Does regulation only bite the less profitable? Evidence from the too-big-to-fail reforms

Profitability underpins the opportunity cost of shrinking assets and the ability to generate capital. It thus shapes banks’ responses to higher capital requirements. We present a stylised model to formalise this insight and test our theoretical predictions on a cornerstone of the too-big-to-fail reforms. Leveraging textual analysis to identify the treatment date, we show that less profitable banks reduced their systemic importance as intended by regulation. Those close to the regulatory thresholds that determine bank-specific capital surcharges – a source of exogenous variation in the regulatory treatment – shrunk by even more. In contrast, more profitable banks continued to expand.