How Do Banks Respond to Capital Regulation? — The Impact of the Basel III Reforms in the United States

Abstract

Understanding banks' responses to capital regulation is essential for regulators to use this key tool of modern banking regulation effectively. We study how and when US banks responded to changes to the way capital ratios are measured, changes that were introduced as part of the adoption of Basel III. We find that small banks — those below USD 10bn — responded neither before nor after the release of the new rules to the change in measured capital they experienced under the new rules. In contrast, we show that regional banks — those with total assets between USD 10bn and USD 50bn — adjusted their capital ratios to partially compensate for the changes resulting from the new rules: On average, if a bank's capital ratio when measured under the new rules was lower than under the old rules, then the bank took steps to increase its capital ratio, compared to a bank whose capital ratio did not change with the new rules. This adjustment took place prior to the publication of the specific language applicable to US banks, suggesting that the changes were largely expected by that time. Both groups of banks responded in the periods following the release of the new US rules in relation to their exposure to mortgage servicing rights, suggesting that the severe treatment of this asset class was not expected. The bank responses we estimate take place well before the Basel III rules started to come into force after 2014, emphasizing the importance of policy announcements in shaping bank behavior.