Pro-Cyclical Capital Regulation and Lending

Abstract

We combine particular institutional features of the stepwise introduction of asset risk-specific capital charges by German banks with the event of the Lehman shock to test the theory of pro-cyclicality of capital regulation and to quantify the magnitude of this regulation on firms’ access to lending. The Lehman shock resulted in an increase of credit risk during the implementation period of the internal ratings-based (IRB) approach to capital regulation. At this point, banks introducing IRB had transferred only a portion of their loan portfolios to the new approach. Exploiting the variation of the regulatory approach within IRB banks and the fact that many firms borrow from several IRB banks at the same time allows us to systematically control for both bank-level and firm-level heterogeneity. Loans to the same firm decline by about 3.5 percent more when the loan is part of an IRB portfolio as compared with a portfolio using the traditional regulatory approach. Since banks tend to reduce especially large IRB credit exposures during the recession, firms relying on IRB loans experience an even stronger reduction in aggregate borrowing (5 to 10 percent larger) as compared with firms relying on loans under the traditional approach. Our findings have important implications for the design of capital regulation (i.e., Basel III).