Do stricter capital requirements harm bank profitability? This question has been a key topic in debates on financial regulation since at least the global financial crisis. This study finds no evidence that higher capital requirements reduce profitability. However, differences in these requirements across jurisdictions can create competitive advantages for certain banks. Nevertheless, lowering capital requirements is not an effective strategy for improving profitability and could even be detrimental if reciprocated by foreign jurisdictions.

In the aftermath of the 2007‑09 global financial crisis, the Basel III reforms introduced stricter capital requirements to enhance the resilience of the banking sector. However, these requirements have been implemented unevenly across jurisdictions, raising concerns about their impact on banks’ profitability and international competitiveness. This paper examines whether stricter capital requirements and their international differences influence banks’ profitability, with a focus on large banks in the US and Europe. The findings challenge the notion that stricter capital requirements harm profitability and highlight the nuanced effects of regulatory differences on globally active banks.

Leveraging a comprehensive dataset on banks in the US and the EEA

The empirical study uses a comprehensive dataset of large banks in the US and the European Economic Area (EEA), covering the period from 2019 to 2024. To assess the impact of capital requirements, voluntary capital buffers, and international regulatory differences on banks’ profitability, the study employs panel regression models. Key variables include profitability measures such as return on assets (RoA), bank-specific capital requirements under Basel III, and macroeconomic controls like GDP growth and interest rates. The study also explores potential spillover effects by examining how differences in capital requirements between jurisdictions influence the profitability of banks with cross-border exposures.

Adding to the literature on the capital-profitability nexus

The paper builds on three strands of literature: the relationship between capital ratios and banks’ profitability, the impact of capital requirements on bank profitability, and the international spillovers of regulatory policies. One key theoretical argument is that higher capital requirements could increase banks’ refinancing costs, potentially reducing profitability. However, well-capitalized banks may also benefit from lower default risk and improved operational efficiency, which could offset these costs. This study expands on the existing literature by focusing on capital requirements – rather than solely on capital ratios – and by analyzing the effects of international regulatory differences on banks’ profitability across a broad sample of US and EEA banks.

No evidence that higher capital ratio or requirements reduce profitability

The study finds no evidence that higher capital requirements negatively affect banks’ profitability. In fact, for German significant institutions (SIs), higher capital requirements are even positively associated with profitability. This suggests that well-capitalized banks may benefit from enhanced stability and efficiency, outweighing the potential costs of higher capital. Notably, banks that hold voluntary capital above the regulatory minimum tend to exhibit higher profitability. This finding underscores the importance of excess capital as a strategic tool for banks to manage risks and seize market opportunities.

International differences in regulation matter for some globally active banks

Differences in capital requirements between jurisdictions can influence the profitability of globally active banks.
For example, German SIs with substantial US exposure benefit from the regulatory gap between requirements in both regions. However, this advantage is not observed for US banks operating in the EEA or for other EEA banks with US exposure.

Lowering requirements is not an effective strategy to boost profitability

Based on the estimated spillover effects, the study considers two policy scenarios. In a unilateral scenario where only the home country reduces requirements, German SIs with substantial US exposure experience a modest profitability boost. However, in a reciprocal scenario where both the home and foreign jurisdictions lower requirements, the potential profitability gains disappear, and the overall effect turns negative. This highlights the risks of a “race to the bottom” in regulatory standards.

Important take-away for regulatory policies

The findings challenge the argument that stricter capital requirements harm banks’ profitability. Instead, higher requirements either have no significant effect or are positively associated with profitability. However, international differences in capital requirements can create competitive imbalances, benefiting banks operating abroad.

The study offers two take-aways from a regulatory policy perspective. First, harmonizing capital regulation across jurisdictions is essential to mitigate regulatory spillovers and ensure a level playing field. For instance, the EU's countercyclical capital buffer, which applies uniformly to all exposures in each country, could serve as a model for international coordination. Second, reducing capital requirements is not an effective way of enhancing banks’ profitability in a sustainable fashion. In fact, it could undermine the resilience of the banking sector, and therefore financial stability, by triggering a regulatory race to the bottom.