The aim of this paper is to examine whether and to what extent bank capital requirements and liquidity standards influence the level of bank stability. Our approach is that both capital and liquidity affect lending growth, which in turn affects bank stability. We construct a panel dataset on a sample of 2,054 commercial banks from 117 developed and developing countries during the 2000-16 period. By applying a two-stage least squares (2SLS) empirical methodology, our findings show that capital and liquidity have a negative direct impact on the level of bank stability. However, this influence is counteracted by an indirect positive effect through the increased level of credit. Our results are not homogeneous across legal and institutional environments. In particular, we provide evidence on more relevant relationships in countries with higher level of protection of creditor rights and lower restrictions on non-traditional banking activities. Our empirical findings are robust to different specifications of the empirical model and to potential endogeneity problems.
Policy Implications• Notwithstanding the tightening Basel III regulation, lending has increased in the presence of higher capital requirements and liquidity coverage ratios. However, this increased in lending is not independent upon the legal and institutional setup.• Although it is fundamental to study the direct effects of capital and liquidity requirements on stability, policymakers should deal not only with these direct effects, but also with the different channels of this transmission mechanism and, specifically, with the lending channel.
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