Credit allocation, capital requirements and procyclicality

Despite the fact that beneficial allocational effects happen to be a key inspiration for the Basel II capital adequacy reform, the interaction of these effects with Basel II’s procyclical impact has been less talked about. In this report, we check out effect of capital requirements on the allocation of credit and its interaction with procyclicality, and evaluate Basel I and Basel II type capital requirements. We take into account competitive credit markets where entrepreneurs of different capacity can apply for loans for one-period investment projects of two different risk types. The potential risk of a project further is dependent upon the condition of the economy, modelled as a two-state Markov process. In this particular kind of setting, too much risk taking usually occurs because higher-type borrowers cross-subsidize lower-type borrowers via a pricing regime dependant 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. What this means is that the ensuing decrease in the proportion of high-risk investments may mitigate the procyclical effect of Basel II on economic activity. Furthermore, we find that ideal risk-based capital requirements needs to be set lower in recessions than in normal times. Our simulations reveal that when measured by either cumulative output or output variation, Basel II type capital requirements may actual be somewhat less procyclical than flat capital requirements. The largest reduction in procyclicality is however achieved with optimal risk-based capital requirements that are significantly more than Basel II requirements and which are adjusted downwards in recession periods.

Author: Esa Jokivuolle,Ilkka Kiema,Timo Vesala

Source: Research Discussion Papers, Bank of Finland

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