The Impact of Capital on Lending in Economic Downturns and Investor Protection – the Case of Large EU Banks

This paper attempts to find out whether better quality of investor protection matters for the effect of capital ratio on loan growth of large EU banks in 1996-2011. We focus on several measures of the quality of investor protection with a proven track record in the banking literature, i.e.: anti-self-dealing index, ex-ante-control and ex-post-control of anti-self-dealing indices, and creditor protection rights index. Our results show that better investor protection decreases the procyclical impact of capital on lending. This effect is statistically significant for the ex-post-control index. This is consistent with the view that better shareholders rights reduces bank risk-taking, in particular during economic booms, which results in weakened sensitivity of bank lending to capital ratios in economic downturns. This effect holds for both unconsolidated and consolidated data and is robust to sensitivity checks.