Hand stacking piles of coins on top of wooden brick with words "Basel III" on it
VoxEU Column Financial Regulation and Banking

Capital requirements and lending: Basel III has something to teach us

The long-run benefits of bank capital strength are undisputed, but the short-term impacts on lending of stricter capital requirements are less obvious. This column shows that after Basel III was enforced in Italy in 2014, low-capitalised banks slowed down credit to firms and raised interest rates, compared to capital-strong lenders. They also rebalanced portfolios towards safer borrowers. However, surprising outcomes surface for banks in the lowest tail of capitalisation. The regulatory impact on lending eventually affects firms’ investment decisions.

Regulators and supervisors impose requirements on banks to guide their behaviour. Still, the effect of higher capital requirements on lending is debated, both theoretically and empirically. The issue is policy relevant, as shown by the attention that international bodies, including the Financial Stability Board, have devoted to this topic (Financial Stability Board 2018, 2019). Acharya et al. (2021) also suggest that regulators’ aggressive loosening can end up directing credit to suboptimal targets.

In the long run, the benefits of capital strength are hardly contended: large capital buffers enhance bank resilience, including against black swans (i.e. unforeseeable events) (Mendicino et al. 2021), and this should secure more stable lending flows. By contrast, in the short run, some scholars suggest that stricter risk-based capital requirements increase banks’ funding costs; this makes lending less attractive, at least during a transition phase (e.g. Aiyar et al. 2014, Aiyar et al. 2014, Acharya et al. 2018, Gropp et al. 2019). Others argue that an increase in capital requirements might, under some conditions, reduce average banks’ funding costs and thus create the conditions to increase bank lending (Begenau 2020, Admati et al. 2013, Bassett and Berrospide 2018). Finally, to complete the options on the shelf, recent papers open the door to a half-way conclusion: capital requirements depress lending up to a certain bindingness, but this impact becomes comparatively milder for banks that get particularly constrained; it could even be reverted for some lenders, for which stricter rules would eventually produce an increase in lending (Bahaj and Malherbe 2020).

To shed light on the issue, one can exploit quasi-natural experiments, coupled with granular data on firms, banks, and their relationships (Galardo and Vacca 2022). To do this, we need a few ingredients. First, an exogenous shock should break the timeline in a period before and a period after the shock. Second, it should be possible to separate the sample of banks into two subsamples, in order to compare their after-shock reactions: more affected banks versus less or unaffected banks.

For example, at the moment of the concrete adoption of the stricter Basel III capital requirements (the exogenous shock, in 2014), some Italian banks were more heavily affected than others: banks that had lower accumulated capital buffers at the moment the new rules entered into force might have modified their lending behaviour more clearly than their capital-richer peers. In which direction and with which consequences? In this column, we look at what happened in Italy in the period 2009-2018 and try to explore four possible consequences of a tighter capital regulation.

Credit and its cost

Capital is thought to be more expensive than debt. If banks facing stricter requirements experience an increase in the cost of funding, they should have fewer lending opportunities, and pass at least part of the higher funding costs onto borrowers. In our view, the post-Basel developments support this conclusion. In the first years after Basel III, more capital-constrained Italian banks experienced a weaker credit dynamic than other lenders did, 1 and their loans came at higher rates for firms. The annual growth of credit to firms is estimated to have been 1.5 percentage points lower for particularly affected banks compared to other banks. At the same time, the interest rate charged by affected banks was 16 basis points higher than the rate charged by banks affected to a lesser extent. 2

All these patterns are true even after controlling away a host of possible alternative drivers of what we observe in those years, and in particular disentangling demand-driven developments to insulate the supply side.

Relocating risk

Basel III requirements are risk-sensitive (Ambrocio and Jokivoulle 2018). Therefore, capital-constrained banks can react to higher requirements by reducing the average riskiness of their loan portfolio, rather than reducing the dollar size of this portfolio or slowing down the growth thereof, as assumed above. This potential relocation of bankers’ money from risky to safer borrowers is not necessarily an unintended effect of the regulation: Basel III aimed at sounder credit, rather than less credit.  

First, we class borrower firms into risk buckets, according to their probability to default in a one-year time. Then, we find that, in the early post-Basel period, the subgroup of most capital constrained banks reduced loans and raised the interest rates applied to the riskiest customers, when compared with capital-rich peers on the same footing. The same is true if one looks at loans to small and micro borrowers, which tend to fall in the risky classes: after 2014 weaker banks became more cautious in extending credit to small firms, when compared to less leveraged banks. And this happened in spite of a small and medium-sized enterprise (SME)supporting factor that mitigates capital requirements for European loans to SMEs.

The ‘forced safety effect’

In recent work, Bahaj and Malherbe (2020) posit that the link between enforced capital requirements and extended credit might be non-linear. Sure, the negative slope (higher requirements leading to less credit) is the expected outcome for most banks. But, when it comes to the least capitalised banks, stricter regulation might have an additional effect: by forcingthese banks to become safer, the stricter regulation actually broadens their lending opportunities. The reasoning goes as follows: since a safer bank is more likely to benefit from the whole income produced by a loan, rather than default before reaping all benefits, it will be more willing to seize investment opportunities (i.e. extending new loans) that, as a weaker bank, it would have otherwise dismissed. If the hypothesis is true, the relation linking capital requirements’ bindingness and lending should be U-shaped, rather than downward-sloped.

For the first time, we have sufficient heterogeneity in our bank sample to test whether this is the case. We do find that this is the case (see Figure 1): when we focus on the lowest tail of the bank capitalisation range, the short-term impact of Basel III on lending gets weaker, although the overall sign is not reverted; and this is true both for the amount of loans and for the rates applied thereto. Of course, more generous credit supply by the weakest banks at the arrival of Basel III could suggest some gamble for resurrection (e.g. extending high-risk, high-rate loans). This moral hazard hypothesis (Acharya et al. 2018) deserves more attention in the future debate.

Figure 1 Forcing safety

Figure 1 Forcing safety

Source: Galardo and Vacca (2022).
Notes: This figure plots the estimated difference in credit growth (left panel) and in interest rate (right panel) as a function of the average capital ratio between 2008 and 2013.

Does this matter for firms?

In principle, customers of a capital-constrained bank could shift to another bank when the stricter capital requirement pushes their original lender towards a tougher credit-supply attitude. In this scenario, capital requirements just induce relocation of credit across banks, but do not affect firms’ opportunities to produce and to invest; regulators would affect the financial system equilibria, but not the real economy outcomes. To address the issue, it is useful to focus on the total credit obtained by each firm. A firm can be labelled as ‘Basel-affected’ if it heavily borrowed from low-capitalised banks before the reforms (see above): the larger the share of credit obtained from low-capitalised banks before 2014, the more the firm can be assumed to have been exposed to the exogenous shock represented by Basel III.

According to our estimates, these Basel-affected firms do not manage to switch their lenders, and therefore they obtain less credit than their peers in the first post-Basel years, and pay higher interest rates. Consequently, they invest less than other firms, ceteris paribus (see Figure 2). All in all, we share the view that the effects of financial regulation spill over the real world, and do not stay confined in the financial realm.

Figure 2 Firms’ investment is eventually Basel-affected

Figure 2 Firms’ investment is eventually Basel-affected

Source: our elaborations on Galardo and Vacca (2022).
Notes: This figure plots the one-year ahead difference in investment between firms exposed to the regulatory reform due to their main bank being low capitalised between 2008 and 2013, and other firms. The bars show 95 percent confidence intervals, t = 0 refers to the implementation in Italy of Basel III more stringent risk based capital requirements in 2014.


The long-run benefits of capital strength for banks and their customers are unquestioned. By contrast, the short-term impact of higher capital requirements on lending is widely debated. To contribute to this debate, we look at empirical evidence. The Basel III adoption in Italy in the middle of the last decade suggests that the transition phase to attain higher capital buffers could worsen the dynamics of credit and its costs, and reduce lenders’ risk appetite. However, even during the transition, the link is not trivial: by forcing heavily undercapitalised lenders to move on the safer side, stricter rules bring benefits to their lending activity in the short run as well, as predicted by recent theoretical work. Notably, all these impacts are not confined to the financial system, but also extend to the real economy (e.g. to firm investments).

Authors’ note: The opinions expressed here are those of the authors and do not involve the Banca d'Italia.


Acharya, V V, A N Berger, and R A Roman (2018), “Lending implications of US bank stress tests: Costs or benefits?”, Journal of Financial Intermediation 34: 58–90.

Acharya, V V, S Lenzu and O Wang (2021), “Zombie lending and policy traps”, VoxEU.org , 29 October.

Admati, A R, P M DeMarzo, M F Hellwig, and P C Pfleiderer (2013), “Fallacies, irrelevant facts, and myths in the discussion of capital regulation: Why bank equity is not socially expensive”, Working paper, Stanford Graduate School of Business.

Aiyar, S, C W Calomiris, and T Wieladek (2014), “Does macro-prudential regulation leak? Evidence from a UK policy experiment”, Journal of Money, Credit and Banking 46(s1): 181–214.

Aiyar, S, C W Calomiris, J Hooley, Y Korniyenko, and T Wieladek (2014), “The international transmission of bank capital requirements: Evidence from the UK”, Journal of Financial Economics 113(3): 368–382.

Ambrocio G and E Jokivuolle (2018), “On the risk sensitivity of bank capital requirements”, VoxEU.org, 14 May.

Bahaj, S and F Malherbe (2020), “The forced safety effect: How higher capital requirements can increase bank lending”, Journal of Finance 75(6:, 3013-3053.

Bassett, W F and J M Berrospide (2018), The impact of post stress tests capital on bank lending, Basel III Monitoring Report.

Begenau, J (2020), “Capital requirements, risk choice, and liquidity provision in a business-cycle model”, Journal of Financial Economics 136(2): 355–378.

Financial Stability Board (2018), Evaluation of the effects of financial regulatory reforms on infrastructure finance.

Financial Stability Board (2019), Evaluation of the effects of financial regulatory reforms on small and medium-sized enterprise (SME) financing: Final report.

Galardo, M and V Vacca (2022), “Higher capital requirements and credit supply: evidence from Italy”, Bank of Italy Working Papers, N. 1372.

Gropp, R, T Mosk, S Ongena, and C Wix (2019), “Banks response to higher capital requirements: Evidence from a quasi-natural experiment”, The Review of Financial Studies 32(1): 266–299.

Mendicino, C, K Nikolov, J F Rubio-Ramírez, J Suarez and D Supera (2021), “How much capital should banks hold?”, VoxEU.org, 24 February.


  1. To be more precise, all the estimations look at the change in extended credit, rather than just the outstanding amounts, but the bottom line message is equivalent.
  2. The average rate in our sample over the whole period is 5.68%.