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Basel II Capital Requirements, Firms' Heterogeneity, and the Business Cycle

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Author Info
Ines Drumond () (CEMPRE and Faculdade de Economia, Universidade do Porto)
José Jorge () (CEMPRE and Faculdade de Economia, Universidade do Porto)

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Abstract

This paper assesses the potential procyclical effects of Basel II capital requirements by evaluating to what extent those effects depend on the composition of banks' asset portfolios and on how borrowers' credit risk evolves over the business cycle. By developing a heterogeneous-agent general equilibrium model, in which firms' access to credit depends on their financial position, we find that regulatory capital requirements, by forcing banks to finance a fraction of loans with costly bank capital, have a negative effect on firms' capital accumulation and output in steady state. This effect is amplified with the changeover from Basel I to Basel II, in a stationary equilibrium characterized by a significant fraction of small and highly leveraged firms. In addition, to the extent that it is more costly to raise bank capital in bad times, the introduction of an aggregate technology shock into a partial equilibrium version of the model supports the Basel II procyclicality hypothesis: Basel II capital requirements accentuate the bank loan supply effect underlying the bank capital channel of propagation of exogenous shocks.

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Publisher Info
Paper provided by Universidade do Porto, Faculdade de Economia do Porto in its series FEP Working Papers with number 307.

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Length: 50 pages
Date of creation: Jan 2009
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Handle: RePEc:por:fepwps:307

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Related research
Keywords: Business Cycles; Procyclicality; Financial Constraints; Bank Capital Channel; Basel II; Heterogeneity;

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Find related papers by JEL classification:
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
E10 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - General

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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Inês Drumond, 2008. "Bank Capital Requirements, Business Cycle Fluctuations and the Basel Accords: A Synthesis," FEP Working Papers 277, Universidade do Porto, Faculdade de Economia do Porto. [Downloadable!]
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