Credit cycle and balancing the capital gap: Evidence from Korea

This paper examines balance sheet adjustments of a banking sector due to credit cycles using data from national and regional banks in South Korea, which is a leading emerging market. Specifically, banks’ target capital ratios are estimated and compared with actual capital ratios to identify capital gaps, and the responses to the gaps are then analyzed using a panel model. The empirical results show that the expansion of the credit-to-GDP gap increases the target capital, hence reducing the capital gap. Additionally, changes in the capital gap impact banks’ asset compositions and managerial behaviors. A decrease in the capital gap lowers the growth rate of total assets, risk-weighted assets, and loan obligations, but increases the growth rate of core capital relative to risky assets by a higher degree than that of the risk-weighted assets itself. Similar results are shown in various cases using other popular indicators as predictor variables for credit cycles.