1. 1 Credit Allocation, Capital Requirements and Procyclicality Esa Jokivuolle (Bank of Finland) Timo Vesala (Tapiola Group) Earlier circulated as ”Portfolio Effects and Efficiency of Lending under Basel II”, Bank of Finland Discussion Paper 13/2007

2. 2 Background Alleged pros and cons of Basel II (Pro:) Alleviates the potential allocative distortions across credit risk categories, which Basel I requirements may have resulted -Given that equity is the costly form of finance, a uniform capital requirement may punish low-risk assets and favor high-risk assets -Risk-based Basel II requirements may result in a portfolio shift from high- to low-risk assets which may also improve allocative efficiency (Con:) Basel II may amplify ‘pro-cyclicality’ in bank lending

3. 3 Motivation  However, procyclicality (the con) should not be analysed in isolation from the allocational effects (the pro)

4. 4 Paper in brief Our basic model of bank financing with asymmetric information yields overinvestment in high-risk projects (like in De Meza-Webb, 1987) Show that a uniform capital requirement (Basel I) makes this overinvestment worse Show that risk-based capital requirements (Basel II) can unwind the overinvestment and achieve optimal allocation Assuming that high-risk projects generate most credit losses in downturns, we argue that the unwinding of the high-risk overinvestment alleviates procyclicality

5. 5 The model ‘Entrepreneurs' choose between investments of different risk characteristics ‘high-risk' or ‘low-risk' investment, labor market participation as a fixed outside option Entrepreneurs differ in their success probabilities Governed by the entrepreneur’s type parameter θ Project success probabilities p(θ) and q(θ ), respectively Risk-neutral banks cannot observe individual success rates but they rationally expect the equilibrium average success probabilities within each investment class

6. 6 The model Expected outputs from high-risk and low-risk projects: p(θ)v and q(θ)s; ie, if a project fails it produces nothing De Meza-Webb (1987) assumption: i.e. success of the high-risk project is more sensitive to entrepreneur’s type

7. 7 Efficient project selection / Definition of overinvestment θ 0 1 ‘high-risk’ investments ‘low-risk’ investments labor market

8. 8 Competitive loan prices Average success rates: Loan prices: Capital requirement

9. 9 Entrepreneurial payoffs

10. 10 Equilibrium analysis Definition 1 A perfect Bayesian equilibrium specifies a pair which is a solution to the following pair of equations: I.e. the marginal types should be indifferent between choosing a high- or low-risk project and between a low-risk project and labour market, respectively. Note that the average types follow directly from the marginal types.

11. 11 ’Flat-rate’ regime (’Basel I’) Result 1 Given flat-rate capital requirements, there is overinvestment in high-risk projects as entrepreneurs with inefficiently low success rates choose this investment opportunity; i.e., There is overinvestment even with zero capital requirement but the flat-rate capital requirement makes it worse Intuition: leverage effect, which capital requirements effectively strengthen via loan prices, spurs risk-taking High types cross-subsidize lower types

12. 12 ‘Risk-based’ regime (‘Basel II’) Result 2 The equilibrium cut-offs are efficient if Note that the optimal level of risk-based capital requirements increases in the level of the interest rate.

13. 13 ‘Risk-based’ regime… Optimal risk-based capital requirements provide a sorting device via competitive loan pricing, abolish the cross- subsidization from high to low type entrepreneurs and thus unwind the overinvestment in high-risk projects. If the interest rate is an indicator of the business cycle, then our result supports the idea that overall capital requirements should be increased in booms and vice versa.

14. 14 Allocational effects and pro-cyclicality Assumption: High-risk projects fail more easily than low-risk projects in economic downturns  Under risk-based regime, reduced overinvestment in high-risk projects reduces loan losses in a downturn compared to flat-rate regime Thus, the pro-cyclical impact of Basel II may be alleviated by the favourable allocational effect Cf. Gordy and Howells (2006): “endogenous response by banks to Basel II does not necessarily lead to exacerbation of macroeconomic cycles

15. 15 Conclusions Under De Meza–Webb assumption, there is typically excess risk-taking in the credit market Flat-rate capital requirements exacerbate this problem Risk-based capital requirements reduce overinvestment in high-risk projects More efficient (and less risky) allocation may counterbalance the pro-cyclicality inherent in Basel II Tentative support to the idea of linking the level of capital requirements to the business cycle phase