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In Rememberance: World Trade Center (WTC)

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Loan Pricing under Basel Capital Requirements

by Rafael Repullo of CEMFI & CEPR, and
Javier Suarez of CEMFI & CEPR

July 2004

Abstract: We analyze the loan pricing implications of the reform of bank capital regulation known as Basel II. We consider a perfectly competitive market for business loans where, as in the model underlying the internal ratings based (IRB) approach of Basel II, a single risk factor explains the correlation in defaults across firms. Our loan pricing equation implies that low risk firms will achieve reductions in their loan rates by borrowing from banks adopting the IRB approach, while high risk firms will avoid increases in their loan rates by borrowing from banks that adopt the less risk-sensitive standardized approach of Basel II. We also show that only a very high social cost of bank failure might justify the proposed IRB capital charges, partly because the net interest income from performing loans is not counted as a buffer against credit losses. A net interest income correction for IRB capital requirements is proposed.

JEL Classification: G21, G28, E43.

Keywords: Bank regulation, capital requirements, credit risk, internal ratings, loan interest rates, loan defaults, net interest income.

Published in: Journal of Financial Intermediation, Vol. 13, No.4, (October 2004), pp. 496-521.

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