How Do Banks Adjust to Stricter Supervision?

Abstract

We exploit a discontinuity in the assignment of banks to the European Central Bank's new supervisory framework and a major stress test to identify the effects of increased regulatory scrutiny on bank balance sheets. We find that banks adjust to stricter supervision by reducing leverage, and most of the adjustment stems from shrinking assets rather than from raising equity. We estimate a 7 percent reduction in leverage, two thirds of which are due to asset shrinkage. Securities are adjusted much more strongly than the loan book. On the liability side, banks mainly reduce their reliance on wholesale funding. Using data on the issuance of large corporate loans, we find that very weak banks also reduce the supply of credit. The evidence emphasizes banks' reluctance to adjust capital when target leverage changes and suggests that macroprudential considerations matter for stress-testing in practice.

Keywords: bank capital, deleveraging, stress-testing, macroprudential policies, Euro area

JEL Classification: C21, E51, G21, G28