The Procyclical Effects of Basel II

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 (modeled as a two-state Markov switching process) can impair their capacity to lend in the future and, as a precautionary measure, may hold capital buffers. We find that the new regulation may change the behavior of these buffers from countercyclical to procyclical. Yet, the higher buffers maintained in expansions may be insufficient to prevent a significant contraction in the supply of credit at the arrival of a recession. This credit crunch can be reduced by smoothing the transition from low to high capital charges.