Bank capital regulation, loan contracts, and corporate investment

• Bank loan contracts specify the use of funds by the borrowing firm.
• The more funds are directed to tangible assets, the less risky the loan will be.
• A less risky loan requires less bank capital which makes the loan less expensive.
• To save on financing costs, firms prefer highly tangible over productive assets.
• Bank capital regulation corrects for this incentive putting a lower limit on costs.

This paper studies the link between bank capital regulation, bank loan contracts and the allocation of corporate resources across firms’ different business lines. Credit risk is lower when firms write contracts that oblige them to invest mainly into projects with highly tangible assets. We argue that firms have an incentive to choose a contract with overly safe and thus inefficient investments when intermediation costs are increasing in banks’ capital-to-asset ratio. Imposing minimum capital adequacy for banks can eliminate this incentive by putting a lower bound on financing costs.