Rethinking Basel III and beyond: a theory model to understand credit allocation and real state bubbles

We develop a theoretical framework that explains the decision-making process of banks concerning the allocation of credit to two sectors: (i) households seeking real estate assets, and (ii) companies requiring capital for consumer goods production. By analyzing the interaction between the credit and the real estate markets, the model shows how in the context of high lending capacity, banks have a natural incentive to bias the credit allocation towards real estate acquisition. This, in turn, leads to a trade-off where productive capital funding takes a backseat, fostering the emergence of real estate bubbles. We conclude that the “one-size-fits-all” banks’ macroprudential capital requirements policy might fail in the prevention of credit financial bubbles. Instead, a more effective approach will need to account for real estate market, production technology as well as credit market and banks’ characteristics. On the one hand, these conclusions highlight the importance of the flexible macroprudential capital buffers introduced in Basel III, suggesting a tailored approach based on specific factors. On the other hand, they also suggest to consider important changes in the capital regulation, such as reducing the mortgages capital requirements benefits or incorporating differentiation by loan purpose, credit market concentration or bank’s local market share as potential capital buffer requirement add-ons.