DP11607 A positive analysis of bank behaviour under capital requirements
|Author(s):||Saleem Bahaj, Frédéric Malherbe|
|Publication Date:||November 2016|
|Programme Areas:||Financial Economics, Monetary Economics and Fluctuations, Macroeconomics and Growth|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=11607|
We propose a theory of bank behaviour under capital requirements. The sign of the lending response to a change in capital requirement is ambiguous due to the interplay between risk-taking incentives and debt overhang considerations. Optimal lending is typically U-shaped in the capital requirement. Changes in expected returns on loans shift this relationship. The lower expected returns the lower its slope. Using UK regulatory data (1989-2007), we find support for this prediction. It follows that a bank mainly adjusts to a higher capital requirement through cutting lending when expected returns are low, and by raising capital when they are high.