The effect of higher capital requirements on bank lending: the capital surplus matters

The existing literature has displayed mixed results in terms of the relationship between tighter bank capital regulation and lending, which may be due to poor approximation of capital requirements. We emphasise the crucial role of the excess of bank capital over the minimum capital requirement, the capital surplus, in the transmission of more stringent capital regulation. Specifically, we explore the effect of higher capital requirements on bank credit growth in the Czech Republic, drawing on a unique confidential bank-level dataset. Our results indicate that higher additional capital requirements have a negative effect on the credit supply of banks maintaining lower capital surplus. We estimate the effect on annual credit growth to be between 1.2 and 1.8 pp, using a wide range of model specifications and estimation techniques. Furthermore, the relationship between the capital surplus and credit growth proves to be significant also at times of stable capital requirements, i.e., the capital surplus does not serve only as an intermediate channel of higher capital requirements.