We propose a theory of bank behaviour under capital requirements that accounts for both risk-shifting incentives and debt overhang considerations. A key result is that the bank’s lending response to an increase in the requirement need not be negative. The sign and the magnitude of the response depend on the bank’s balance sheet and economic prospects, and lending is typically U-shaped in the requirement. Using UK regulatory data, we find empirical support for the hypothesis that a bank mainly adjusts to a higher requirement by cutting lending when expected returns are low, but by raising capital when they are high. Joint with Saleem Bahaj.
(JEL Codes: G21, G28)