The Role of Managerial Protections on Bank Capital Requirements

Abstract

Can tightening capital requirements lead to greater lending? We introduce a model to illustrate how the effect of capital requirements on bank lending can qualitatively depend on the extent of managerial protections against shareholder actions. Protections encourage managers to pursue unprofitable projects. While managers can still be disciplined by debt, if a financial institution’s debt is constrained by capital requirements, then a higher level of investment can serve as a partial substitute. Capital requirements can therefore spur increased investment for banks with managerial protections. Empirically, we study banks facing stress-tests following the great recession and find evidence consistent with our model, that there was an increase in lending for banks with strong protections compared to banks with weak protections. These results provide new insights into the central role that corporate governance and incentives of bank managers have on the effect of bank capital requirements.

Keywords: Managerial protections, Stress testing, Capital structure, Ownership structure, Investment, Banking

JEL Classification: D24, G32