Does Regulation Only Bite the Less Profitable? Evidence from the Too-Big-To-Fail Reforms

What determines banks’ responses to higher capital requirements? We show that profitability is crucial as it underpins the opportunity cost of downsizing and the ability to generate capital. To illustrate this, we assess the introduction of capital surcharges for systemically important banks. Using textual analysis to identify when banks respond, we find that less profitable banks contract in response to higher surcharges. Banks near the exogenous thresholds that determine capital surcharges shrink further. More profitable banks, by contrast, continue to expand, consistent with our theoretical model. Reallocation towards more profitable banks can improve efficiency. However, we show that these banks have been more exposed to tail risks during the pandemic