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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