We study the effects of both tighter and looser bank capital requirements on bank risk-taking. We exploit credit register data matched with firm and bank level data in conjunction with changes in capital requirements stemming from Basel III, including the introduction of a SME supporting bank capital factor in the European Union. We find that tighter capital requirements reduce the supply of bank credit to firms, while looser capital requirements mitigate the credit supply effects of increasing capital. Importantly, at the loan level (credit supply), banks more affected by capital requirements change less the supply of credit to riskier than to safer firms, and these asymmetric effects occur for both the tightening and the loosening of bank capital requirements. Finally, these effects are also important at the firm-level for total credit availability and for firm survival. Interestingly, our results suggest that those banks most impacted by the tighter Basel III capital requirements prioritize credit among ex-ante riskier firms to avoid their closure, consistent with loan evergreening.

A common assumption in the academic literature and in the supervision of banking systems is that franchise value plays a key role in limiting bank risk-taking. As market power is the primary source of franchise value, reduced competition in banking markets has been seen as promoting banking stability. A recent paper by Martínez-Miera and Repullo (MMR, 2010) shows that a nonlinear relationship theoretically exists between bank competition and risk-taking in the loan market. We test this hypothesis using data from the Spanish banking system. After controlling for macroeconomic conditions and bank characteristics, we find support for this nonlinear relationship using standard measures of market concentration in both the loan and deposit markets. When direct measures of market power, such as Lerner indices, are used, the empirical results are more supportive of the original franchise value hypothesis, but only in the loan market. Overall, the results highlight the empirical relevance of the MMR model, even though further analysis across other banking markets is needed.