Does a Large Loss of Bank Capital Cause Evergreening? Evidence from Japan

Abstract Using the real estate lending share of the bank's loan portfolio at the peak of the land price bubble as an instrument for bank capital, we identify the impact of capital adequacy on the allocation of bank lending under the Basel regulatory framework. We find that, in Japan, a large loss of bank capital caused by the regulator's excessively tough stance towards banks not only induced the contraction of the bank lending supply but also the banks' reallocation of their lending portfolios to financially unhealthy industries with a higher concentration of non-performing loans. Keywords: evergreening, bank capital, real estate lending, instrumental variable JEL classification: C31, G21 * I am greatly indebted to Ben Bernanke for his continuous advise, support, and extensive comments. I would like to thank Han Hong, Takeo Hoshi (an editor), Charles Yuji Horioka, Vasso Ioannidou (the designated discussant at the workshop, "Risk Management and Regulation in Banking" held at the Basel Committee for Banking Supervision) Anil K. Kashyap, Miles Kimball, Keiichiro Kobayashi, Jean-Phillip Laforte, Guido Lorenzoni, Yoichi Nemoto, Masaya Sakuragawa, Gary Saxonhouse and Greg Udell and an anonymous referee for useful comments and suggestions. I also benefited from the comments of seminar participants at the Princeton Macro/International Student Workshop, Ban