Credit Allocation, Capital Requirements and Procyclicality

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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
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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

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Motivation

• However, procyclicality (the con) should not be
  analysed in isolation from the allocational
  effects (the pro)

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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

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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 entrepreneurs type parameter ?
• Project success probabilities p(?) and q(?),
  respectively
• Risk-neutral banks cannot observe individual
  success rates but they rationally expect the
  equilibrium average success probabilities within
  each investment class

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The model

• Expected outputs from high-risk and low-risk
  projects p(?)v and q(?)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 entrepreneurs type

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Efficient project selection / Definition of
overinvestment
?
1
high-risk investments
low-risk investments
labor market
0
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Competitive loan prices
Average success rates
Loan prices
Capital requirement
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Entrepreneurial payoffs
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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.
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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

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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.
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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.

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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

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Conclusions

• Under De MezaWebb 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