Bank Capital and Lending During a Downturn

Regulatory changes and stress testing have contributed to the increase in banks' capital ratios since the financial crisis. However, the recent downturn might result in sizable losses and a decline in bank equity. Government agencies have encouraged banks to use their capital buffers and made temporary adjustments to capital regulation as a way to reduce the impact of the reduction in bank capital on lending. Capturing how important is the capital channel requires isolating the effect of the capital reduction from demand and other supply factors. This article presents estimates from a structural model of banking that features big banks with market power and small banks that compete in credit markets and face capital requirements. The model is simulated to generate dynamics similar to those used in the recent stress test sensitivity analysis that the Federal Reserve conducted in light of the coronavirus event.