Capital Requirements, Monetary Policy, and Aggregate Bank Lending: Theory and Empirical Evidence



    Search for more papers by this author
    • NBD Professor of Finance, School of Business, Indiana University, Bloomington. I thank Jimmy Wales and particularly Kathleen Petrie for excellent research assistance. For their helpful comments, I thank Arnoud Boot and other participants at the Tinenbergen Institute Finance Seminar at the University of Amsterdam, participants at a finance seminar at The Board of Governors of the Federal Reserve System, and Mitch Berlin, Todd Milbourn, Richard Shockley, Patty Wilson, and other participants at the 1993 Indiana University Symposium on Design of Securities and Markets, and especially an anonymous referee and René Stulz (the editor). I am very grateful to Richard Shockley for providing the data. I alone am responsible for the contents of this paper.


Capital requirements linked solely to credit risk are shown to increase equilibrium credit rationing and lower aggregate lending. The model predicts that the bank's decision to lend will cause an abnormal runup in the borrower's stock price and that this reaction will be greater the more capital-constrained the bank. I provide empirical support for this prediction. The model explains the recent inability of the Federal Reserve to stimulate bank lending by increasing the money supply. I show that increasing the money supply can either raise or lower lending when capital requirements are linked only to credit risk.