Procyclical Capital Regulation and Lending

ABSTRACT We use a quasi‐experimental research design to examine the effect of model‐based capital regulation on the procyclicality 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 the amount of these loans by 2.1 to 3.9 percentage points more than for loans under the traditional approach with fixed capital charges. We find an even stronger effect when we examine aggregate firm borrowing, suggesting that microprudential capital regulation can have sizeable real effects.