DP11607 A positive analysis of bank behaviour under capital requirements

Author(s): Saleem Bahaj, Frédéric Malherbe
Publication Date: November 2016
Keyword(s):
JEL(s): G21, G28
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.