The economic effects of changes to bank capital regulation: evidence from the United Kingdom

Strong bank capitalisation provides long‑run financial‑stability benefits. However, transitioning to higher capital levels may involve short‑run costs. We analyse the effects of prudential capital changes on lending behaviour, macroeconomic outcomes, and banking competition using UK data within a structural VAR framework with sign and narrative restrictions. Narrative constraints draw on the UK regulator’s 2014–15 stress tests and the 2016 annual cyclical scenario. Impulse responses indicate that banks primarily adjust by reducing risk-weighted assets rather than raising new equity. Higher capital requirements entail negligible long-run costs, with modest short-run macroeconomic effects consistent with other VAR studies on bank capital. These impacts are driven by a contraction in lending and increase in spreads across sectors. We find that effects of altering prudential capital requirements are state dependent. Altering during recessions, as compared with expansions, amplifies short-run contractions, but these are more short-lived, with output recovering more quickly. Indicators of market power (Boone, HHI, Lerner) suggest that tighter capital requirements temporarily reduce banking competition.