How Do Banks Adjust to Stricter Supervision?
AbstractWe exploit a discontinuity in the assignment mechanism of the European Central Bank's Comprehensive Assessment in order 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 mostly reduce their reliance on wholesale funding. Using data on syndicated
loan issuance, we find that very weak banks also reduce the supply of credit. The evidence highlights banks' reluctance to adjust capital when target leverage changes and suggests that macroprudential considerations matter for stress-testing in practice.