Higher capital requirements and credit supply: evidence from Italy

We use a rich dataset on bank loans to Italian firms matched to information on firms’ and banks’ characteristics, and exploit the implementation of Basel III reforms in Italy to investigate the impact of higher risk-based capital requirements on credit supply. While we do not address the steady state impact of capital requirements, we find that the introduction of higher requirements is associated with credit tightening in the early years after the reform. Banks affected to a larger extent by the new requirements tighten credit supply towards risky firms in favour of sounder ones. We also show that banks with particularly strong or particularly weak pre-reform capital positions tighten the credit to a lesser extent, i.e., the lending supply response is U-shaped with respect to initial capital, as predicted by the forced safety effect (Bahaj and Malherbe 2020). Finally, firms borrowing more from less capitalized banks were only partially able to switch their lenders, experienced a worsening in lending conditions and invested less compared to other firms after Basel III implementation.