Bank Capital Requirements, Lending Supply, and Economic Activity: A Scenario Analysis Perspective

Abstract

We evaluate the relation between bank capital, lending supply, and economic activity using Italian data over 1993–2015, a period which covers three key post-crisis regulatory and supervisory measures (the Basel III reform, the 2011 European Banking Authority [EBA] stress test, the European Central Bank's [ECB] Comprehensive Assessment, and launch of the Single Supervisory Mechanism—SSM). We quantify the impact of increased bank capital requirements using a novel procedure that recovers the magnitude of the policy measures, relying on scenario analysis and Bayesian VARs with a rich characterization of the banking sector. We document that the EBA and SSM measures unpredictably raised Tier 1 ratio by about 2.5 percentage points, leading to an average reduction in credit to firms and households by 5% and 4%, respectively, and to a decline in real GDP by over 2% and 4%. The Basel III bank capital increase is instead correctly anticipated in out-of-sample forecasting. These findings are robust to time-varying model parameters and consistent with narrative sign restriction techniques.