VoxEU Column Financial Markets

The impact of capital requirements on bank lending

Since the Global Crisis, support has grown for the use of time-varying capital requirements as a macroprudential policy tool. This column examines the effect of bank-specific, time-varying capital requirements in the UK between 1990 and 2011. In response to increased capital requirements, banks gradually increase their capital ratios to restore their original buffers above the regulatory minimum, reducing lending temporarily as they do so. The largest effects are on commercial real estate lending, followed by lending to other corporates and then secured lending to households.

The financial crisis has led to widespread support for greater use of time-varying capital requirements on banks as a macroprudential policy tool (see for example Yellen 2010 and Hanson et al. 2011). Policymakers aim to use these tools to enhance the resilience of the financial system, and, potentially, to curb the credit cycle. Under Basel III, national regulatory authorities will be tasked with setting countercyclical capital buffers over the economic cycle. In the UK, the Financial Policy Committee (FPC) also has the power to set capital requirements at the sectoral level.1

In recent research (Bridges et al. 2014), we aim to identify the effect of changing regulatory capital requirements on bank capital and bank lending. Between 1990 and 2011, the UK supervisory authorities set bank-specific, time-varying capital requirements. By exploiting variation in those capital requirements, we are able to answer two questions:

How do changing capital requirements affect the capital ratios that banks hold?
How do changing capital requirements affect lending to different sectors of the economy, say to commercial real estate versus mortgages?

Using a rich new dataset containing detailed information on capital requirements and bank lending in the UK over a span of more than 20 years, we show that:

Changing regulatory capital requirements affects bank capital ratios and lending.
Banks are keen to keep unchanged their buffers of capital above the regulatory minima, and tend to rebuild their excess capital buffers over three to four years.
Banks respond to increased capital requirements by reducing lending more to the real estate sectors (household and commercial) and less to other types of lending.

Our central estimate is that, following a one percentage point permanent increase in capital requirements, a bank increases its capital ratio to restore its capital buffer – by 0.4pp after one year, by 0.9pp after 3 years, and broadly one-for-one in the long run (Figure 1).

Figure 1. Capital ratio impulse response

We then examine whether changes in capital requirements affect bank lending. By estimating equations for both bank capital and lending growth, we allow for changes in capital requirements to impact lending both directly and indirectly, through the response of bank capital. We consider separately lending to different sectors in the economy: i) secured lending to households; ii) unsecured lending to households; iii) lending to commercial real estate corporations; and iv) lending to non-real estate non-financial corporations. We find that increases in capital requirements are typically associated with reductions in loan growth, but, interestingly, the results vary across sectors.

An increase in capital requirements is associated with a temporary reduction in household secured loan growth (Figure 2). Household secured loan growth (which, in the UK, comprises the majority of the stock of loans) initially falls, with a one percentage point increase in capital requirements leading to a peak impact of a 0.8 percentage point reduction in quarterly loan growth. After the first year, as the bank accumulates capital in order to restore its buffer, loan growth returns to close to its long-run average. For comparison, we estimate a largely insignificant response on household unsecured loan growth.

Figure 2. Impact of an increase in capital requirements on secured loan growth

Note: Secured loan growth impulse response following a permanent one percentage point increase in the capital requirement at time 0.

The other considerable effect from increasing capital requirements is a reduction in corporate lending, especially to the commercial real estate sector. Faced with a 1pp increase in capital requirements, banks reduce commercial real estate loan growth by around 4pp after one quarter. Loan growth to private non-financial corporations in other industries also falls following an increase in capital requirements, albeit by less than for commercial real estate companies – quarterly loan growth falls by 2.1pp in the first quarter.

Interpreting the results

Taken together, our results suggest that using bank capital requirements as policy levers is likely to have significant effects on bank capital ratios as well as bank lending. In response to an increase in capital requirements, banks gradually increase their capital ratios to restore the buffers above the regulatory minimum that they originally held. Banks reduce lending temporarily as they rebuild those buffers. The largest effects arise for commercial real estate lending, followed by lending to other corporates and then secured lending to households.

Our findings support the literature that argues that the Modigliani-Miller (1958) theorem, long held as a central pillar in the theory of finance, does not always hold in practice. Increasing bank capital requirements means requiring more equity per unit of assets. The Modigliani-Miller theorem implies that, for a given portfolio of assets, changes in the composition of a bank’s funding do not affect the overall cost of funds for the bank, and as a result, should not change the supply of credit. If this holds, changing capital requirements would not affect bank lending. In practice, a range of possible frictions exist, which mean that increasing bank capital requirements are unlikely to be neutral for credit supply.

Concluding remarks

Our results reflect how, on average, individual banks responded in the past to a change in their own confidential and microprudential capital requirements. As such, they cannot be used to directly infer the macroeconomic effects of macroprudential capital requirements, which will apply to the banking sector as a whole and be part of a very different policy framework. And during the transition to higher global regulatory standards, the effects of changes in capital requirements may be different. For example, increasing capital requirements might augment rather than reduce lending for initially undercapitalised banks. But we lack empirical evidence on as yet untried macroprudential capital requirements. And to the extent that there will be similarities in the way in which banks respond to changes in capital requirements across regimes, our results are likely to contain some quantitative insights into how changing capital requirements in a macroprudential regime might affect lending.


Bank of England (2014), “The Financial Policy Committee’s powers to supplement capital requirements”, Policy Statement. 

Bridges, J, D Gregory, M Nielsen, S Pezzini, A Radia, and M Spaltro (2014), “The impact of capital requirements on bank lending”, Bank of England Working Paper 486. 

Hanson S G, A K Kashyap, and J C Stein (2011), “A Macroprudential Approach to Financial Regulation”, Journal of Economic Perspectives, 25(1): 3–28.

Yellen, J L (2010), “Macroprudential Supervision and Monetary Policy in the Post-crisis World”, Speech at the Annual Meeting of the National Association for Business Economics, Denver, CO, 11 October. 


1 More specifically, the FPC has Direction powers over these tools. See Bank of England (2014) for a policy statement on these tools.

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