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The Forced Safety Effect: How Higher Capital Requirements Can Increase Bank Lending

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  • SALEEM BAHAJ
  • FREDERIC MALHERBE

Abstract

Government guarantees generate an implicit subsidy for banks. A capital requirement reduces this subsidy, through a simple liability composition effect. However, the guarantees also make a bank undervalue loans that generates surplus in states of the world in which it defaults. Raising the capital requirement makes the bank safer, which alleviates this problem. We refer to this mechanism, which we argue is empirically relevant, as the forced safety effect.

Suggested Citation

  • Saleem Bahaj & Frederic Malherbe, 2020. "The Forced Safety Effect: How Higher Capital Requirements Can Increase Bank Lending," Journal of Finance, American Finance Association, vol. 75(6), pages 3013-3053, December.
    • Handle: RePEc:bla:jfinan:v:75:y:2020:i:6:p:3013-3053
    DOI: 10.1111/jofi.12958
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