Working Paper: CEPR ID: DP8897
Authors: Rafael Repullo; Javier Suarez
Abstract: We develop and calibrate a dynamic equilibrium model of relationship lending in which banks are unable to access the equity markets every period and the business cycle is a Markov process that determines loans' probabilities of default. Banks anticipate that shocks to their earnings and the possible variation of capital requirements over the cycle can impair their future lending capacity and, as a precaution, hold capital buffers. We compare the relative performance of several capital regulation regimes, including one that maximizes a measure of social welfare. We show that Basel II is significantly more procyclical than Basel I, but makes banks safer. For this reason, it dominates Basel I in terms of welfare except for small social costs of bank failure. We also show that for high values of this cost, Basel III points in the right direction, with higher but less cyclically-varying capital requirements.
Keywords: banking regulation; Basel capital requirements; capital market frictions; credit rationing; loan defaults; relationship banking; social cost of bank failure
JEL Codes: E44; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Basel II (G28) | banks' supply of credit (E51) |
| Basel I (F34) | banks' supply of credit (E51) |
| Basel II (G28) | procyclicality of lending (G21) |
| Basel I (F34) | procyclicality of lending (G21) |
| Basel II (G28) | anticipate capital requirement variations (D25) |
| Basel II (G28) | larger capital buffers during expansions (E22) |
| Basel II (G28) | credit supply contraction in recessions (E51) |
| Basel II (G28) | net welfare benefit (J32) |
| high social costs of bank failure (F65) | Basel III's capital requirements (G28) |
| Basel III's capital requirements (G28) | bank stability (G28) |