Bank Response to Higher Capital Requirements: Evidence from a Quasi-Natural Experiment

The Harvard Law School Forum on Corporate Governance and Financial Regulation 2018-05-24

Posted by Thomas C. Mosk (Goethe University Frankfurt), on Thursday, May 24, 2018
Editor's Note: Thomas C. Mosk is Assistant Professor of Finance at the Center of Excellence SAFE of the Goethe University Frankfurt. This post is based on an article forthcoming in the Review of Financial Studies by Professor Mosk; Reint Gropp, Professor of Economics at the Halle Institute for Economic Research; Steven Ongena, Professor of Banking at the University of Zurich; and Carlo Wix, Ph.D. candidate in Finance at Goethe University Frankfurt.

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 increase their regulatory capital ratios by either increasing their levels of regulatory capital (the numerator of the capital ratio) or by decreasing their levels of 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 if many banks simultaneously engage in cutting lending. In Banks Response to Higher Capital Requirements: Evidence from a Quasi-Natural Experiment, we study the impact of the 2011 European Banking Authority (EBA) capital exercise—which required a subset of European banks to increase their regulatory capital ratios—on banks’ balance sheets and the transmission of this regulatory intervention to the real economy.

We find that capital exercise banks increased their capital ratios by reducing their risk-weighted assets and not by raising their levels of equity. Banks reduced lending to corporate and retail customers, resulting in lower asset, investment, and sales growth for firms obtaining a larger share of their bank credit from capital exercise banks.