Effects of capital requirements on bank behavior

The project studies how banks adjust their balance sheets in response to higher capital requirements. In order to increase their capital ratios, banks can adjust their balance sheets in two different ways: They can either increase their levels of regulatory capital (the numerator of the capital ratio), or they can reduce their levels of risk-weighted assets (the denominator of the capital ratio) (Admati et al., 2010). A reduction in risk-weighted assets can entail adverse effects on the real economy if many banks simultaneously decide to sell assets (fire sales) or reduce lending (credit crunch) (Hanson et al., 2011). Empirically identifying the effect of higher capital requirements on banks' balance sheet adjustment faces a number of challenges: Most importantly, one needs to find exogenous variation incapital requirements. Since capital requirements are rather constant, there is little variation

over time; and when they do change, they mostly change for all banks in a given economic region at the same time, leaving no cross-sectional variation to exploit. The project addresses these empirical challenges by exploiting the 2011 capital exercise conducted by the European Banking Authority (EBA) as a natural experiment. The capital exercise required a subset of European banks to reach and maintain a 9 percent core tier 1 capital ratio by the end of June 2012, while other European banks were not subject to this increase in capital requirements. The rule by which banks were selected to be included in the capital exercise allows disentangling the effect of capital requirements from effects associated with bank size. Banks were included in the capital exercise in descending order of their market shares by total assets in each Member State' such that the exercise covered "50% of the national banking sectors in each EU Member State, as expressed in terms of total consolidated
assets as of end of 2010." (EBA, 2011). Since national banking sectors in Europe differ with regard to total size and concentration of market shares, the country-specific selection threshold yields a considerable overlap in size between banks participating and not participating in the capital exercise. These institutional features of the capital exercise allow us to employ a difference-in-difference matching approach to identify the causal effects of higher capital requirements on banks' balance sheet adjustment.