How Do Markets React to Tighter Bank Capital Requirements

We use hikes in the countercyclical capital buffer [CCyB] to measure how tighter bank capital requirements affect their solvency and value, according to market participants. Two features of the CCyB in Europe allow for a unique identification strategy of the effect of such requirements. First, national authorities make quarterly announcements of CCyB rates. Second, these hikes affect all European banks proportionally to their exposure to the country of activation. We show that CCyB hikes translate in lower CDS spreads for affected banks, indicating that markets perceive higher solvency. On the other hand, bank valuations do not react. Markets therefore consider that higher capital requirements translate into more stable banks at no material cost for shareholders. We claim that these effects relate to the capital constraint itself, as opposed to the potential signal conveyed on the state of the financial cycle.