Identifying channels of credit substitution when bank capital requirements are varied

What kinds of credit substitution, if any, occur when changes to banks’ minimum capital requirements induce banks to change their supply of credit? The question is central to the new ‘macroprudential’ policy regimes that have been constructed in the wake of the global financial crisis, under which minimum capital ratio requirements for banks will be employed to control the supply of bank credit. Regulatory efforts to influence the aggregate supply of credit may be thwarted to some degree by ‘leakages’, as other credit suppliers substitute for the variation induced in the supply of credit by regulated banks. Credit substitution could occur through foreign banks operating domestic branches that are not subject to capital regulation by the domestic supervisor, or through bond and stock markets. The UK experience for the period 1998-2007 is ideally suited to address these questions, given its unique regulatory history (UK bank regulators imposed bank-specific and time-varying capital requirements on regulated banks), the substantial presence of both domestically regulated and foreign regulated banks, and the United Kingdom’s deep capital markets. We show that leakage by foreign branches can occur either as a result of competition between branches and regulated banks that are parts of separate banking groups, or because a foreign banking group shifts loans from its UK-regulated subsidiary to its affiliated branch. The responsiveness of affiliated branches is nearly twice as strong. We do not find any evidence for leakages through capital markets. These findings reinforce the need for the type of international co-ordination, specifically reciprocity in capital requirement regulation, which is embedded in Basel III and the European CRD IV directive, which will be gradually phased in starting January 2014.