Scandinavian Working Papers in Economics
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Bank of Finland Research Discussion Papers, Bank of Finland

No 13/2007:
Portfolio effects and efficiency of lending under Basel II

Esa Jokivuolle () and Timo Vesala ()

Abstract: Although 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.

Keywords: Basel II; bank regulation; capital requirements; credit risk; procyclicality; (follow links to similar papers)

JEL-Codes: D41; D82; G14; G21; G28; (follow links to similar papers)

23 pages, October 3, 2007

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