DP6862 The Procyclical Effects of Basel II

Author(s): Rafael Repullo , Javier Suarez

Publication Date: June 2008

Keyword(s): banking regulation , Basel II , business cycles , capital requirements , credit crunch , loan defaults , relationship banking

JEL(s): E43 , G21 , G28

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP6862.asp.asp

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.