Portfolio effects and efficiency of lending under Basel II
AbstractAlthough beneficial allocational effects have been a central motivation 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 Basel II on the efficiency of bank lending. We consider competitive credit markets where entrepreneurs may apply for loans for investments of different risk profiles. In this setting, excessive risk taking typically arises because low risk borrowers cross-subsidize high risk borrowers through the price system that is based on average success rates. We find that while flat-rate capital requirements (such as Basel I) amplify overinvestment in risky projects, risk-based capital requirements alleviate the cross-subsidization effect, improving allocational efficiency. This also suggests that Basel II does not necessarily lead to exacerbation of macroeconomic cycles because the reduction in the proportion of high-risk investments softens the cyclicality of bank lending over the business cycle.
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Bibliographic InfoPaper provided by Bank of Finland in its series Research Discussion Papers with number 13/2007.
Length: 23 pages
Date of creation: 03 Oct 2007
Date of revision:
Basel II; bank regulation; capital requirements; credit risk; procyclicality;
Find related papers by JEL classification:
- D41 - Microeconomics - - Market Structure and Pricing - - - Perfect Competition
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-10-13 (All new papers)
- NEP-BAN-2007-10-13 (Banking)
- NEP-FMK-2007-10-13 (Financial Markets)
- NEP-REG-2007-10-13 (Regulation)
- NEP-RMG-2007-10-13 (Risk Management)
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