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The Procyclical Effects of Basel II

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  • Rafael Repullo

    () (CEMFI, Centro de Estudios Monetarios y Financieros)

  • Javier Suarez

    () (CEMFI, Centro de Estudios Monetarios y Financieros)

Abstract

We analyze the cyclical effects of moving from risk-insensitive (Basel I) to risk-sensitive (Basel II) capital requirements in the context of a dynamic equilibrium model of relationship lending in which banks are unable to access the equity markets every period. Banks anticipate that shocks to their earnings as well as the cyclical position of the economy can impair their capacity to lend in the future and, as a precaution, hold capital buffers. We find that the new regulation changes the behavior of these buffers from countercyclical to procyclical. Yet, the higher buffers maintained in expansions are insufficient to prevent a significant contraction in the supply of credit at the arrival of a recession. We show that cyclical adjustments in the confidence level behind Basel II can reduce its procyclical effects without compromising banks’ long-run solvency.

Suggested Citation

  • Rafael Repullo & Javier Suarez, 2008. "The Procyclical Effects of Basel II," Working Papers wp2008_0809, CEMFI.
    • Handle: RePEc:cmf:wpaper:wp2008_0809
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    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • 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

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