Bank capital regulation and interest margins: An empirical study of U.K. banks

This paper examines the long-run and short run components of the relationship between bank capital and intermediation margins.  This is an important element of assessments of the macroeconomic impact of higher prudential standards, but empirical evidence on the direction and magnitude of the relationship is scarce and contradictory.  We argue that deviations from the Modigliani-Miller Theorems may result in a substantial positive relationship between bank capital and interest margins in the long run, other things equal.  However, fluctuations of capital ratios around the banks’ optimal target may drive a negative relationship in the short run and in periods of transition.  We argue that this explains the divergent findings of the extant literature, and we present evidence from an econometric analysis of a sample of large UK banks which separately identifies the two effects in the same period and hence provides an estimate of the long-run impact of capital on interest margins.  We also contribute to the literature on how banks pass on costs by providing evidence on how the long-run bank capital component in spreads is distributed between household and corporate margins.