The Macroeconomic Effects of Bank Capital Requirement Tightenings: Evidence from a Narrative Approach

Bank capital regulations are intended to enhance financial stability in the long run, but
may, in the meanwhile, involve costs for the real economy. To examine these costs we
propose a narrative index of aggregate tightenings in regulatory US bank capital
requirements from 1979 to 2008. Anticipation effects are explicitly taken into account
and found to matter. In response to a tightening in capital requirements, banks
temporarily reduce business and real estate lending, which temporarily lowers
investment, consumption, housing activity and production. A decline in financial and
macroeconomic risk helps sustain spending in the medium run. Monetary policy also
cushions negative effects of capital requirement tightenings on the economy.