The Spillover Effects of Prudential Regulation on Banking Competition

Abstract

Summary: European supervisors aggressively requested more capital at large banks. That may cut credit to the economy. We confirm that especially larger banks cut loans while less-significant banks partly offset that credit drop. Moreover, we identify nasty spillovers from that interaction. Specifically, larger banks’ deleveraging was associated with significant portfolio worsening for mid-sized banks. We conjecture that while small banks’ loan expansion was somewhat shielded by superior soft-information-based technologies, medium-sized banks were fully exposed to lending to bad borrowers as they boosted loans by relying on credit scoring and Internal Rating Based models. That is proving tricky through the prolonged European dip.

Back to the Roots of Internal Credit Risk Models: Does Risk Explain Why Banks’ Risk-Weighted Asset Levels Converge Over Time?

“…Our study relates directly to the literature on the effect of changes in capital requirements on bank credit supply (e.g., Hyun and Rhee, 2011;Brei et al, 2013;Han et al, 2018;De Jonghe et al, 2020;Fraisse et al, 2020) and rests on an understanding of the real effects of increasing capital requirements. Ferri and Pesic (2020) suggest that high capital requirements reduce national credit supply with potential negative effects on medium-size banks. Moreover, Juelsrud and Wold (2020) show that banks react to higher capital requirements by reducing their average risk weights and document their influence on the real economy.…”