Abstract - Credit allocation, capital requirements, and procyclicality

Although beneficial allocational effects have been a central motivator for the Basel II capital adequacy reform, the interaction of these effects with Basel II's procyclical impact has been less discussed. In this paper, we investigate the effect of risk-based capital requirements on the allocation of credit. We consider competitive credit markets where entrepreneurs can apply for loans for investments with different risk profiles. In this setting, excessive risk taking typically arises because higher-type borrowers cross-subsidize lower-type borrowers through a pricing regime that is based on average success rates. We find that while flat-rate capital requirements (such as Basel I) increase overinvestment in risky projects, risk-based capital requirements alleviate the cross-subsidization effect and improve allocational efficiency. This suggests that Basel II need not lead to exacerbation of macroeconomic cycles because the ensuing reduction in the proportion of high-risk investments will mitigate the procyclical effect of bank lending over the business cycle. Moreover, the level of optimal risk-based capital requirements should increase in the level of interest rates.

Esa Jokivuolle
Bank of Finland
02.Dec 2008

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