by Joe Peek and Eric S. Rosengren
May/June 1995

New England's recovery from our most recent recession has been marked by unusually slow growth in bank lending. As of the third quarter of 1994, total loans still had recovered only to 76 percent of the level attained at the peak in the third quarter of 1989. Numerous recent studies have identified low bank capital ratios as a factor contributing to slow growth in loans, but a direct link between the level of bank lending and bank regulation has been established only recently.

To better understand how regulatory policy might directly influence bank lending, this article examines the ways that bank supervisors intervene when a bank's financial situation deteriorates. If a bank's problems are serious, regulators will impose a formal action, a legally enforceable agreement requiring a bank to improve its performance. Among the conditions included in formal regulatory actions, capital requirements have played a key role in altering bank lending behavior. The study documents that the correlation between bank capital and loan shrinkage found in earlier studies has a regulatory link, through the requirements imposed in formal actions.

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