The IRB Approach and Bank Lending to Firms

Abstract

This paper examines the impact of the regulatory approach adopted to calculate capital requirements on banks’ lending policies. Since the capital absorption of loans to high-risk borrowers is greater under the internal ratings-based (IRB) method than under the standardized approach (SA), IRB banks may raise interest rates and reduce credit to riskier borrowers following their regulatory regime shift. The analysis examines banks’ lending policies around each of the shifts that occurred between 2007 and 2017. First, in a context of declining rates and credit growth, banks adopting the IRB approach decreased interest rates (credit) less (more) for riskier than for safer borrowers when compared with SA intermediaries. Second, an existing credit relationship with a high-risk borrower is more likely to end after the shift. Third, the results at the firm level suggest that high-risk borrowers partly compensated the reduction in bank credit by obtaining funds from SA institutions, but that they were not able to offset the rise in their average cost of credit because of the significant costs involved in switching lenders.