Capital Requirements and Bank Lending

Project Start:02/2014
Category: Financial Intermediation, Transparency Lab
Funded by:LOEWE

Topic and Objectives

This project studies the impact of higher capital requirements on banks’ balance sheets and its transmission to the real economy. Basel III, which will become fully effective in 2019, significantly increases capital requirements for banks. However, at this point, the economic implications of such higher capital requirements are still unclear. Banks can, in principle, increase their regulatory capital ratios in two different ways: they can either increase their levels of regulatory capital (the numerator of the capital ratio) or they can shrink their risk-weighted assets (the denominator of the capital ratio). While raising capital is generally considered “good deleveraging” by regulators, shrinking assets has potentially adverse effects on the supply of credit to the real economy if many banks simultaneously engage in cutting lending. How banks adjust their balance sheets in response to higher capital requirements is thus an empirical question of crucial importance for understanding the real implications of the higher capital requirements recently imposed under Basel III. The most important challenge in studying the effect of capital requirements is to find exogenous variation in capital requirements. Yet, capital requirements tend to vary little over time, and when they do change, they change for all banks in a given economic area at the same time, leaving no cross-sectional variation to exploit. We address these empirical challenges by exploiting the 2011 capital exercise, conducted by the European Banking Authority (EBA), as a quasi-natural experiment. The capital exercise required a subset of European banks to reach and maintain a 9% core tier 1 capital ratio by the end of June 2012. We exploit the country-specific selection rule of the EBA capital exercise, based on bank size, and compare EBA banks, subject to the higher capital requirements (i.e., our treatment group) with similar, other European banks not subject to higher capital requirements (i.e. our control group).

Key Findings

  • First, we document that EBA banks raised their regulatory capital ratios by 1.9 percentage points compared to banks not subject to the higher capital requirements. EBA banks achieved this by reducing their levels of risk-weighted assets by 16 percentage points rather than by increasing their levels of capital relative to the matched control group.
  • We show that this reduction in total assets can mainly be attributed to a reduction in outstanding customer loans. This finding, however, is not sufficient to conclude that the supply of credit by EBA banks contracted, since it might very well just reflect a reduction in credit demand by firms borrowing from EBA banks.
  • In order to disentangle credit supply from credit demand, we use syndicated loan data and find that EBA banks reduced their credit supply of syndicated loans by 27 percentage points relative to banks in the control group.
  • Ultimately, the degree to which a reduction in credit supply from EBA banks implies real effects at the firm level depends on the extent to which other banks, not subject to higher capital requirements, “pick up the slack”. Hence, we investigate how EBA banks’ reduction in lending due to the increase in capital requirements affects the growth of firms which obtain a larger share of their bank credit from EBA banks. We find that firms with a high EBA borrowing share exhibited 4 percentage points less asset growth, 6 percentage points less investment growth, and 5 percentage points less sales growth than firms less reliant on funding from EBA banks.

Policy Implications

An important policy implication of our paper is that capital requirements which target the regulatory capital ratio have potentially adverse effects on the real economy. As suggested by Hanson, Kashyap, and Stein (2011), targeting the absolute amount of new capital that has to be raised instead of the capital ratio could mitigate this problem, an approach which has been successfully applied in the U.S. stress tests conducted in 2009. In this context, our paper highlights the risks associated with capital regulation that focuses on capital ratios as the policy target variable while leaving it to the discretion of banks how to increase their capital ratios.

Related Published Papers

Author/sTitleYearProgram AreaKeywords
Reint Gropp, Thomas Mosk, Steven Ongena, Carlo WixBank Response to Higher Capital Requirements: Evidence from a Quasi-Natural Experiment
Review of Financial Studies
2019 Financial Intermediation, Transparency Lab Bank capital ratios, Bank regulation, Credit supply

Related Working Papers

No.Author/sTitleYearProgram AreaKeywords
156Reint Gropp, Thomas Mosk, Steven Ongena, Carlo WixBank Response to Higher Capital Requirements: Evidence from a Quasi-Natural Experiment2016 Financial Intermediation, Transparency Lab Bank capital ratios, Bank regulation, Credit supply