## wp1724

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---

### I. Introduction and key conclusions
- Basel III emphasizes higher capital quality and higher capital ratios as a key prudential tool.
- Two bank responses to higher capital-adequacy requirements could raise macroeconomic costs:
  - Widening spreads between lending and deposit rates to boost net income.
  - Reducing assets and loans.
- Paper scope and sample:
  - Five largest banks in each of: Bulgaria, the Czech Republic, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia for 2008—2014.
  - Final sample: 38 commercial banks out of 45 (data availability over entire period).
- Key high-level conclusions:
  - Most banks in the EU emerging-market countries used retained earnings to increase capital adequacy ratios.
  - Where profitability struggled, banks used issuance of new equity or balance-sheet shrinkage (mainly by lending less).
  - Accumulation of capital through retained earnings is considered a benign strategy of capital accumulation from a macroeconomic perspective.

### II. Data, definitions, and methodology
- Data sources and definitions:
  - Bankscope balance sheets and income statements (unconsolidated where available; consolidated if unconsolidated unavailable).
  - Definition of capital based on Basel II standards over the whole period.
  - Risk weighted assets as reported by Bankscope used in CAR computations.
- Decomposition framework (Cohen and Scatigna (2014) log-linearized identity):
  - Capital components: B = capital (equity, book value); B_NI = newly-issued equity; NI = net income (comprehensive); Div = paid dividends; Rev = revaluations; RWA = risk weighted assets; TA = total assets.
  - Capital accumulation decomposed into newly issued equity (B_NI), retained earnings (NI adjusted for Div), and revaluations.
  - Net income decomposed: NI = NII + NOI + TaxRev, where NII = net interest income, NOI = net operating income (net non-interest income), TaxRev = other net income (mainly taxes paid and revaluations).
- Strategy ranking (least to most macroeconomically costly, informed by Roger and Vlcek (2011)):
  1. Issue new equity (dilution)
  2. Reduce dividend payments and/or return on equity
  3. Increase retained earnings by:
     - 3a) Increasing operating efficiency (raise net income while keeping spreads and dividends unchanged)
     - 3b) Increasing net income through higher lending margins (keeping dividends unchanged)
  4. Reduce risk-weighted assets by:
     - 4a) Shift loan composition toward assets perceived as less risky (e.g., government bonds)
     - 4b) Cut overall size of loan portfolios or slow growth (most costly)

### III. Macroeconomic scenarios and illustrative costs (Roger and Vlcek, 2011 findings reproduced)
- Scenario: 1 p.p. increase in capital requirements over a two-year horizon. Peak lending spread (basis points) and peak of output decline (%) under alternative scenarios:
  - Peak lending spread (basis points):
    - Euro Area: 50, 60, 13, 60
    - US: 40, 70, 15, 62
  - Peak of output decline (%):
    - Euro Area: -0.3, -0.3, -0.5, -0.6
    - US: -0.2, -0.3, -0.5, -0.6
  - Transition costs (% p.a.), computed as cumulative output loss over the simulation period:
    - Euro Area: -0.6, -1.0, -1.3, -2.0
    - US: -0.4, -1.0, -1.5, -2.1

### IV. CAR dynamics (2008—2014): aggregate patterns and country-level decomposition
- Aggregate pattern:
  - Capital to risk weighted assets increased in all countries: from about 10—15 percent in 2008 to about 15—25 percent in 2014 (an increase by almost 1 pp on average per year).
  - Countries with largest increases: Latvia, Lithuania, Slovenia.
  - Basel III phase-in started in 2013; CAR increases during 2008—2014 reflect regulatory signaling and crisis-driven deleveraging/de-risking.
- Country-level CAR changes and decomposition (2008 → 2014; change and cumulative contributions in percentage points; contributions sum to Change):
  - BLG: 14.8 → 18.8; Change 4.0; Accumulation of capital 5.4; RWA to TA 4.1; Total Assets -5.5
  - CZE: 10.4 → 16.5; Change 6.1; Accumulation of capital 6.9; RWA to TA 2.5; Total Assets -3.3
  - HUN: 13.2 → 16.3; Change 3.1; Accumulation of capital 0.6; RWA to TA 2.8; Total Assets -0.3
  - LAT: 13.8 → 23.1; Change 9.3; Accumulation of capital 5.1; RWA to TA 6.1; Total Assets -1.9
  - LIT: 13.4 → 23.6; Change 10.2; Accumulation of capital 4.1; RWA to TA 6.2; Total Assets -0.1
  - POL: 11.1 → 14.4; Change 3.3; Accumulation of capital 8.0; RWA to TA 1.4; Total Assets -6.1
  - ROM: 13.6 → 16.9; Change 3.3; Accumulation of capital 1.7; RWA to TA 4.5; Total Assets -2.9
  - SLO: 10.9 → 22.8; Change 11.9; Accumulation of capital -3.0; RWA to TA 8.2; Total Assets 6.7
  - SVK: 9.4 → 17.8; Change 8.4; Accumulation of capital 8.1; RWA to TA 1.3; Total Assets -1.0
- Interpretation:
  - Positive RWA to TA contributions in all countries indicate banks reduced portfolio riskiness (Strategy 4a used widely).
  - Where Total Assets contribution is negative (BLG, CZE, LAT, POL, ROM, SVK), balance-sheet expansion partially offset CAR gains; accumulation of capital was the main positive contributor.
  - SLO shows accumulation of capital contributed negatively and relied on asset shrinkage and risk-weighting changes.
  - In countries with growing total assets, accumulation of capital contributed roughly twice as much as the reduction in riskiness to CAR increases.

### V. Equity accumulation decomposition (normalized by 2008 RWA)
- Country-level equity (2008 → 2014) and contributions (Change; Net Income; Dividends; Newly issued Equity; Revaluations):
  - BLG: 14.2 → 22.5; Change 8.3; Net Income 11.1; Dividends -5.4; Newly issued Equity 2.8; Revaluations -0.2
  - CZE: 14.1 → 24.8; Change 10.7; Net Income 18.6; Dividends -11.8; Newly issued Equity 2.0; Revaluations 1.9
  - HUN: 11.8 → 13.7; Change 1.9; Net Income -0.1; Dividends -2.3; Newly issued Equity 5.0; Revaluations -0.7
  - LAT: 13.0 → 18.5; Change 5.6; Net Income 2.3; Dividends -2.9; Newly issued Equity 6.0; Revaluations 0.2
  - LIT: 12.9 → 19.1; Change 6.2; Net Income 0.2; Dividends -0.3; Newly issued Equity 6.2; Revaluations 0.1
  - POL: 12.1 → 25.6; Change 13.5; Net Income 15.5; Dividends -7.7; Newly issued Equity 4.2; Revaluations 1.5
  - ROM: 12.7 → 16.3; Change 3.6; Net Income 3.0; Dividends -1.2; Newly issued Equity 1.2; Revaluations 0.6
  - SLO: 8.9 → 10.0; Change 1.1; Net Income -17.9; Dividends -0.1; Newly issued Equity 18.7; Revaluations 0.4
  - SVK: 11.0 → 19.6; Change 8.6; Net Income 11.5; Dividends -6.9; Newly issued Equity 3.6; Revaluations 0.4
- Key findings:
  - In most countries with growing balance sheets, equity accumulation relied mainly on retained earnings (Net Income contribution) rather than newly issued equity.
  - Newly issued equity accounted for about one third of equity increases in many cases.
  - Less-profitable or loss-making sectors (e.g., SLO, LIT, HUN) relied more on newly issued equity and reduced or stagnant balance sheets.
  - Dividend contributions are often negative (dividend payments reduced the equity contribution), indicating reluctance to cut payout ratios in many cases.

### VI. Profitability, net income components, loan volumes, and lending spreads
- Profitability and income composition:
  - Return on assets declined towards advanced-country levels; profitability remained above advanced-country averages for many countries, but Hungary, Latvia, Lithuania, and Slovenia faced profitability issues.
  - Net other income (mainly taxes and revaluations) became more negative and more than doubled in most countries in 2008—2014.
- Operating efficiency:
  - Most banking sectors reduced operating costs supporting return on assets (consistent with Strategy 3a), except HUN, SLO, and SVK where net operating income did not improve.
- Net interest income:
  - Increased above pre-crisis period in CZE, HUN, ROM, and SVK; declined in other countries.
- Loan volumes and funding:
  - Share of loans in total assets increased in all countries except HUN and LAT.
  - About half of the banking sectors increased loans-to-deposits ratios.
  - Higher loan shares and higher loans-to-deposits ratios did not lead to higher measured asset risk (RWA/TA declined).
- Lending spreads:
  - No observed increase in lending spreads in 2008—2014 above the pre-crisis average; most countries reduced spreads compared to pre-crisis levels.
  - Exceptions with higher spreads: HUN and SLO.

### VII. Synthesis of observed adjustment strategies and macroeconomic implications
- Predominant observed strategies:
  - Profitable banking sectors: mainly retained earnings (Strategy 3a), stable dividends, expanding balance sheets — considered the most benign from a macroeconomic perspective.
  - Struggling banking sectors: reliance on newly issued equity (Strategy 1) and reduction in asset riskiness (Strategy 4a); often accompanied by balance-sheet contraction (Strategy 4b), which is the most costly macroeconomically.
- Cross-country patterns:
  - Banks used combinations of strategies rather than a single channel to raise CARs.
  - Risk-weight reduction (RWA/TA decline) was pervasive across all countries.
  - The feared widespread lending retrenchment from higher capital requirements did not materialize across Emerging Europe as a whole.
- Policy-relevant conclusion:
  - Profitability matters: profitable sectors adjust via retained earnings and efficiency gains (lower macroeconomic cost), while weaker sectors rely on new equity injections and asset-side adjustments (higher macroeconomic cost).
  - Increases in CARs reflect a mix of regulatory anticipation (Basel III signaling), crisis-driven de-risking, and country-specific fundamentals; policy assessments should account for heterogeneity across banking sectors.

### VIII. Appendix highlights
- Capital accumulation identity and log-linearized decomposition provided to link observed accounting flows to CAR changes.
- Stylized facts:
  - Banks in EU emerging markets are highly profitable in aggregate, with narrow distribution of CARs and relatively homogeneous loan shares of assets.
  - HUN, LIT and SLO deleveraged measured by shares of loans and assets in GDP; other countries saw continued growth.
- Leverage arithmetic and WACC implications (illustrative assumptions and tabulated WACC):
  - WACC = RoE * E/(D+E) + RoD * (1- E/(D+E))
  - Illustrative assumptions: RoD = 0.05; RoE = 0.15.
  - Reported numerical implications:
    - Increasing the share of equity in total liabilities from 10% to 20% raises WACC by 1 percentage point.
    - Going from 3% to 5% increases WACC by 20 basis points.
  - Selected E/(D+E) and corresponding WACC values:
    - E/(D+E) = 0.02 -> WACC = 0.052
    - E/(D+E) = 0.03 -> WACC = 0.053
    - E/(D+E) = 0.05 -> WACC = 0.055
    - E/(D+E) = 0.1  -> WACC = 0.06
    - E/(D+E) = 0.15 -> WACC = 0.065
    - E/(D+E) = 0.2  -> WACC = 0.07
    - E/(D+E) = 0.25 -> WACC = 0.075
    - E/(D+E) = 0.3  -> WACC = 0.08
    - E/(D+E) = 0.35 -> WACC = 0.085
    - E/(D+E) = 0.4  -> WACC = 0.09
    - E/(D+E) = 0.45 -> WACC = 0.095
    - E/(D+E) = 0.5  -> WACC = 0.1
    - E/(D+E) = 0.55 -> WACC = 0.105

*Source: wp1724 (excerpt).*

### References .............................................................................................................

### wp1724 - References

### I. INTRODUCTION
- Basel III regulatory reform emphasizes higher capital quality and higher capital ratios as a key prudential tool.
- Concerns about macroeconomic costs arise from two potential bank responses to higher capital-adequacy requirements:
  - Widening spreads between lending and deposit rates to boost net income.
  - Reducing assets and loans.
- Both strategies could result in a credit slowdown with adverse effects on real economic activity.
- Banks can adjust to higher capital requirements in multiple ways; the structure of adjustment matters for macroeconomic costs.
- This paper assesses strategies used by commercial banks in EU emerging-market countries to meet tighter regulatory measures introduced with the start of the world financial crisis.
- Data and scope:
  - Five largest banks in each of: Bulgaria, the Czech Republic, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia.
  - The paper assesses how banks reacted to capital requirements and possible implications for macroeconomic costs of the adjustment.
- Key conclusion summary:
  - Most banks in the EU emerging-market countries used retained earnings to increase capital adequacy ratios.
  - Where banking-sector profitability struggled, banks resorted to issuance of new equity or shrinkage of balance sheets, mainly by lending less, to meet higher capital-adequacy requirements.
  - Accumulation of capital through retained earnings is considered a benign strategy of capital accumulation from a macroeconomic perspective.

### II. THEORY AND RELATED LITERATURE
- Modigliani-Miller Theorem (MMT) background and relevance:
  - MMT states that under efficient-market assumptions an increase in the share of equity relative to liabilities lowers the riskiness of the bank and lowers the cost of equity, preserving the total cost of liabilities.
  - MMT implies debt-equity ratio should not affect firm market value; deviations from MMT can occur when assumptions (efficient markets, absence of bankruptcy costs, tax-code frictions) do not hold.
  - The paper treats MMT as a useful benchmark even for emerging markets while recognizing potential larger deviations there.
- Selected empirical and modeling findings cited:
  - Kashyap and others (2010):
    - Using a panel of US publicly-traded banks from 1976—2008, they compute that a ten-percentage-point increase in the capital-adequacy requirement would increase the weighted-average cost of capital by about 25 basis points (bp), or up to 45 bp using extreme assumptions.
    - These are steady-state results; transition path may be more costly, arguing for gradual phase-in of Basel III rules.
  - Miles and others (2013):
    - For the United Kingdom, if leverage falls by half, the weighted average cost of capital increases by 18 – 33 bp.
  - Macroeconomic Assessment Group (2010) and Basel Committee on Banking Supervision (2010) ex-ante assessments:
    - Both studies assumed bulk of adjustment comes through lending spreads without a change in required return on equity.
    - Macroeconomic Assessment Group (2010) estimated that a 1 percentage point (pp) increase in capital ratios over 4 years would raise interest rate spreads by around 15 bp, pushing down lending volume by approximately 1.5 percent and causing real GDP to decline by about 0.2 percent from the baseline path at the trough.
    - Basel Committee on Banking Supervision (2010) estimated that a 1 pp increase in capital implies higher spreads by 13 bp in the long run, leading to 0.1 percent decline in the output level compared to the baseline.
  - Roger and Vlcek (2011):
    - Found modest macroeconomic impacts of Basel III, but macroeconomic costs vary by adjustment strategy.
    - Lowest private macroeconomic costs when capital is raised by retaining earnings through a lower dividend payout ratio.
    - Raising capital by widening lending spreads increases macroeconomic costs by roughly one half relative to the retained-earnings strategy.
    - Reducing bank assets more than doubles macroeconomic costs compared to the retained-earnings strategy; asset reduction is most likely when a very rapid adjustment in capital ratio is required.
    - Costs of adjustment are much less if cuts in lending are to the riskiest clients.
  - Cohen (2013) and Cohen and Scatigna (2014):
    - Assessment of 94 of the world’s largest banks for 2008—2012 found banks mainly used retained earnings to meet higher regulatory standards.
    - Wider lending spreads and lower dividend payouts contributed to retained earnings.
    - On average, banks continued to expand lending with a lesser role for reductions in asset riskiness.
- This paper builds on and extends Cohen and Scatigna (2014) by using accounting data for individual banks and decomposing cumulative change in capital-to-risk-weighted-asset ratios, equity growth, and dynamics of net income.
- Stylized facts for banks in the EU emerging-market countries:
  - These banks are small by world-asset-size ranking.
  - Most are subsidiaries with a parent in an advanced country.
  - All banks in the sample had a CAR above the 8 percent regulatory minimum at the sample start.

### Findings and implications emphasized in the paper
- Bank adjustment strategies observed or discussed:
  - Retained earnings as the primary source of capital accumulation for most banks in the sample.
  - Issuance of new equity used where profitability was insufficient to generate retained earnings.
  - Balance-sheet shrinkage, mainly via reduced lending, occurred in some less-profitable banking sectors.
- Macroeconomic implications:
  - Retained-earnings-based capital accumulation is viewed as the least costly for real activity.
  - Strategies that involve higher lending spreads or asset reductions are associated with larger macroeconomic costs.

*Source: wp1724 - References (excerpt).*

### 2008. Furthermore, 29 banks out of 38 in our sample had a CAR above 10.5 percent (8

### wp1724 - 2008.

### Key facts and sample
- Sample: five largest banks in each of Bulgaria (BLG), Czech Republic (CZE), Hungary (HUN), Latvia (LAT), Lithuania (LIT), Poland (POL), Romania (ROM), Slovakia (SVK), and Slovenia (SLO) for 2008—2014.  
- Estonia excluded because data do not cover the period of interest.  
- Final sample: 38 commercial banks out of 45 (data availability over entire period).  
- 29 banks out of 38 in our sample had a CAR above 10.5 percent (8 percent as regulatory minimum and 2.5 percent as a conservation buffer).  
- Data sources and definitions: Bankscope balance sheets and income statements (unconsolidated where available; consolidated if unconsolidated unavailable). Definition of capital based on Basel II standards over the whole period. Risk weighted assets as reported by Bankscope used in CAR computations.

### Data and methodology
- Decomposition framework: Cohen and Scatigna (2014) log-linearized identity linking capital accumulation, changes in riskiness (RWA/TA), and total asset growth. Key accounting identity components:
  - B = capital (equity, book value)
  - B_NI = newly-issued equity (proxy for newly issued capital)
  - NI = net income (comprehensive)
  - Div = paid dividends
  - Rev = revaluations
  - RWA = risk weighted assets, TA = total assets
- Accumulation of capital decomposed into:
  - Newly issued equity (퐵푁퐼)
  - Retained earnings (net income adjusted for dividends)
  - Revaluations
- Net income further decomposed: NI = NII + NOI + TaxRev, where
  - NII = net interest income
  - NOI = net operating income (net non-interest income)
  - TaxRev = other net income (mainly taxes paid and revaluations)
- Strategy ranking (from least to most macroeconomically costly, informed by Roger and Vlcek (2011) results):
  1. Issue new equity (dilution)
  2. Reduce dividend payments and/or return on equity
  3. Increase retained earnings by:
     - 3a) Increasing operating efficiency (raise net income while keeping spreads and dividends unchanged)
     - 3b) Increasing net income through higher lending margins (keeping dividends unchanged)
  4. Reduce risk-weighted assets by:
     - 4a) Shift loan composition toward assets perceived as less risky (e.g., government bonds)
     - 4b) Cut overall size of loan portfolios or slow growth (most costly)

### Macroeconomic scenarios and illustrative costs (Roger and Vlcek, 2011 — Table 1 reproduced as findings)
- 1 p.p. increase in capital requirements over a two-year horizon. Peak lending spread (basis points) and peak of output decline (%) under alternative scenarios:
  - Peak lending spread (basis points):
    - Euro Area: 50, 60, 13, 60
    - US: 40, 70, 15, 62
  - Peak of output decline (%):
    - Euro Area: -0.3, -0.3, -0.5, -0.6
    - US: -0.2, -0.3, -0.5, -0.6
  - Transition costs (% p.a.), computed as cumulative output loss over the simulation period:
    - Euro Area: -0.6, -1.0, -1.3, -2.0
    - US: -0.4, -1.0, -1.5, -2.1

### CAR dynamics (2008—2014) — aggregate patterns and magnitudes
- Capital to risk weighted assets increased in all countries: from about 10—15 percent in 2008 to about 15—25 percent in 2014 (an increase by almost 1 pp on average per year).
- Countries with largest increases: Latvia, Lithuania, Slovenia (associated with banking sector problems or crisis).
- Basel III phase-in started in 2013; however, CAR increases during 2008—2014 reflect both regulatory signaling and crisis-driven deleveraging/de-risking.

### CAR decomposition results (Table 3 findings; all values are cumulative contributions in percentage points)
- Country-level CAR (Capital to RWA) and decomposition (2008 → 2014; Change = column 3; contributions columns sum to Change):
  - BLG: 14.8 → 18.8; Change 4.0; Accumulation of capital 5.4; RWA to TA 4.1; Total Assets -5.5
  - CZE: 10.4 → 16.5; Change 6.1; Accumulation of capital 6.9; RWA to TA 2.5; Total Assets -3.3
  - HUN: 13.2 → 16.3; Change 3.1; Accumulation of capital 0.6; RWA to TA 2.8; Total Assets -0.3
  - LAT: 13.8 → 23.1; Change 9.3; Accumulation of capital 5.1; RWA to TA 6.1; Total Assets -1.9
  - LIT: 13.4 → 23.6; Change 10.2; Accumulation of capital 4.1; RWA to TA 6.2; Total Assets -0.1
  - POL: 11.1 → 14.4; Change 3.3; Accumulation of capital 8.0; RWA to TA 1.4; Total Assets -6.1
  - ROM: 13.6 → 16.9; Change 3.3; Accumulation of capital 1.7; RWA to TA 4.5; Total Assets -2.9
  - SLO: 10.9 → 22.8; Change 11.9; Accumulation of capital -3.0; RWA to TA 8.2; Total Assets 6.7
  - SVK: 9.4 → 17.8; Change 8.4; Accumulation of capital 8.1; RWA to TA 1.3; Total Assets -1.0
- Interpretation of contributions:
  - Positive RWA to TA contributions in all countries indicate banks reduced portfolio riskiness (Strategy 4a used widely).
  - Where Total Assets contribution is negative (BLG, CZE, LAT, POL, ROM, SVK), balance-sheet expansion partially offset CAR gains; accumulation of capital was the main positive contributor.
  - Where Total Assets contribution is positive (SLO) or small, balance-sheet contraction (Strategy 4b) helped raise CARs; SLO shows accumulation of capital contributed negatively, indicating reliance on asset shrinkage and risk-weighting changes.
  - In countries with growing total assets, accumulation of capital contributed roughly twice as much as the reduction in riskiness to CAR increases.

### Equity accumulation decomposition (Table 4 findings; values normalized by 2008 RWA)
- Equity in 2008 to RWA_base → Equity in 2014 to RWA_base → Change; Contributions: Net Income, Dividends, Newly issued Equity, Revaluations
  - BLG: 14.2 → 22.5; Change 8.3; Net Income 11.1; Dividends -5.4; Newly issued Equity 2.8; Revaluations -0.2
  - CZE: 14.1 → 24.8; Change 10.7; Net Income 18.6; Dividends -11.8; Newly issued Equity 2.0; Revaluations 1.9
  - HUN: 11.8 → 13.7; Change 1.9; Net Income -0.1; Dividends -2.3; Newly issued Equity 5.0; Revaluations -0.7
  - LAT: 13.0 → 18.5; Change 5.6; Net Income 2.3; Dividends -2.9; Newly issued Equity 6.0; Revaluations 0.2
  - LIT: 12.9 → 19.1; Change 6.2; Net Income 0.2; Dividends -0.3; Newly issued Equity 6.2; Revaluations 0.1
  - POL: 12.1 → 25.6; Change 13.5; Net Income 15.5; Dividends -7.7; Newly issued Equity 4.2; Revaluations 1.5
  - ROM: 12.7 → 16.3; Change 3.6; Net Income 3.0; Dividends -1.2; Newly issued Equity 1.2; Revaluations 0.6
  - SLO: 8.9 → 10.0; Change 1.1; Net Income -17.9; Dividends -0.1; Newly issued Equity 18.7; Revaluations 0.4
  - SVK: 11.0 → 19.6; Change 8.6; Net Income 11.5; Dividends -6.9; Newly issued Equity 3.6; Revaluations 0.4
- Key findings:
  - In most countries with growing balance sheets, equity accumulation relied mainly on retained earnings (Net Income contribution) rather than newly issued equity; newly issued equity accounted for about one third of equity increases in many cases.
  - Banks generally avoided cutting dividends (dividend contributions often negative but banks reluctant to reduce payout ratios); dividend stability suggests parent-subsidiary relationships influenced payout behavior.
  - Less profitable or loss-making banking sectors (e.g., SLO, LIT, HUN) relied more on newly issued equity (often public sources or parent injections) and reduced or stagnant balance sheets.

### Net income, profitability, loan volumes, and spreads
- Profitability:
  - Return on assets declined towards advanced-country levels; profitability remained above advanced-country averages for many countries, but Hungary, Latvia, Lithuania, and Slovenia faced profitability issues.
  - Net other income (mainly taxes and revaluations) became more negative and more than doubled in most countries in 2008—2014, dampening net income on assets.
- Operating efficiency:
  - Most banking sectors reduced operating costs supporting return on assets (consistent with Strategy 3a), except HUN, SLO, and SVK where net operating income did not improve.
- Net interest income:
  - Increased above pre-crisis period in CZE, HUN, ROM, and SVK; declined in other countries.
  - Net interest income determined by loan/deposit volumes and interest spreads.
- Loan volumes and funding:
  - Share of loans in total assets increased in all countries except HUN and LAT.
  - About half of the banking sectors increased loans-to-deposits ratios.
  - Higher loan shares and higher loans-to-deposits ratios did not lead to higher measured asset risk (RWA/TA declined).
- Lending spreads:
  - No observed increase in lending spreads in 2008—2014 above the pre-crisis average; most countries reduced spreads compared to pre-crisis levels, except countries with banking problems (HUN and SLO) where spreads were higher.

### Synthesis of adjustment strategies and macroeconomic implications
- Predominant bank strategies observed:
  - Profitable banking sectors: mainly retained earnings (Strategy 3a), stable dividends, expanding balance sheets — considered the most benign from a macroeconomic perspective.
  - Struggling banking sectors: reliance on newly issued equity (Strategy 1) and reduction in asset riskiness (Strategy 4a); often accompanied by balance-sheet contraction (Strategy 4b), which is the most costly macroeconomically.
- Cross-country pattern:
  - Banks used combinations of strategies rather than a single channel to raise CARs.
  - Risk-weight reduction (RWA/TA decline) was pervasive across all countries.
  - Evidence suggests the feared widespread lending retrenchment from higher capital requirements did not materialize across Emerging Europe as a whole.

### Conclusion (policy-relevant findings)
- The threat of notable lending reduction in response to higher capital requirements did not materialize broadly in Emerging Europe during 2008—2014.
- Profitability matters: profitable banking sectors tend to adjust via retained earnings and efficiency gains (lower macroeconomic cost), while weaker sectors rely on new equity injections and asset-side adjustments (higher macroeconomic cost).
- Regulatory and macroeconomic context: increases in CARs reflect a mix of regulatory anticipation (Basel III signaling), crisis-driven de-risking, and country-specific fundamentals; policy assessments should account for heterogeneity across banking sectors.

*Source: wp1724 - 2008. (Bankscope and authors’ computations; Roger and Vlcek (2011); Cohen and Scatigna (2014) referenced in source).*

### References

### References

### Key cited works
- Admati, A., P.M. DeMarzo, M. Hellwig, and P. Pfleiderer, 2013: Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive, GSB Stanford, mimeo.
- Admati, A. and M. Hellwig, 2013: The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It, Princeton University Press.
- Andrle, M., Kumhof, M., Laxton, D. and D. Muir, 2015: “Banks in Global Integrated Monetary and Fiscal Model”, IMF Working Paper 55/15.
- Basel Committee on Banking Supervision, 2010: “An Assessment of the Long-term Economic Impact of Stronger Capital and Liquidity Requirements”, Retrieved from BIS website: http://www.bis.org/publ/bcbs173.pdf
- Cohen, B. H., 2013. “How Have Banks Adjusted to Higher Capital Requirements?” in BIS Quarterly Review, September 2013. BIS.
- Cohen, B. H. and M. Scatigna, 2014. “Banks and Capital Requirements: Channels of Adjustment.” BIS Working Paper No. 443, BIS.
- European Systemic Risk Board, 2015. “ESRB report on the regulatory treatment of sovereign exposures,” ESRB.
- Kashyap, A.K., J.C. Stein and S. Hanson, 2010: “An Analysis of the Impact of `Substantially Heightened’ Capital Requirements on Large Financial Institutions”, University of Chicago, Booth School of Business, mimeograph.
- Macroeconomic Assessment Group, 2010: “Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements: Final Report”. Retrieved from BIS website: http://www.bis.org/publ/othp12.pdf.
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### Appendix: Capital Accumulation Decomposition (A)

### Identity and definitions
- Starting identity:
  - 퐵푡 = 퐵푡−1 + 퐵푡푁퐼 + 퐼푛푐표푚푒푡 − 퐷푖푣푡.
  - Where 퐵 is capital, 퐵푁퐼 is newly issued capital, 퐼푛푐표푚푒 is a sum of net income and other income, and 퐷푖푣 are dividend payments.
- After dividing by 퐵푡−1 and by risk weighted assets 푅푊퐴:
  - 퐵푡/푅푊퐴푡 퐵푡−1/푅푊퐴푡−1 = (1+ 퐵푡푁퐼/퐵푡−1 + 퐼푛푐표푚푒푡/퐵푡−1 − 퐷푖푣푡/퐵푡−1) 푅푊퐴푡/푇퐴푡 푅푊퐴푡−1/푇퐴푡−1 푇퐴푡/푇퐴푡−1

### Log-linearized decomposition
- After log-linearization:
  - 퐵푡푅푊퐴푡 − 퐵푡−1푅푊퐴푡−1 = 푆[ln(1+ 퐵푡푁퐼/퐵푡−1 + 퐼푛푐표푚푒/퐵푡−1 − 퐷푖푣푡/퐵푡−1) − ln(푅푊퐴푡/푇퐴푡 푅푊퐴푡−1/푇퐴푡−1) − ln(푇퐴푡/푇퐴푡−1)]
- Scaling factor S equals:
  - 푆 = (퐵푡푅푊퐴푡 − 퐵푡−1푅푊퐴푡−1) / ln(퐵푡푅푊퐴푡 / 퐵푡−1푅푊퐴푡−1)

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### Appendix: Stylized Facts (B)

### Banking sector profitability and dispersion
- Banks in EU emerging markets are highly profitable despite the real economy slowdown in the wake of the recent financial crisis.
- Banking sectors in these countries reached the highest average return on assets (RoA) in the EU.
- Countries with banking sector issues (Latvia, Slovenia, Hungary, and Lithuania) either experienced losses or low RoA.

### Distributional evidence (figures summarized)
- Figures present distributions of CAR, RoE, and loans as a share of assets using bank-level data aggregated across countries.
- Boxplot summary characteristics:
  - Boxes capture quartiles; tick line is the median; vertical lines depict lower/higher extreme values; points/dots are outliers.
- Observations:
  - Relatively narrow distribution of CARs across banks with almost no downward outliers.
  - Share of loans as a share of total assets is relatively homogenous among banks.
  - RoE varies across banks from 0 to 20.

### Leverage and balance-sheet dynamics across countries
- The banking sectors in HUN, LIT and SLO deleveraged measured by shares of loans and assets in GDP.
- In contrast, the shares continued to grow in remaining countries.
- Figures referenced:
  - Figure B1: Average return on assets in EU countries in 2008—2014 (percent p.a.)
  - Figure B3: Capital Adequacy Ratio (CAR, %)
  - Figure B4: Return on Equity (%)
  - Figure B5: Loans Share of Assets
  - Figure B6: Assets and loans on GDP – only banks used in the paper, percent

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### Appendix: The Leverage Arithmetic (C)

### Two main quantitative points
- Even with a strong departure from the Modigliani-Miller Theorem (MMT), when the return on equity does not change, the weighted-average cost of capital does not increase in a dramatic manner.
- Banks are leveraged, which allows profitable banks to decrease their leverage quickly, should they choose to do so.

### 1) Weighted Average Cost of Capital (WACC) under deviation from MMT
- WACC formula:
  - WACC = RoE * E/(Debt+E) + RoD *(1- E/(Debt+E))
  - Where RoE is the return on equity, E stands for equity and RoD is the return on debt.
- Illustrative assumptions:
  - RoD = 0.05
  - RoE = 0.15
- Qualitative numerical implications reported:
  - Increasing the share of equity in total liabilities from 10% to 20% raises WACC by 1 percentage point.
  - Going from 3% to 5% increases WACC by 20 basis points.
- Empirical references:
  - Estimates (Kashyap and others (2010) and Miles and others (2012)) suggest the MMT “offsetting power” is about one half; hence the actual estimate is roughly one half of the effect if MMT does not hold.

### 2) Leverage dynamics: costs and benefits
- Leverage can hurt in bad times and boost profitability in good times.
- Profitable banks starting from a sizeable degree of leverage can decrease leverage in a relatively short period, depending on the use of profits.
- Options for banks using profits:
  - Significantly lengthen the maturity structure of their balance sheet and keep leverage unchanged.
  - Lower leverage.

### Numerical table excerpt (selected values)
- R_Equity = 0.15
- R_Debt = 0.05
- E/(D+E) values and corresponding WACC values listed:
  - E/(D+E) = 0.02 -> WACC = 0.052
  - E/(D+E) = 0.03 -> WACC = 0.053
  - E/(D+E) = 0.05 -> WACC = 0.055
  - E/(D+E) = 0.1  -> WACC = 0.06
  - E/(D+E) = 0.15 -> WACC = 0.065
  - E/(D+E) = 0.2  -> WACC = 0.07
  - E/(D+E) = 0.25 -> WACC = 0.075
  - E/(D+E) = 0.3  -> WACC = 0.08
  - E/(D+E) = 0.35 -> WACC = 0.085
  - E/(D+E) = 0.4  -> WACC = 0.09
  - E/(D+E) = 0.45 -> WACC = 0.095
  - E/(D+E) = 0.5  -> WACC = 0.1
  - E/(D+E) = 0.55 -> WACC = 0.105

*Content based on "wp1724 - References" (PDF chapter/section).*

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_Source: https://www.imf.org/-/media/files/publications/wp/wp1724.pdf_