Cornett et al (2011) and Kapan and Minoiu (2013) report that banks relying more heavily on stable sources of funding, such as core deposits and equity capital, continued to lend relative to other banks during the crisis. And Jimenez et al (2014) find that, in periods of economic weakness, loan applications were less likely to be rejected by Spanish banks that were well-capitalised. A recent paper by Bank of England colleagues identifies a distinct channel through which bank capital affects crisis severity (Tracey, Schnittker and Sowerbutts (2017)). They use banks’ misconduct fines as a novel instrument to identify exogenous negative bank capital shocks. They find that banks respond to such shocks by relaxing their lending standards, as measured by the loan-to-value and loan-to-income ratios on new mortgages. This is likely to increase their vulnerability to future shocks, increasing crisis severity. This evidence suggests that some of the benefits of higher capital requirements may have been understated in the original LEI study, with implications for the range of optimal capital requirements. For example, if we assumed that every percentage point of extra capital increased the level of real GDP each period in the  13  Relatedly, Demirguc-Kunt et al (2010) and Beltratti and Stulz (2012) find that poorly capitalised banks had lower stock returns during the financial crisis. And Boyson et al (2014) find that banks that entered the recent financial crisis with higher capital were less likely to see their funding dry up during the crisis.

These arguments make it difficult to specify strict regulatory rules for all seasons. They point to the need for a forward-looking, horizon scanning approach with scope for supervisory judgement and macroprudential discretion (BCBS (2017)). This does not, however, obviate the potential benefits from seeking, over time, to specify clearer mandates and regulatory reaction functions, especially on the macroprudential front. Incentives and Arbitrage  The empirical exercise in the previous section looked at how a set of regulatory standards, applied counterfactually, might have done in spotting stress among a set of banks. Plainly, any such counterfactual 27  All speeches are available online at www.bankofengland.co.uk/speeches  27  exercise is subject to significant caveats. The most important of these is that it cannot take account of how changes in the regulatory regime might themselves have reshaped risk-taking incentives at the time. This Lucas Critique plainly looms large in the field of financial regulation. Financial regulation, like any tax, is very likely to change the behaviour of the party subject to it. This is neither surprising nor, necessarily, undesirable. Indeed, sometimes it is the precise purpose of the regulation in the first place. For example, average risk weights on assets held in the trading book have increased by 45% across a sample of major UK banks between 2006 and 2013. Partly in response, trading books have shrunk by, on average, 24% across these banks and by 45% across the world’s G-SIBs. This was an intended, and probably desirable, behavioural response to a necessary recalibration of regulatory standards.