Model-based regulation: lending in times of Covid

When the coronavirus (COVID-19) pandemic struck, it was vital for many firms to retain access to funding from banks. In order to calculate their capital requirements, banks measure borrowers’ credit risk using either “their own”, internal ratings-based (IRB) models, or a standardised approach. This analysis examines whether model-based bank regulation constrained lending during the COVID-19 crisis. Results show that banks using their own models extended less credit than banks using a standardised approach. This outcome was not dependent on borrowers’ characteristics, or the credit booms seen in some countries, but is connected to the IRB models that some banks use. Certain features of the models such as the “downturn loss-given default” parameter, which reflects how much money a bank can expect to lose when borrowers default on loans during downturns, are helpful to bolster banks’ resilience and preserve their intermediation capacity during times of economic decline. JEL Classification: G21, G28