Bank Capital Adjustment Process and Aggregate Lending ∗

This paper proposes a new micro-founded measure to quantify the aggregate capitalisation of banking sectors taking into account both market discipline and regulatory constraints. It allows to study the connection between micro capital shortfalls and macro impacts of capital shortages on aggregate lending. We first estimate a partial adjustment process allowing to recover the implicit capital tar-get of banks. We then compute a country-specific aggregate measure of capital shortfall. As it uses mostly slow moving balance sheet variables, this measure is a valuable complement to market-based indicators, which has several interesting features. (i) Our quantitative index of bank capitalisation is consistent with the qualitative reports of the ECB Bank Lending Survey. (ii) This index correlates with future fluctuations in aggregate lending, especially when a banking system is under-capitalised. (iii) The adjustment of capital constrained banks mostly impact loans to domestic non-financial agents. Thus, this market-implied bank capital ad-justment can help detecting vulnerabilities and reversals in the lending cycle, and as such is particularly relevant for financial stability monitoring