Portfolio Effects, Efficiency of Lending, and Procyclicality Under Basel II

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Abstract
In this paper, we investigate the effect of the new Basel II capital adequacy regulation on the efficiency of bank lending. We consider competitive credit markets where entrepreneurs may apply loans for investments of different risk profiles. In this kind of 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 the endogenous response by banks to 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.

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