Regulatory Arbitrage and Bad Loans
40 Pages Posted: 9 Jun 2014
Date Written: June 8, 2014
The banks’ forbearance lending to weak firms was one of primary reasons for the prolonged non-performing loan problem in Japan. We analyze whether regulatory arbitrage using lax enforcement of capital requirements was a motive for Japanese banks to continue loans to weak firms. We find evidence supporting the view that regulatory arbitrage was a motive of bad loans Two measures of regulatory arbitrage, the difference between the risk-based capital and the market-valued capital as a proportion of bank asset, and the subordinated debt as a proportion of bank asset, are useful in uncovering evidence that Japanese banks had the perverse incentive of extending bad loans in an attempt to inflate regulatory capital in the 1990s.
Keywords: regulatory arbitrage, bad loans, capital requirements, accounting discretion
JEL Classification: G21 G28
Suggested Citation: Suggested Citation