The Forced Safety Effect : How Higher Capital Requirements Can Increase Bank Lending

Even though a capital requirement reduces this subsidy, a bank may optimally respond to a higher capital requirement by increasing lending. This requires that the marginal loan generates positive residual cashflows in the states of the world where the bank just defaults. Since an increase in the capital requirement makes the bank safer, it makes the shareholders internalise such cash flows. We dub this mechanism, which we argue is empirically relevant, the forced safety effect.