Working Paper: CEPR ID: DP6862
Authors: Rafael Repullo; Javier Suarez
Abstract: We analyze the cyclical effects of moving from risk-insensitive (Basel I) to risk-sensitive (Basel II) capital requirements in the context of a dynamic equilibrium model of relationship lending in which banks are unable to access the equity markets every period. Banks anticipate that shocks to their earnings as well as the cyclical position of the economy can impair their capacity to lend in the future and, as a precaution, hold capital buffers. We find that the new regulation changes the behavior of these buffers from countercyclical to procyclical. Yet, the higher buffers maintained in expansions are insufficient to prevent a significant contraction in the supply of credit at the arrival of a recession. We show that cyclical adjustments in the confidence level behind Basel II can reduce its procyclical effects without compromising banks' long-run solvency.
Keywords: banking regulation; Basel II; business cycles; capital requirements; credit crunch; loan defaults; relationship banking
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) | bank lending behavior (G21) |
| transition from Basel I to Basel II (G28) | procyclical capital buffers (E22) |
| procyclical capital buffers (E22) | reduction in credit supply during downturns (E51) |
| adjustments to confidence levels in Basel II (G21) | mitigate procyclical effects (E44) |
| cyclical position of the economy (E32) | capital buffers (G28) |
| anticipated shocks to earnings (G17) | capital buffers (G28) |