Does More Capital Make Banks Safer? Market-Based Evidence From the 2011 European Banking Authority Capital Exercise

Abstract

I exploit the 2011 EBA Capital Exercise as a quasi-natural experiment to estimate the impact of higher capital requirements on six market measures of bank risk, using difference-in-differences and matching strategies. I find that the Capital Exercise triggered significant increases in the risk of Capital Exercise banks relative to non–Capital Exercise banks according to four of the six risk measures, contrary to the predictions of standard financial theory. Moreover, among Capital Exercise banks, I find that the Capital Exercise generated larger increases in risk for more undercapitalized banks. These results are robust to potential confounders from pre-existing trends and the European sovereign debt crisis. My results indicate that policymakers must beware the signaling effects of raising capital requirements, particularly in times of crisis.