Credit Allocation, Capital Requirements and Procyclicality

by Esa Jokivuolle of the Bank of Finland,
Ilkka Kiema of the University of Helsinki, and
Timo Vesala of the Tapiola Group

October 28, 2010

Abstract: We show how banks' excessive risk-taking, stemming from informational asymmetries in loan markets, can lead to an excessive output loss in a recession. Risk-based capital requirements can alleviate the output loss by reducing excessive risk-taking in ""normal"" times. Model simulations suggest that the differentiation of risk-weights in the Basel framework might be further increased in order to take full advantage of the allocational effects of capital requirements. Our analysis also provides a new rationale for the countercyclical elements of capital requirements.

JEL Classification: D41, D82, G14, G21, G28.

Keywords: bank regulation, Basel III, capital requirements, credit risk, crises, procyclicality

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