Bank Credit Creation Under Basel Ⅲ Regulations

Strengthening financial regulation is the focus of China’s ongoing financial reform. Moreover, analyzing credit and money supply under bank regulation is a fundamental issue in the study of bank regulation. This paper adopts the credit creation theory of banking to explore this issue. The theory argues that banks create credit and money when they provide loans. This implies that deposit supply is no longer the main constraint on credit supply; bank regulation becomes a key constraint on credit and money creation. The paper analyzes the effects of capital adequacy ratios, leverage ratios, liquidity coverage ratios, and net stable funding ratios on credit and money supply. The paper discusses the impacts of capital shocks (credit defaults) or reserve shocks (deposit transfers) on credit and money supply under the regulations. The study finds that these shocks cause banks to expand or contract their balance sheets, leading to an increase or decrease in their credit and money supply. There is a multiplier relationship between the change in credit and money supply and the intensity of the shocks. Different regulations correspond to different multipliers. How the supply of credit and money is determined is the fundamental issue in the study of money and banking. I develop a model based on the credit creation theory of banking. The supply of deposits is not the main constraint on that of credit. Instead, bank regulations become the key constraints on the creation of credit and money. When banks comply with regulations, capital or reserve shocks affect credit and money supply. In response to the shocks, banks adjust their credit and money supply. These adjustments lie at the heart of the model and determine changes in banks’ abilities to create credit and money. The changes in the abilities present the impacts of capital or reserve shocks under the regulations. I find that the impacts are given by the multipliers that relate the shocks to the changes in the abilities. The different regulatory regimes correspond to differing multipliers. Under capital adequacy ratios or leverage ratios, banks deplete the credit and money supply in response to capital shocks. Either of the multipliers is greater than one. In response to reserve shocks, the effect under capital adequacy ratios differs from that under leverage ratios. If banks are subject to capital adequacy ratios, they do not react to reserve shocks. By contrast, subject to leverage ratios, banks will increase their credit supply by the size of reserve shocks. Under liquidity coverage ratios, banks either increase or decrease the credit and money supply in response to capital shocks. The reason is that capital shocks decrease both cash outflows (dividend payments) and cash inflows (loan repayments). Accordingly, the values of the liquidity coverage ratio may rise or fall after capital shocks. By contrast, by reducing high quality liquid assets, reserve shocks reduce the credit and money supply. The multipliers are larger than one. Under net stable funding ratios, either capital shocks or reserve shocks force banks to decrease the credit and money supply. The findings offer valuable insights for designing effective policies aimed at influencing the supply of credit and money.