Risk Migration from the Banking Industry to the Real Economy

This study investigates whether bank regulations pertaining to capital and liquidity, which are designed to promote a resilient banking system, cause risk migration from the banking industry to the real economy. Specifically, I examine whether borrowers increase their risk-taking after incurring higher borrowing costs due to Basel III. Using a difference-in-differences research design to compare borrowers of banks that are more affected by Basel III (i.e., banks with $250 billion or more in total consolidated assets) with borrowers of banks that are less affected, I find that the borrowers more affected by Basel III (a) experienced a relative increase in loan costs, (b) displayed a relative increase in accounting- and market-based volatility, and (c) incurred a relative increase in investments in risky activities with uncertain benefits. These findings suggest that borrowers are exposed to moral hazard: to compensate for the increased borrowing costs, they are incentivized to take on more risk in pursuit of higher expected returns. Such results are not driven by adverse selection, time trend, or bank size. This study highlights a potential unintended consequence of bank regulations on borrower risk-taking.