Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/212071 
Year of Publication: 
2007
Series/Report no.: 
Bank of Finland Research Discussion Papers No. 13/2007
Publisher: 
Bank of Finland, Helsinki
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.
Subjects: 
Basel II
bank regulation
capital requirements
credit risk
procyclicality
JEL: 
D41
D82
G14
G21
G28
Persistent Identifier of the first edition: 
ISBN: 
978-952-462-375-9
Document Type: 
Working Paper

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