A positive analysis of bank behaviour under capital requirements

We propose a theory of bank behaviour under capital requirements that accounts for both risk-shifting incentives and debt overhang considerations. A key result is that the bank’s lending response to an increase in the requirement need not be negative. The sign and the magnitude of the response depend on the bank’s balance sheet and economic prospects, and lending is typically U-shaped in the requirement. Using UK regulatory data, we find empirical support for the hypothesis that a bank mainly adjusts to a higher requirement by cutting lending when expected returns are low, but by raising capital when they are high. (JEL Codes: G21, G28) ∗Corresponding author Frederic Malherbe at: London Business School, Regent’s Park NW1 4SA, London United Kingdom, tel: +442070008428, email: [email protected]. This paper draws extensively on the BoE Staff Discussion Paper (Bahaj et al. 2016) that we have written with Jonathan Bridges and Cian O’Neill. We thank them for their contribution and for allowing us to use this previous work. We are grateful to Courtney Escudier and Amar Radia for their help in compiling the bank panel data set used in this paper, to Sebastian Hohmann and Oleg Rubanov for outstanding research assistance, and to Heski Bar-Isaak, Max Bruche, Matthieu Chavaz, Carmelo Salleo, Stijn Ferarri, Peter Feldhutter, Tom Norman, Daniel Paravisini, José-Luis Peydro and Hélène Rey for their discussions and comments. David Curry, David Chilvers and Kenneth Duncan were kind enough to share their memories of how the UK regulatory regime operated under Basel 1. We also thank seminar and conference participants at the University of Zurich, the University of Bonn, the London Business School, the Bank of England, the Econometric Society European Summer Meetings, the ECB’s Macroprudential Research Group and the Dutch National Bank for useful feedback. The views expressed here are those of the authors and do not necessarily reflect those of the Bank of England, the MPC, the FPC or the PRA Board.