The Journal of Finance, Vol. 71, Issue 2, pp. 919-956, 2016

Pro-Cyclical Capital Regulation and Lending

We use a quasi-experimental research design to examine the effect of model-based capital regulation on the pro-cyclicality of bank lending and firms' access to funds. In response to an exogenous shock to credit risk in the German economy, capital charges for loans under model-based regulation increased by 0.5 percentage points. As a consequence, banks reduced these loans by 2.1 to 3.9 percentage points more than loans under the traditional approach with fixed capital charges. We find an even stronger effect when we examine aggregate firm borrowing, suggesting that micro-prudential capital regulation can have sizeable real effects.