Credit Lines and Capital Adequacy

I show how capital regulations, by imposing a low or zero cost on undrawn credit lines, can lead to ex post misallocation of credit across different borrowers following a market shock. This effect is in addition to the liquidity impact of credit line drawdowns highlighted by previous literature. In a theoretical model, I examine why capital regulations give the bank an incentive to offer more credit lines than it would optimally want to support, fully drawn, on its balance sheet. I draw implications for both capital regulations and monetary policy. I also show suggestive empirical evidence consistent with this mechanism. When undrawn, credit lines generate surplus but face low cost: they generate surplus by providing a signal of firm quality to the market yet face low or zero capital requirements under Basel I and II. A bank has an incentive to build up exposure to credit lines in order to benefit from surplus in the good state. However, this will constrain its ability to provide credit to other borrowers when credit market turmoil causes firms to draw heavily on existing lines. I show how banks will reduce exposure if a sufficiently high capital charge is imposed on undrawn lines. I present implications for countercyclical capital regulation; a lower capital requirement in the bad state will serve to reduce misallocation in the bad state. I also show that a low interest rate in the good state will worsen misallocation in the bad state; if agents anticipate interest rates will be low in good times, banks will increase their exposure ex ante in order to benefit from the surplus generated in good times