Portfolio Substitution and the Effects of Bank Capital Regulation
Abstract
Banks allocate their portfolios across different types of loans and securities. A large literature finds that stronger capital requirements reduce bank lending, but these studies generally estimate the total bank-level response to a change in regulation that shifts multiple assets’ regulatory costs simultaneously. Evaluating counterfactual policies that impose a different pattern of regulatory penalties across assets from those observed in the data requires a model of how an asset’s supply responds to its own regulatory cost versus how it responds to those of other assets. I develop a structural framework and empirical method to estimate asset-level supply elasticities separately from portfolio substitution. I use changes in bank-level requirements that change the regulatory penalties of different assets by different amounts, while the model’s portfolio adding-up constraint links each asset’s supply response to the regulatory penalties of all other assets. My method recovers positive supply elasticities for every asset category, with securities holdings responding more to regulatory costs than loans. Its predictions match out-of-sample bank portfolio responses to changes in capital regulation. Applying these estimates to the post-crisis strengthening of capital regulation, I argue that stronger capital requirements account for about 28% of large banks’ shift from lending to securities since 2011.
