Portfolio effects and efficiency of lending under Basel II

Arbeitspapier

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.

Object Details

• ISBN: 978-952-462-375-9
• Language: Englisch

References and Relationships

• Bibliographic citation: Series: Bank of Finland Research Discussion Papers ; No. 13/2007

Classification and Topics

• Classification: Wirtschaft ; Market Structure, Pricing, and Design: Perfect Competition ; Asymmetric and Private Information; Mechanism Design ; Information and Market Efficiency; Event Studies; Insider Trading ; Banks; Depository Institutions; Micro Finance Institutions; Mortgages ; Financial Institutions and Services: Government Policy and Regulation
• Subject: Basel II ; bank regulation ; capital requirements ; credit risk ; procyclicality

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Jokivuolle, Esa ; Vesala, Timo
• Event: Veröffentlichung
• (who): Bank of Finland
• (where): Helsinki
• (when): 2007

Further information

• Handle: http://hdl.handle.net/10419/212071
• Last update: 10.03.2025, 11:44 AM CET