Discussion paper

DP11607 A positive analysis of bank behaviour under capital requirements

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.


Malherbe, F and S Bahaj (eds) (2016), “DP11607 A positive analysis of bank behaviour under capital requirements”, CEPR Press Discussion Paper No. 11607. https://cepr.org/publications/dp11607