Credit allocation, capital requirements and output

Abstract

We show how banks excessive risk-taking, stemming from informational asymmetries in loan markets, can lead to an excessive output loss when a recession starts. 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 JEL classification numbers: D41, D82, G14, G21, G28