Risk-sensitive capital requirements are a key feature of bank capital regulations prescribed by the Basel norms. Unlike Basel I norms, where capital requirements were independent of credit risk for corporate lending, Basel II norms prescribed differential risk weights based on credit risk (BCBS, 2006). The risk-sensitive approach introduced by Basel II required banks around the world to estimate their capital requirements for corporate lending based on borrower-specific credit risk.¹ The regulation has led to substantial changes in bank capital requirements across credit rating categories. In this study, we quantify the impact of Basel II implementation (Basel II henceforth) on credit flows to the real sector across countries and identify a range of responses adopted by firms to mitigate its impact. Specifically, we examine whether Basel II affects the financing and real outcomes of less creditworthy firms to a greater degree compared to more creditworthy firms.

Anecdotal evidence suggests that banks have advised their clients to be prepared for the impact of Basel II on credit supply. An advisory issued by J.P. Morgan encouraged its clients to maintain a better risk profile to ensure greater access to corporate loans.² Firms have also alerted their shareholders about the likely adverse impact of Basel II on credit availability. For instance, Noble Energy mentioned in its 2013 Annual Report, “As a result, traditional lending practices could change, resulting in more restricted access to funds or reduced availability of funds at rates and terms we consider to be economic.” (p. 42). A survey by the US Chamber of Commerce found that on account of the regulatory change, most businesses faced financing difficulties and nearly one-fifth of firms delayed or cancelled planned investments.³ Kashyap and Stein (2004) argue that “...if it is expensive for banks to raise and/or hold additional capital, a too-stringent capital requirement will lead to a reduction in bank lending, with the associated underinvestment on the part of those borrowers who are dependent on bank credit.”

The credit supply shock associated with Basel II is likely to be transmitted to firms through the linkage between firms’ credit ratings and the differential capital charges incurred by banks. Exposure to firms with credit rating of B+ or lower incurs higher capital charges (150% risk weight) for banks after the implementation of Basel II relative to the pre-Basel II period, when all exposures invited only 100% risk weight. On the contrary, exposure to firms with rating of BB- or higher incurs the same or lower capital charges (100% or lower risk weight) after the implementation of Basel II. Accordingly, we define firms with credit rating of B+ or lower as high capital charge (HCC) firms, and those rated BB- or higher as non-HCC firms. Given the cross-sectional variation in the bank capital charges for lending to HCC firms and non-HCC firms, we investigate the likely impact of Basel II implementation on firm-level outcomes. In particular, we examine how the regulation has impacted volume of debt financing for such firms. We also investigate several indirect channels through which firms may attempt to mitigate the fall in bank credit, for instance, through lower payouts, lowering capital investments, and greater reliance on trade credit.

We exploit the staggered nature of the implementation of Basel II across our sample of 52 countries (see Table A1 in the Internet Appendix for the implementation timeline) to reliably identify its effect on firm-level outcomes through a difference-in-differences (DiD) analysis. The regulatory change in a multi-country set-up permits us to examine the empirical questions in a generalizable manner compared to single country studies. Country-specific studies are prone to confounding effects such as regulatory changes and economic events that can cloud the effects attributed to a policy shock (Angrist and Pischke, 2010).⁴ Our multi-country analysis can largely address the concerns of external validity that arise in single-country studies on the impact of the changes in bank capital regulations (Fraisse, Lé, Thesmar, 2020, Demir, Michalski, Ors, 2017). Moreover, the staggered nature of the implementation also permits us to control for time-invariant differences in the market structure and institutional environment across countries. The key findings of the analysis and their implications are as follows.⁵

First, through the DiD analysis, we find that incremental borrowing by HCC firms declines significantly in the post-Basel II period compared to that by non-HCC firms (the ‘post-Basel II period’ includes the year of implementation and the subsequent years). In an event window spanning five years around the Basel II implementation, we find that incremental borrowing by HCC firms declines by up to 5.4% of their assets in the post-Basel II period. Furthermore, in an analysis involving a longer time period, we find that borrowings by HCC firms decline by about 5.0% in the year of implementation, with the effect persisting for the subsequent two years. These findings suggest that debt financing by the riskier firms, which invite higher capital charges, has declined significantly after the implementation of Basel II. However, we do not find that HCC firms incur a higher cost of debt relative to their non-HCC counterparts during the post-Basel II period. The observed impact on the debt financing of HCC firms can be attributed to the Basel II-induced changes in credit supply as we control for the likely influence of the changes in demand for loans through interactive fixed effects at various levels of aggregation.

Second, we find that HCC firms reduce their dividend payouts to shareholders by about 15% relative to their non-HCC peer group as an outcome of the credit supply shock. However, the findings are weaker with a full set of interactive fixed effects. The weaker impact on payouts may be an outcome of the stickiness of dividends in the short-run.

Third, we find that HCC firms have significantly increased their reliance on accounts payable as a source of credit in the post-Basel II period. The relative increase in the accounts payable of HCC firms is about 0.6% to 0.7%, against the mean accounts payable of 8.2%, in the event window estimation. We also find that in the years following the Basel II implementation, firms tend to reduce the accounts receivables suggesting that they adopt a tighter credit policy. The result that net payables have increased for the HCC firms further strengthens the findings on the impact on trade credit. The increased reliance of HCC firms on trade credit in the post-Basel II period implies that they attempt to fill the shortfall in bank credit through financing from suppliers. Our findings on trade credit complement those of Fraisse et al. (2020), who examine the changes in trade credit reliance in response to Basel II implementation in France. They are also consistent with earlier studies on the response of firms to various credit supply shocks (Casey, O’Toole, 2014, Ferrando, Mulier, 2013).

Finally, we find that the difference in capital investment intensity between HCC and non-HCC firms has significantly widened in the post-Basel II period. The relative reduction in investment intensity of the HCC firms is up to 7.2% in the post-Basel II period, against the mean investment intensity of 20% in our sample. The lower investment intensity observed for the HCC firms suggests that they can only partially compensate for the credit shock through lower payouts and other financing sources. The impact on capital investments is in line with the findings of other studies that report a decline in capital expenditure by firms faced with financing constraints due to credit supply shocks (Aghion, Angeletos, Banerjee, Manova, 2010, Chava and Purnanandam, 2011).

We further investigate the possible heterogeneity in the impact of Basel II across countries. We find that the adverse impact of Basel II on debt financing for HCC firms is higher in countries that adopt the standardized approach to credit risk than in countries that adopt the internal ratings-based approach. The greater impact could be linked to the more conservative capital charges prescribed under the standardized approach. We also observe that the adverse impact on debt financing and firm investments is higher for HCC firms in countries that adopted the regulation prior to 2008 compared to those in countries that adopted in 2009 or later. It is possible that the firms in the late adopter countries, through greater adjustment to their trade credit and payout, are able to better cope with the consequences of the credit shock.

Several robustness tests support our key findings. To better identify the impact of Basel II, we re-examine our key findings with the syndicated bank loans as the dependent variable for a subsample of firms that are covered in the Loan Pricing Corporation (LPC) database. The reduction in the syndicated loans to HCC firms is consistent with the adverse impact on debt financing observed for such firms. Reinforcing our earlier results on the potential substitution of bank credit with alternative channels due to the credit supply shock, we further find that HCC firms have increased their reliance on bond financing. Our findings on the impact of Basel II implementation are robust for a subsample of firms with controls for bank-level heterogeneity. All our key results are also significant with controls for banking crisis episodes and sovereign ratings. Moreover, the results are qualitatively similar when we employ rating as a continuous proxy of credit risk. We conduct a placebo estimation as a falsification test by introducing an artificial intervention before the implementation of Basel II. We find that the wedge in firm-level outcomes between the HCC firms and the non-HCC firms does not change for our key variables in the years following the placebo intervention.

Overall, the findings suggest that Basel II implementation has a significant adverse impact on credit flows to lower-rated firms. The DiD analysis shows an adverse effect on debt financing and bank loans for the HCC firms after controlling for demand shifts. The impact on the debt financing of firms show that risk-sensitive bank capital requirements have adverse distributional consequences for firms, as argued by Diamond and Rajan (2000), Kashyap and Stein (2004), and Allen et al. (2012). When combined with the evidence of increased reliance of HCC firms on bond financing, this strengthens the identification of the key findings as outcomes of the credit supply shock induced by Basel II implementation. The indirect effects of Basel II documented in the study suggest that adversely affected firms attempt to mitigate the consequences of Basel II implementation through a combination of lower shareholder payouts, increased reliance on trade credit, and reduced capital investments.

Our study on the impact of Basel II implementation contributes to the literature on the real impact of changes in bank capital regulation (Acharya, Steffen, 2015, Hasan, Kim, Wu, 2015, Demir, Michalski, Ors, 2017, Gropp, Mosk, Ongena, Wix, 2019, Fraisse, Lé, Thesmar, 2020). Acharya and Steffen (2015) find that under-capitalized banks shifted investments to sovereign bonds with lower capital charges to comply with Basel II in the period leading up to the Eurozone crisis. Gropp et al. (2019) find that European banks subjected to higher capital requirements reduced lending to corporate customers. Fraisse et al. (2020) show that the changes in bank capital requirements due to Basel II implementation in France resulted in lower lending to firms, and a consequent reduction in investment and employment. Hasan et al. (2015) find that bank flows from G-10 countries have become more sensitive to rating changes of destination countries on account of Basel II. In Turkey, Basel II has led to a decrease in the issuance of letters of credit by banks for counterparties with a higher risk (Demir et al., 2017). The preceding studies present evidence of a reallocation of assets by banks due to the regulatory change. To the best of our knowledge, our paper is the first to examine the changes in firm behavior as an outcome of the implementation of risk-sensitive bank capital regulations in a cross-country setting. Notably, we complement the single-country studies of Fraisse et al. (2020) and Demir et al. (2017) on the real effects of Basel II.

The remainder of the paper is as follows. In the next section, we provide the conceptual background of our study and formulate the key hypotheses. Then, we describe the methodology and data employed for our estimations. The subsequent section discusses the key findings and their implications, followed by sections on the heterogeneous impact of Basel II and robustness tests. The final section concludes the study with implications of the findings.