The

Real Effects of Bank Capital Requirements

Matthieu BRUN1, Henri FRAISSE2, David THESMAR3 July 4, 2013 Abstract: We measure the impact of bank capital requirements on corporate borrowing and expansion. We use loan-level data and take advantage of the transition from Basel 1 to Basel 2. While under Basel 1 the capital charge was the same for all firms, under Basel 2, it depends in a predictable way on both the bank's model and the firm's risk. We exploit this two-way variation to empirically estimate the semi-elasticity of bank lending to capital requirement. This rich identification allows us to control for firm-level credit demand shocks and bank-level credit supply shocks. We find very large effects of capital requirements on bank lending: 1 percentage point increase in capital requirement leads to a reduction in lending by approximately 10%. At the firm level, borrowing is reduced, as well as total assets (mostly working capital); we provide some evidence of impact on employment and investment. Overall, however, because Basel 2 reduced the capital requirement for the average firm, our results suggest that the transition to Basel 2 supported firm activity during the crisis period.
The opinions expressed in this document do not necessarily reflect the views of the Autorit de Contrle Prudentiel.

1 ISODEV. Email: Matthieu.brun@isodev.fr. This paper was written when Mathieu Brun was working at the Banque de France. 2 Autorit de Contrle Prudentiel. Email: henri.fraisse@acp.banque-france.fr 3 HEC Paris and CEPR. Email: thesmar@hec.fr

1. Introduction

The financial crisis has led banks to dramatically reduce their leverage under the pressure of both regulators and financial markets. The question we address in this paper is whether tightening capital requirements affects bank lending, and corporate investment. There is, on the subject, considerable debate in the academic literature. On the one hand, there is the "Modigliani-Miller" view (Hanson, Kashyap and Stein, 2009; Admati, DeMarzo, Hellwig, Pfleiderer, 2010), which assumes that banks can easily issue equity. Tighter capital requirements force bank to issue equity and reduce debt, but in doing so only marginally increase the cost of funding for banks. The intuition is that better capitalized banks can issue less risky, and hence cheaper, equity. Under the MM view, tightening capital requirement have a negligible impact on bank lending. The alternative, non-MM view, states that raising equity is expensive, and that banks are constrained by their level of equity capital. When equity is lacking, NPV maximizing banks may have to give up positive NPV projects because they consume too much regulatory capital. Under the non-MM view, an increase in capital requirements would decrease lending (Kashyap and Stein, 2004). In this paper, we estimate the effect of capital requirements on bank lending, and corporate outcomes. To do this, we exploit the change from Basel 1 to Basel 2. This allows us to focus on a shock to the risk weights that is bank-firm specific. While under Basel 1 all loans required a capital charge of 8%, under Basel 2, the capital charge is different and depends on firm credit rating via a model that is bank specific. We thus use this setting to investigate the correlation between change in lending policy and change in the capital charge, at the firm-bank level. We can do this because we have two main sources of information. The first one is a large loan-level dataset of French firms held by the prudential bank regulator. The second one is a dataset that allows us to observe the effective average probability of default that banks assign to firms of each risk category. We then assign this average probability to all firms in our main

sample, conditional on their risk category. Looking at these data we observe that banks assign different default probabilities to firms in the same risk category, which confirms that internal models vary widely across banks. Identification rests on two strengths of our research design. First, capital requirements for lending to a given firm are typically different for two different banks. This is because Basel 2 allows banks to use their own internal model to evaluate the probability of default of a firm. Hence, for given firm risk, we can compare the lending of banks according to the penalties imposed by their internal models, for the same firm observables. Second, our sample has a sizable number of firms that borrow from several banks. For these firms, we can control for unobservable firm-level shifts in credit demand, as the banking literature has done in other contexts (for example, Kwhaja-Mian, 2005; Iyer,Peydro, Schoar, 2012; Jimenez, Ongena, Peydro, Saurina, 2012). Consistently with this literature, we find that making this adjustment does not affect our results very much, suggesting that heterogeneity in bank loan portfolios is not driving the results. What we find. Our analysis has caveats that we do our best to address. First, the goal capital requirements reduce systemic risk. Systemic risk is beyond the scope of this paper, which focuses only on lending effects. But the welfare benefits of having a safer banking system may outweigh the costs of depressed lending that we measure. Second, we measure essentially short-term effects. Because of data availability constraints, our sample stops in the last quarter of 2011, or three full years after the transition to Basel II is implemented. Our year-by-year results do not seem to suggest that the negative impact on lending fades out. But it may be disappear after a longer period. Last, the transition to Basel 2 that we study occurred in the beginning of 2008, exactly when the financial crisis started to hit the global financial system. We do our best to control for this: Our methodology rests on the comparison between firms that received different treatment from the new regulation. In some specifications, we even compare lending to the same firm by banks on which the regulation had a different

impact. Our focus on France also helps a little, as French banks were not extremely hurt by the crisis. But it could still be argued that our estimates are polluted by the financial turmoil. The literature: on regulation: Calomiris paper; macro papers. on Funding shocks: Kwhaja-Mian, 2005 Iyer,Peydro, Schoar, 2012; Jimenez, Ongena, Peydro, Saurina, 2012). Like these paper, we use firm-time fixed effects to control for the fact that banks may have different loan portfolios.

2. The Empirical Strategy

a. Calculating Capital Requirements

Since the Basel I accords in 1988, bank regulators around the world have asked banks to use risk weights to assess the equity needs. The logic is the following. When a bank makes an investment of 100 in a project (for instance a mortgage, or a corporate bond), the regulator requires that the bank holds rx100 euros of equity capital, where r is the equity requirement. Under Basel 1, the equity requirement for corporate lending was 8%. This meant that if a bank had, say, 10bn of equity, it could not make more than 125bn of corporate loans, unless, of course, it was ready to issue new stocks. The Basel 2 accords made capital requirements much more heterogeneous across banks and firms. These new agreements were published in 2004. The idea was to reoptimize regulation so as to take into account the rising complexity of banking activities (for instance, securitization), and also to avoid regulatory arbitrage by adapting capital requirements to the riskiness of investment. Indeed, a flaw the Basel 1 was that, since capital requirements were the same for risky or safe corporations, banks would have strong incentives to only lend to risky banks, so as to maximize expected profits under regulatory constraints.

Our study exploits one key feature of Basel 2: The capital requirement for a loan depends in a predictable way on both the firm's risk and bank's model. When moving to Basel 2, banks may be authorized to follow the "internal risk based" (IRB) approach, whereby they can use their own estimate of the probability of default of the firm to calculate the capital requirement. Remaining banks are required to take the "standardized approach", where the capital requirement is a known function of the firm's official rating. Let us start with IRB banks. For a loan to firm f by bank b, the capital requirement is then given by the following formula: rbf = FIRB (PDbf, LGDbf, Mbf) (1)

where PDbf is firm f's regulatory probability of default, as estimated by bank b, or by the regulator (more on this below). LGDbf is the loss given default Mbf is the maturity of the loan. As banks do in most circumstances, we take LGDbf =.45 and Mbf =2.5.FIRB (.) is a known function. The regulatory probability of default PDbf is not to be confused with the one directly obtained from an internal model based on a scoring approach. The scoring model allows putting each firm into a risk class and each firm of this class bears the same PDbf which is then used for the computation of the capital requirement. In order to limit the procyclicality induced by the Basel II framework, the French regulatory framework imposes that the PD were computed through the cycle meaning the PD of a risk class does not vary over time. However, the rating of a firm might vary over the cycle. Therefore, firms might be associated to different class of risk overt time and might display a time varying PD. We do observe the regulatory default probability PDbf for a large sample of bank-firm linkages in 2008. We have the rating issued by the Bank of France, available for all firms and all years in our sample. Using these observations, we calculate the average effective regulatory PD per rating level. Therefore, we are able to map the Bank de

France rating system into each internal rating system and to associate to each firm a regulatory default probability each year. More formally, we have the relationship: PDbf = 'b.f (2)

where ft is a set of dummies for each value of the firm's official credit rating (which is discrete). b captures the fact that the model to evaluate the PD may differ from bank to bank. Banks that cannot use their own model of PD have to follow the standardized approach. Under this approach, the capital requirement is direct and known function of the official bank of France credit rating of the firm. For bank b and firm f, this leads to: rbf = Fstandardized (f) (3)

where Fstandardized (.) is a known function. Under the standard approach, all firms that have the same official rating have the same capital requirement. Overall, the capital requirement for each bank-firm linkage can be computed and depends both on the firm's rating and the bank's model. This allows identifying the impact of the capital charge separately from the firm's credit rating. Note that if all banks followed the standardized approach, this would not be possible. Fortunately for us, a large fraction of our sample includes banks that were authorized to adopt the IRB approach. For these banks, the capital charge is not perfectly correlated with the firm rating: It also depends on the bank's internal model, summarized by the vector b, which we can identify using a specific dataset on PDs effectively used by IRB banks. The identification also exploits the variation of capital requirement across banks portfolio under the Basel II design. The capital requirement is also a function of the bank's exposure (overall lending) to the firm and the turnover of the firm. Exposure matters in that it allows loans to firms below 50m of turnover and below 1m of exposure to be reclassified as "retail", and therefore benefit from lower capital requirements. In sum, the Basel II leads to four regimes of capital requirement: the

retail treatment versus the corporate treatment and the advanced approach versus the standard approach. An internal model is validated by the regulator at the level of the portfolio (retail versus corporate) of the judicial entity. Therefore within a bank holding company, a firm exposure can be treated under the standard approach by one entity and under the IRB approach by another. We exploit these contrasting regimes in order to assess the impact of higher capital requirement.

b. The Model

Our objective is to test whether equity requirements affect bank lending policy. We focus on the change in lending between before and after the implementation of the Basel 2 regulation, and ask whether changes in equity requirements are correlated with changes in lending. We discuss here our exact estimation strategy, and discuss the sources of identification in the next Section. Using bank-firm loan-level data, we estimate the following equation: Lbf = f + b + .rbf + Xf + bf (3)

where Lbf is the growth of lending by bank b to firm f. rbf is the change in regulatory capital requirement between before and after the reform. Since it is constant, equal to 8% under Basel 1, we take without loss of generality the risk weight in the "post" (Basel 2) period as our measure of change. f is a firm fixed effect, designed to capture the fact that some firm (for instance, risky firms) may simultaneously experience an increase in risk weight, and a reduction of lending, without any causal link between the two. As we discuss below, the model with fixed effects is identified only for firms borrowing from several banks. b is a bank-specific fixed effect, which controls for bank-wide lending decisions; It is identified because the same bank lends to several firms. Xf are sets of firm specific controls designed to capture observable differences in

lending policy that are unrelated to regulation (firm profitability, size, credit rating). bf are error terms, which we cluster at the bank b level. The null hypothesis is that =0. In this case, bank lending is not constrained by regulation, for two possible reasons. First, the bank is well capitalized. In this case, the requirement does not matter, as the bank has enough equity to make the loan, as long as it is NPV>0. Since the NPV of the loan is firm specific (it does not depend on the bank), it should be absorbed by the firm fixed effect. Second, the bank has little equity, but can issue more without friction. Under these conditions, the MM theorem is valid: controlling for loan NPV (the firm fixed effect), the capital requirement does not matter, since the cost of capital is unaffected by the fraction of equity used to finance the bank. One last issue with equation (3) is that we need to estimate rbf at the bank-firm level under the Basel 2 regime. To do this, we use equation (1), which connects rbf with the probability of default PDbf, and equation (2), which connects PDbf with the Bank of France credit ratings that we observe in our data. At this stage we need the coefficients b, which establish the correspondence between the ratings and bank- specific default probabilities. To calibrate b, we use a dataset that reports the PDs effectively used by banks. Since this dataset is not exhaustive but covers a small subset of firms, we calculate the average PD per category of credit rating, and use these numbers to impute the PD for all bank-firm match.

c. Identification

Our estimation technique allows for a sharp identification of the effects of regulation on bank lending. First, equation (3) is a first difference equation. Bank and firm fixed propensities to borrow/lend are already absorbed in the implicit level equation. In its simplest form, (3) is identified of off the correlation between loan growth and capital requirement

increase. At this stage, however, the problem remains that risky firms (those with high capital requirement in the post Basel 2 period) may be borrowing less after Basel 2 was implemented. The problem is especially acute since the post Basel 2 period in our sample coincides with the beginning of the financial crisis, which may have had a stronger effect on the demand and supply of credit to risky firms. Second, the coefficient on the capital charge, , is identified, even when one controls for credit rating of the firm. For now, assume no firm fixed effect f in equation (3). This is because, for a firm with a given credit rating f, different banks face different capital requirements, depending on the model they use. There are two useful sources of variation here. First, the difference between the standard and the IRB approaches: As long as b differs between the two approaches, a bank under IRB faces a different capital requirement than a bank under the standard approach, even if the firm's credit rating is the same. Second, within the IRB approach, bank b and b' also face different capital charges for given rating as long as the models they are using are different enough: b has to be different from b'. This source of identification is the core of our identification strategy. Formally, our identification technique can be understood by combining equations (1)- (3). To clarify exposition, let us assume that the Basel formula F(.) is a linear function of the default probability only (in our empirical approach we take the other inputs as given and constant, like most banks do in practice): we posit F(x)=ax. Let us then take two firms: f, which borrows from bank b, and f', which borrows from bank b'. Assume both firms have the same credit rating . Then, equation (3) for both firms writes: Lbf = a.b + . + bf Lb'f' = a.b' + . + b'f' (4) (5)

In these two equations, we abstract from bank fixed effects (because they do not affect the reasoning here) and from firm fixed effects (to which we return in the next paragraph). Substracting the (5) from (4), we obtain that: Lbf - Lb'f' = a.(bb') + (bf - b'f')

which shows that the coefficient of interest is identified as soon as banks b and b' have different models: bb'. The key to our identification of separately from the direct effect of ratings is that banks have different models. We establish this by (1) controlling for ratings and (2) showing that bb' holds in the data. This discussion remains the same if b follows the standardized approach: Then, it is key for identification that b' follows IRB. Third, we use firms borrowing from multiple banks to control for unobservable firm- level credit demand shocks - and not just observed rating. This is represented in equation (3) by the fixed effect f. For each firm who borrows from different banks, identification relies on the comparison between bank lending depending on the bank's capital charge. We can do this because the capital charge depends on both the firm and the bank (see discussion above). This approach is well known in the banking literature (see for instance: Khwaja and Mian, 2008, Iyer et al, 2011, Jimenez et al, 2012).

3. Data

a. Bank-Level Data

Our sample is made of the six largest banking groups operating in France. They represent around 80% of the total asset of the French banking system. The sample related to the estimation of equation (3) has 256 banks owned by one of these six groups.

b. Loan-level data

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We start from a large dataset of bank-firm linkages available at the Bank of France (Centrale des Risques). A linkage between bank b and firm f exists and is reported in the data as soon as bank b has an exposure of more than 25,000 euro to firm f. The data is thus exhaustive above a certain exposure threshold. The dataset is quarterly, and provides us with the total exposure, as well as the identifiers of the bank and of the firm. Exposure is lumpy on the way up, but continuous on the way down. Exposure increases abruptly when the bank extends a new loan to the firm, and then goes down progressively as the firm repays the loan. We define "lending" as the quarterly change in exposure. We then set lending to zero if exposure decreases - in the data such occurrences typically corresponds to principal repayment. We then create a quarterly panel firm-bank pairs. We include all firm-bank pairs that appear at least once in the large linkage dataset between 2006Q1 and 2012Q4. We then assume that the pair exists throughout the period that we study (2006Q1 - 2012Q4). If, at a given date, the pair is absent from the linkage data, we posit that exposure is equal to zero. We then merge with firm-level accounting and rating information, also available from the Bank of France (Centrale des Bilans). Such information is updated annually. Accounting information follows the tax forms that firms have to fill in and provides us with extremely detailed data on the balance sheet and the income statement. Credit ratings are awarded by a special unit at the Bank of France, which is in charge of maintaining the public credit registry. The credit registry covers a vast number of firms. Because we want to focus on the effect of the Basel 2 implementation, we collapse the dataset into two sub-periods: 2006Q1-2007Q4 (before the reform), and 2008Q1- 2012Q4 (after the reform). For each bank-firm pair, we take the sum of lending in each sub-period. We then take the log of the sup-period lending plus one. Thus, if banks does not lend during one period, the log is zero. We restrict the sample of firms to the firms that provide balance sheet and income statement over the entire period. We take averages of all firm observables. We end up

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with 421,901 bank-firm pairs. We provide summary statistics for the resulting dataset in Table 1A. We finally merge the data with bank-level information on the transition to Basel 2. This data provides us with the transition date (2008Q2 for all banks), and the approach approved by the French supervisor: IRB vs standardized. We focus on banks that are continuously present throughout the sample. On the sample on which regression (3) is estimated, 256 banks are present. All of them do not have exposures within each of the four Basel II regimes. As for the retail portfolio, 142 out 239 transit to the IRB approach. As for the corporate portfolio, 165 out 237 adopt the standardized approach. In terms of bank-firm relationship, out of 429,901 pairs that we follow between before and after the Basel 2 implementation, 291,162 transit to IRB, while the remaining 130,739 follow to the standardized approach. Firms that borrow from several banks make up a large fraction of our sample. 91% of the bank-firm pairs in our sample (387,961 out of 429,901) correspond to the firms borrowing from at least two different banks. Over the period, 73% of the firms have had an exposure to several judicial entities. These observations are especially useful as they allow us to include a firm specific fixed effect in equation (3), thereby controlling for differences, across banks, in the unobservable riskiness of firms. In Table 1B, panel A, we report summary statistics for two subpopulations of our loan-level sample: loans in which the firm borrows from several banks, and loans in which the firm borrows from one bank only. We see that the statistics are similar in the two subsamples, even though the differences in means are statistically significant. We will control for this observables in our regressions. But more convincingly, we will show that regressions results, before controlling for firm fixed effects, are identical in the two subsamples. Panel B, Table 1B investigates the difference between banks that adopt the standard and banks that adopt the IRB approach. The difference between these two categories might contribute to identification: two firms in the same risk class, but borrowing from two banks following different approaches, will face different equity requirements. Our empirical strategy will test if this difference in equity requirements is systematically

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related to differential lending growth. In Panel B, we report the difference in loan-level data for these two subsamples. We find that the summary statistics are similar, even though, once again, averages are significantly different. It may thus be argued that the two subsamples are different. We will deal with this concern by showing that regression results are similar whether we include, or not, banks transiting to the standard approach. Thus, the standard/IRB difference do not importantly contribute to our identification.

c. Common Counterparties

The first dataset ("common counterparties") allows us to measure how bank models for default probabilities differ across banks, for given firm characteristics. This dataset is a survey run in 2007 by the French prudential supervisor, on a sample of firms that borrow from at least two different French banks. For each of these common counterparties, banks report the default probability that they are using to calculate the capital charge of the loan. Thus, this dataset allows to directly compare the PD models that banks are using for the same firms. The dataset contains a lot of additional information, such as the LGD used by the bank (almost always equal to 45%), and firm- level characteristics, such as the credit rating given by the Bank of France. We use these data to calculate a bank-specific correspondence between credit rating and default probabilities. We first collapse the 11 bank of France rating categories into 6 categories: This is because, to attribute equity requirements under the standardized approach, the regulator only uses these 6 categories. We then calculate, for each bank and each of the 6 risk categories, the average regulatory PD of the firms in the sample (not the effective probability of default, but the one that banks assign according to the CC survey). This is how we obtain the b parameter in equation (2). We then use this bank-specific parameter to impute, in our entire sample (described in Section above), the default probabilities for each bank-firm pair. We then transform these default probabilities into capital charges using the Basel formula (1). We provide summary

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statistics on the resulting capital charges in Table 1A. For the average firm, the transition to Basel 2 led to a decrease in capital charge by approximately 1.9 percentage points (from 8% to 6.1 on average). This is consistent with the general idea that Basel 2 aimed at fostering SME financing. It should be noted however that the cross sectional s.d. of the change in equity requirements is about 2%, so that a significant fraction of the firms in our sample experienced increases capital charges. We exploit this variation in our empirical Section. Key to our identification strategy is that banks have different models for default probabilities, i.e. that the b are different across banks. We check this in Table 2, where, for each class of credit rating separately, we regress the imputed PD on a full set of bank dummies. We then test whether we can reject the null hypothesis that all banks use the same model, i.e. that the b are all equal, conditional on the rating. The first three columns of Table 2 show that, conditional on firm ratings, there is substantial heterogeneity in probabilities of default. Columns 4-8 show that the null hypothesis that all bank fixed effects are equal is strongly rejected by the data for all ratings groups. Moreover, bank fixed effects explain a considerable amount of the variance of PDs. The unexplained variation comes from the fact that we average observations across quarters of a sub period. Since banks may change credit rating, we take the integer part of the average rating, as an approximation for the average ration across periods. This creates composition effects that add noise to our construct.

d. Firm-level data

Last, we collapse the dataset constructed in Section 3.a. into firm-level data. The objective here is to evaluate the impact of the Basel 2 reform on firm-level decisions and outcome such as capital structure and investment. In particular, an important question is whether firms that can borrow more from one bank because of the transition to Basel 2 end up borrowing more in total, or whether they reduce they borrowing from other banks. We start from the loan-level data described in Section

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3.a. For all observations corresponding to the same firm, we then take the average of all variables. Firm-level accounting variables are not affected by this procedure, as they are by definition the same across all firm-bank linkages corresponding to the same firm. Summary statistics are reported in Table 3. They show that few composition effects arise, when compared with Table 1A. The average change in capital charge is the same: a decrease by about 2.2 percentage points after Basel 2 was implemented. Sales grow by 10% on average. Lending which accordingly to our definition cumulates the new loans on the two sub periods- increases by 147%. Note that this large increase is due to our definition of change in lending which implies for a firm borrowing X in the post period and nothing in the pre period a change of log(1+X) and which considers a bank- firm relationship as soon as an exposure appears on the total period. On the sample of firms that borrow in both periods, the lending increases by 67%. In the following section, we will test the robustness of our results considering alternative definitions of what a bank-firm pair is. All these numbers do not differ widely from those obtained in Table 1A: This is because multi-bank borrowing firms are not very different from single-bank firms, as already observed in Table 1B. We have added a few more firm- level accounting variables in this Table. Exposure is the total exposure to all banks, averaged over quarters and differentiated. Consistently with more borrowing (lending increases), total bank exposure increases by 58%.

4. Results

a. The Effect of Basel 2 on Bank Lending

Table 4 reports the regression results of various specifications of equation (3). We start with Panel A. In column 1, there are no firm-level controls, and no fixed effects. In this very raw specification, we find a negative impact on lending of higher capital requirement but this impact is not significant at conventional levels. Column 2 includes

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firm-level controls: the pre and post-period average bank of France rating discretized into 6 categories, as well as the pre-Basel 2 level of log sales and ROA. These variables are designed to control for firm size and financial health before the reform. Credit ratings are also included because they serve to calculate the equity requirements, and we want to make sure that the effect of requirements is not identified on firm credit risk, but on its interaction with the model of the bank. Including these controls actually almost doubles the size of our estimate which now turns out to be strongly significant. In column 3, we further include a bank fixed effects, to alleviate the concern that conservative banks (whose equity requirement is high under their own internal model) may be linked to firms that do not borrow very much for other reasons. For instance, mutual banks may be lending to SMEs that do not seek to grow very much, especially in times of crises, and may also end up with higher capital requirements, either because of conservative risk-management practices, or because they were only allowed to adopt the standard approach (which has higher capital requirements). As can be seen from Column 3, controlling for bank fixed effects does change our estimate in a significant manner. We find that a two percentage point decrease in capital charge (say, from 8 to 6%) leads to an increase by 8.74*0.02=17.5 percentage point increase in bank lending. This corresponds to about 6% of the sample s.d. of bank lending growth. Our model thus has a priori reasonable explanatory power for this kind of microeconomic study. In aggregate, the model estimates that the Basel 2 reform has boosted corporate lending by 0.022*8.74=19 percentage points, where2.2% is the average reduction in equity requirement coming from Basel 2. This is 14% of the increase in lending observed between the two sub-periods. Columns 4-5 seek to control for credit demand shocks by including a firm-level fixed effect in equation (3). The firm fixed effect also allows to control for unobserved heterogeneity in firm-level credit risk that may affect a bank's decision to lend. Note that, for this heterogeneity to matter, it would have to explain lending beyond what the bank of France rating can do. Firm-level risk unobserved heterogeneity is identified of off firms that borrow from several different banks (they constitute almost 73% of

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our firm data): The statistical procedure checks that for the average firm, lending growth tends to be larger with banks whose capital charge has decreased the most. We first check that the multi-bank firm sample has similar properties to the overall sample. In column 4, we re-run the same specification as in column 3, but restrict the sample to multibank firms. We find a similar coefficient. In column 5, we include the firm fixed effect, and find a coefficient that is slightly larger but the difference between the two is not statistically significant. Panels B and C further investigate the underlying variation that permits to identify the coefficient on capital charge. In Panel B, we replace the capital charge by a dummy variable equal to one if the bank transitions to the "standardized approach", and zero if it is allowed to adopt the IRB approach. In this panel, we seek to investigate the identifying power of the IRB/standardized difference in capital charge. First, notice that the IRB approach is more advantageous in terms of capital requirements: This was to encourage banks to build good internal risk models. Going to Table 1B, we see that the capital charge decreases slightly more for loans with an IRB bank: - 1.7 percentage points for standardized banks, versus -2.1 ppt for IRB ones. Looking now at Table 4, panel B, we see all the specifications (columns 1 to 5) generate small and insignificant estimates. This suggests that the lending growth differential between IRB and standardized banks do not contribute significantly to identification. Results from Panel C show that the effect is mainly identified within the set of banks that adopt the IRB approach. The differences in risk models across banks described in Table 2 are large enough to also strongly contribute to identification. In Panel C, we restrict ourselves to loans where the bank adopts the IRB approach. In this sample, the capital charge varies both with the bank and the firm, as it depends on the average default probability the bank assigns to firms, per category of credit rating. We see that, for all 5 specifications, the coefficient is strongly significant and has the same order of magnitude as in Panel A.

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b. Additional Tests
We then consider alternative measures of lending and definition of the bank-firm relationship. In Table 2, recall that once an exposure of the bank b to the firm f was observed over the whole period, the pair bank-firm was considered. In the panel A of Table 5, we restrict ourselves to bank-firm pairs when the firm has taken out at least one new loan from the bank within the entire period. As before, we take the same 5 econometric specifications. The impact of the capital requirement is then magnified leading to a significant impact of higher capital requirement on lending growth in all specifications. To measure loan growth at the intensive margin, we take lending growth of firm-bank linkages for which we observe at least one loan in both periods. We report the result of this regression in Table 5, Panel B. We find that the intensive margin effect that we estimate is smaller than the overall effect estimated in Table 4. The coefficient hovers around 3. This means that 2 percentage point decrease in the equity requirement (-0.019 is the sample mean) would lead to a 6 points decrease in lending at the intensive margin, much smaller than the 19 points obtained globally (in Table 4, Panel A).

We then investigate the transition dynamics, and show that the effect of the reform increases over the years until 2011 (we do not have firm controls for the year 2012). We have to compare the lending granted in 2011, 2010 and 2009 taken separately to the one made in the pre reform period. In order to compare the parameters associated to the change in capital requirement to the same parameter estimated with the whole post period we consider another definition of lending. Indeed, if we stick to our former definition, the parameter will be less comparable since the likelihood to get a new loan is of course greater when considering more years in the post period and that the amount of new loans accrue over time. Alternatively, we now define lending as the log of the average exposure over one year of the post period when considering the post

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period year separately. When we collapse all the post periods, we define lending as the log of the average exposure over the entire post period. For instance, in Table 5, Panel A, we use as dependent variable the change between the log of average post reform exposure and the log of average exposure in the pre period. In Table 5, Panel B, we use as dependent variable the change between the log of average exposure in 2009 and the log of average exposure in the pre period. Panel C focuses on 2010 and Panel D on 2011. In each panel, we take the whole sample and report results for all the 5 specifications used in Table 4. Looking at all specifications, we conclude that the effect became more pronounced over the years. This is consistent with the financial crisis, a time where it was notoriously difficult for banks to raise external equity.

c. The Effect of Basel 2 on Corporate Outcomes

We now test for the impact of the regulation change on firm-level outcomes. To do this, we run the following regression at the firm level: Yf = .rf + Xf + f (6)

where Yf is the change in firm policy (debt, investment etc.), and Xf is a set of firm level controls (the same as in Tables 4-6). rf is the average of all changes in equity requirement, across all banks to which the firm f is linked. The f are assumed to be heteroskedastic. We report the results in Table 7. Note that, since we focus on firm-level outcome (not loan level ones), this methodology does not permit to control for bank nor firm fixed effects. This is a limitation of our study. What gives us confidence in our estimates, however, is that the estimates, with or without bank and firm FE, tend to be stable (see Table 4, Panel A). This suggests that the potential biases that may arise from bank or firm-level

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heterogeneity (bank-level credit supply shocks, firm-level credit demand shocks etc) are not too large. We first show that the reform affected overall firm borrowing. We have shown in Tables 4-6 that the change in capital requirement affects bank lending, but it may be the case that firms can substitute shrinking lending by one bank with borrowing from another bank. It may alternatively be the case that the ability to borrow from one particular bank (because of decreasing capital charge) would cause the firm to borrow less from other banks. In both cases, even though the reform is shown to have an impact at the loan level, it may have no impact at the firm level. We check this in columns 1-3, Table 7, using our two different measures of firm borrowing. In column 1, we look at average firm borrowing across all linkages. This measure is the closest to the regressions already run in Tables 4-5, except that we aggregate at the firm level. For each firm and each date, we calculate the sum of loans made across all bank-firm linkages. We then sum this measure across dates of each sub period. Finally, we take the log and differentiate. This measure is exactly identical to the loan growth measure used in Table 4-5 for firms who are linked to only one bank (about half of our sample). As shown in column 1, we obtain an estimate of the impact of the reform that is slighty lower than the baseline estimates (-3.17 in table 7 to be compared with -5.8 in table 4, suggesting that there is little substitution within our sample given the precision of the estimates). In column 2, we use as dependent variable average total bank exposure. In the initial bank-firm linkage data, we aggregate total exposure across all banks at the firm- quarter level. We then take average total exposure across quarters of each subperiod, take the log and differentiate. We find in column 2 that the effect estimated in column 1 is slightly lower than the one displayed in table 6, column 2 at the bank-loan level. The fact that the estimate has similar size for stocks and flows suggests that the maturity of the loans tends to be short, so that a reduction in lending would quickly lead to a reduction in the stock of debt.

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In columns 4-7, we show that a decrease in average equity requirement leads to the expansion of a firm's assets, working capital and employment. In column 4, we find that a 2 ppt increase in capital requirement leads to an increase in total assets, as well as current assets, by about 1 ppt. The effect is a bit smaller, although with a similar order of magnitude, for employment: For the average firm in our sample, the transition to Basel 2 helped create 0.31 x 0.022 = 0.68 additional ppt of employment. This is to be compared with a 3.2% average employment growth in our sample.

5. Conclusion
Although present at the heart of the policy debate on the banking regulation, the impact of higher capital requirement on lending and real outcome has been rarely examined in the academic literature at the micro level. This paper evaluates such impact. The implementation of the Basel II regulatory framework in 2008 in France led banks to substantially modify the regulatory capital associated to each credit line of their corporate portfolio. Exploiting the French national credit register and the internal bank rating models, we are able to match each loan at the firm-bank level with a risk weighted asset charge applied by the bank. We identify the impact of the capital requirement by contrasting the lending of several banks charging different regulatory capital to the same firm. These charges differ across banks because banks are either under different regulatory regimes (e.g. advanced, foundation or standard approach of Basel II) or simply because they differ in their internal models. Therefore our approach controls for demand effect. Depending on our definition of lending at the extensive margin, on new loans or exposure- we find an increasing impact ranging from 3 to 8 percent of an increase of capital requirement by one percent. This impact translates to real corporate outcomes such as employment and investment.

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 References

Admati, Anat, DeMarzo, Peter, Hellwig, Martin and Pfleiderer, Paul, 2010, "Fallacies, Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive", Stanford GSB WP 2065 Aiyar, Shekhar, Calomiris, Charles and Tomasz Wiedalek, 2012, "Does Macro-Pru Leak? Evidence from a UK Policy Experiment", NBER WP 17822 Hanson, Sam, Kashyap, Anil and Stein, Jeremy, 2011, "A Macroprudential Approach to Financial Regulation", Journal of Economic Perspectives, Vol 25(1), pp 328 Iyer, Raj, Lopes, Samuel, Peydro, Jose-Luis and Antoinette Schoar, 2011, "The Interbank Liquidity Crunch and the Firm Credit Crunch: Evidence from the 2007-2009 Crisis", mimeo UPF and MIT Jimnez Gabriel, Steven Ongena, Jos Luis Peydr and Jess Saurina, 2012, "Credit supply and monetary policy: Identifying the bank balance-sheet channel with loan applications, American Economic Review, 102 (5), 2301-2326. Kashyap, Anil and Stein, Jeremy, 2004, "Cyclical Implications of the Basel II capital standardss", Economic Perspectives, Federal Reserve Bank of Chicago, vol. 28 Kwhaja, Asim, and Mian, Atif, 2008, "Tracing the Impact of Bank Liquidity Shocks", American Economic Review, vol 98(4)

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Figures and Tables

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Table 1A: the different Basel II regimes

Note: The unit of observation is a bank-firm linkage. Basel II considers four different regimes of capital requirement: the retail exposure (less than one million of exposure and 50 millions of turnover), the corporate exposure (more than one million of exposure or more than 50 millions of turnover). The retail portfolio and the corporate portfolios of a given entity can be treated either under the standard approach or the advanced approach. This table displays the number of banks, the number of exposures, the total amount of exposures in each of the four regulatory regimes. We start from the universe of bank-firm linkages with bank exposure above 25,000. These data are quarterly. For a pair to be followed throughout 2006:1 - 2012:4, we require it to be in the bank-firm linkage dataset at least once in the period (2006:1 - 2012:4). We then match these data with annual firm-level accounting information. In our final dataset, we have 421,901 bank-firm linkages. The average exposure is computed over the 2008:1-2012:4 period. The regulatory regime of a given entity for a given regulatory portfolio has been provided by the French supervisory authority.

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 Table 1B: Summary Statistics of the Loan-Level Dataset

Note: The unit of observation is a bank-firm linkage. Change in log lending is defined as the difference between the log of the sum of new loans granted to the firm f by the bank b in the post period and the log of the sum of new loans granted to the firm f by the bank b in the pre period pre period. For the other variables, "Change in X" the difference between the average of X in the post reform period (2008:1 - 2011:1) and the average of X in the pre period (2006:1 - 2007:4). "Pre reform X" is the average of X in the pre period (2006:1 - 2007:4). To construct these averages, we start from the universe of bank-firm linkages with bank exposure above 25,000. These data are quarterly. For a pair to be followed throughout 2006:1 - 2012:4, we require it to be in the bank-firm linkage dataset at least once in the period (2006:1 - 2012:4). We then match these data with annual firm-level accounting information. Finally, we use 2007 bank-risk class averages from the "common counterparties" and the Banque de France rating of the firm to impute regulatory PDs and capital charges for each bank-firm pair and each quarter. We then take the average of all variables over the two sub-periods (pre and post reform), and then differentiate. In our final dataset, we have 421,901 bank-firm linkages.

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