We propose a theory of bank behaviour under capital requirements that accounts for both risk-shifting incentives and debt overhang considerations. A key result is that the bank's lending response to an increase in the requirement need not be negative. The sign and the magnitude of the response depend on the bank's balance sheet and economic prospects, and lending istypically U-shaped in the requirement. Using UK regulatory data, we find empirical support for the hypothesis that a bank mainly adjusts to a higher requirement by cutting lending when expected returns are low, but by raising capital when they are high.

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We propose a theory of bank behaviour under capital requirements. The sign of the lending response to a change in capital requirement is ambiguous due to the interplay between risk-taking incentives and debt overhang considerations. Optimal lending is typically U-shaped in the capital requirement. Changes in expected returns on loans shift this relationship. The lower expected returns the lower its slope. Using UK regulatory data (1989-2007), we find support for this prediction. It follows that a bank mainly adjusts to a higher capital requirement through cutting lending when expected returns are low, and by raising capital when they are high.