Banks’ regulatory risk tolerance

Abstract

In managing their capital, banks balance the risk of breaching regulatory requirements against the cost of maintaining and speedily restoring “management” buffers. Using 68 quarters of data on 17 US and 17 euro-area banks, we find systematic reductions in steady-state management buffer targets and attendant rises in regulatory risk tolerance (RRT) following the Great Financial Crisis (GFC). This phenomenon is particularly pronounced at banks with higher capital requirements post GFC. In parallel, banks facing more volatile management buffer shocks set higher management buffer targets, suggesting that RRT is a conscious choice. High-RRT banks tend to respond to a depletion of their management buffers by cutting lending, whereas low-RRT banks reduce the riskiness of their assets in other ways — thus highlighting real-economy effects of capital management strategies.