Working Paper: CEPR ID: DP3917
Authors: Rafael Repullo; Javier Suarez
Abstract: We analyse the implications for the pricing of bank loans of the reform of capital regulation known as Basel II. We consider a perfectly competitive market for business loans where, as in the model underlying the internal ratings based (IRB) approach of Basel II, a single risk factor explains the correlation in defaults across firms. Our loan pricing equation implies that low-risk firms will achieve reductions in their loan rates by borrowing from banks adopting the IRB approach, while high-risk firms will avoid increases in their loan rates by borrowing from banks that adopt the less risk-sensitive standardized approach of Basel II. We also show that only an extremely high social cost of bank failure might justify the proposed IRB capital charges for high-risk loans, partly because the margin income from performing loans is not counted as a buffer against credit losses, and we propose a margin income correction for IRB capital requirements.
Keywords: bank regulation; capital requirements; credit risk; internal ratings; loan defaults; margin income
JEL Codes: E43; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Basel II capital requirements (G28) | loan pricing (G19) |
| IRB approach (C90) | loan rates for low-risk firms (G21) |
| standardized approach (C91) | loan rates for high-risk firms (G21) |
| capital charges (G32) | interest rates offered to firms (E43) |