Loan Supply Shocks, Prudential Regulation, and the Business Cycle

How do the business cycle effects of loan supply shocks depend on the state of prudential regulation in the euro area? To address this question, we first identify regulatory cycles from a cumulative prudential policy index that tracks the evolution of the regulatory stance in the euro area. Using sign restrictions in a local projections framework with state-dependency, we identify loan supply shocks and analyze their business cycle effects in regimes with tight and loose prudential regulation. We find that in tight regimes, expansionary shocks trigger a boom-bust cycle. In the loose regime, results appear inconclusive. We also observe tendencies toward asymmetry in the responses across regimes. While results for the tight regime are robust, the effect of shocks on the business cycle is sensitive to identified loose regimes.