Capital requirements and banks’ behavior: Evidence from bank stress tests

Abstract

This paper examines the impact of higher regulatory capital on banks’ behavior using stress tests as a quasi-natural experiment. I employ an exogenous source of variation in bank capital requirements based on the U.S. Federal Reserve’s selection rule. I find that banks meet higher capital ratios through issuing equity that expands their assets and reduces debts. The capital requirements transmit to the real economy through the bank lending channel. Stress-tested banks increase lending while reducing credit supply to small and riskier borrowers. Dependent firms on borrowing from stress-tested banks reduce assets and investments extensively in response to the credit loss.