Steven Ongena (University of Zurich)

We first investigate the use of taxation as a complementary tool to capital requirements to monitor bank risk in a simple mean-variance model for portfolio selection, where banks are subjects to capital regulation and regulatory risk weights are not perfectly aligned with the risk of the bank assets. We show that when the fiscal cost of leverage decreases: (1) banks rely more on equity, (2) shift the composition of their assets towards loans, (3) and take less risk. Overall, taxes partly offset distortions induced by capital requirements. To test the model predictions, we then exploit the staggered introduction of tax reforms across Europe between 1996 and 2012 that increase the fiscal cost of leverage either by subsidizing equity or by taxing bank liability net of equity. Employing both bank- and loan-level data, we confirm that when the fiscal cost of leverage increases, banks simultaneously decrease leverage and lend relatively more.

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