Bank Capital Adjustment Process and Aggregate Lending

This paper proposes a new micro-founded measure to quantify the aggregate capitalisation of banking sectors taking into account both market discipline and regulatory constraints. It allows studying the connection between micro capital shortfalls from an implicit bank specific capital target and macro impacts of capital shortages on aggregate lending. (i) Our quantitative country-wide index of bank capitalisation is consistent with the qualitative reports of the ECB Bank Lending Survey. (ii) This index correlates with future fluctuations in aggregate lending,especially when a banking system is under-capitalised. (iii) The adjustment of capital constrained banks mostly impact loans to domestic non-financial agents. Thus our measure suggests that (a) countercyclical capital requirements may be less effective if market constraints are more important, and (b) slow moving balance sheet variables can help detect vulnerabilities and reversals in the lending cycle.