Shocks to bank capital: evidence from UK banks at home and away

This paper assesses how shocks to bank capital may influence a bank’s portfolio behaviour using novel evidence from a UK bank panel data set from a period that pre-dates the recent financial crisis. Focusing on the behaviour of bank loans, we extract the dynamic response of a bank to innovations in its capital and in its regulatory capital buffer. We find that innovations in a bank’s capital in this (pre-crisis) sample period were coupled with a loan response that lasted up to three years. Banks also responded to scarce regulatory capital by raising their deposit rate to attract funds. The international presence of UK banks allows us to identify a specific driver of capital shocks in our data, independent of bank lending to UK residents. Specifically, we use write-offs on loans to non-residents to instrument bank capital’s impact on UK resident lending. A fall in capital brought about a significant drop in lending in particular, to private non-financial corporations. In contrast, household lending increased when capital fell, which may indicate that – in this pre-crisis period – banks substituted into less risky assets when capital was short.