Research Discussion Papers, Bank of Finland
Credit allocation, capital requirements and procyclicality
(), Ilkka Kiema
() and Timo Vesala
Abstract: Although beneficial allocational effects have been a
central motivator 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 capital requirements
on the allocation of credit and its interaction with procyclicality, and
compare Basel I and Basel II type capital requirements. We consider
competitive credit markets where entrepreneurs of varying ability can apply
for loans for one-period investment projects of two different risk types.
The risk of a project further depends on the state of the economy, modelled
as a two-state Markov process. In this type of setting, excessive risk
taking typically arises because higher-type borrowers cross-subsidize
lower-type borrowers via a pricing regime based on average success rates.
We find that risk-based capital requirements (such as Basel II) alleviate
the cross-subsidization effect and can be chosen so as to implement
first-best allocation. This implies that the ensuing reduction in the
proportion of high-risk investments may mitigate the procyclical effect of
Basel II on economic activity. Moreover, we find that optimal risk-based
capital requirements should be set lower in recessions than in normal
times. Our simulations show that when measured by either cumulative output
or output variation, Basel II type capital requirements may actual be
slightly less procyclical than flat capital requirements. The biggest
reduction in procyclicality is however achieved with optimal risk-based
capital requirements which are considerably higher than Basel II
requirements and which are adjusted downwards in recession periods.
Keywords: Basel II; bank regulation; capital requirements; credit risk; procyclicality; (follow links to similar papers)
JEL-Codes: D41; D82; G14; G21; (follow links to similar papers)
40 pages, September 22, 2009
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