auk Regulatory Agreements Real and Estate Lending

Recent studies have found that banks with low capital ratios have significantly decreased their lending to the real estate sector. This correlation between real estate lending and bank capital could be the result of voluntary decisions by banks to-recapitalize, or it could be the result of direct actions taken by bank regulators. We find that banks with low capital ratios reduce their real estate lending substantially more after formal regulatory actions have been initiated by regulators. Furthermore, this reduction in lending is particularly large for the categories of real estate borrowers most likely to be bank dependent. * Professor of Economics, Boston College, and Visiting Economist, Federal Reserve Bank of Boston ** Vice President and Economist, Federal Reserve Bank of Boston The authors thank Robert Chicoski and Lucille Rexroad for able research assistance. The views expressed in this paper are those of the authors and do not necessarily reflect positions of the Federal Reserve Bank of Boston or the Federal Reserve System. Bank Regulatory Agreements and Real Estate Lending Recent studies have highlighted the important role of bank capital in the reduction in real estate lending by banks during the past economic downturn (Peek and Rosengren 1994a; Hancock and Wilcox 1993, 1994a, 1994b). While the association between low levels of bank capital and reduced real estate lending has been established in these studies, a direct regulatory link to the reduction in real estate lending has not been clearly established. This paper examines the specific actions taken by regulators that would cause banks to reduce lending to the real estate sector and establishes such a link. As a bank’s financial condition deteriorates, regulators progressively increase the pressure on banks to take actions to improve their financial condition. If remedial action is necessary, regulators normally will require a bank’s board of directors to sign an informal agreement to undertake such actions, called a memorandum of understanding; usually it remains confidential. If the bank fails to abide by a memorandum of understanding, or if the bank’s financial condition is more serious, regulators will impose a formal action, which is legally enforceable and publicly disclosed. The major constraining factor in these regulatory actions is a requirement to improve capital ratios dramatically, usually within two years or less. Given their impaired financial condition, few of these banks are able to raise new equity at a cost they view as reasonable. Thus, given that many of these banks are reporting negative income, the only viable alternative for raising capital ratios for most of these troubled banks is to decrease