Credit Allocation, Capital Requirements and Procyclicality
by Esa Jokivuolle of the Bank of Finland,
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.
Keywords: bank regulation, Basel III, capital requirements, credit risk, crises, procyclicality