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Basel II Capital Requirements, Firms' Heterogeneity, and the Business Cycle

Ines Drumond () and José Jorge ()
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José Jorge: CEMPRE and Faculdade de Economia, Universidade do Porto

FEP Working Papers from Universidade do Porto, Faculdade de Economia do Porto

Abstract: This paper assesses the potential procyclical effects of Basel II capital requirements by evaluating to what extent those effects depend on the composition of banks' asset portfolios and on how borrowers' credit risk evolves over the business cycle. By developing a heterogeneous-agent general equilibrium model, in which firms' access to credit depends on their financial position, we find that regulatory capital requirements, by forcing banks to finance a fraction of loans with costly bank capital, have a negative effect on firms' capital accumulation and output in steady state. This effect is amplified with the changeover from Basel I to Basel II, in a stationary equilibrium characterized by a significant fraction of small and highly leveraged firms. In addition, to the extent that it is more costly to raise bank capital in bad times, the introduction of an aggregate technology shock into a partial equilibrium version of the model supports the Basel II procyclicality hypothesis: Basel II capital requirements accentuate the bank loan supply effect underlying the bank capital channel of propagation of exogenous shocks.

Keywords: Business Cycles; Procyclicality; Financial Constraints; Bank Capital Channel; Basel II; Heterogeneity (search for similar items in EconPapers)
JEL-codes: E44 E32 G28 E10 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2009-01
New Economics Papers: this item is included in nep-ban, nep-bec, nep-cfn, nep-dge, nep-fmk, nep-mac, nep-reg and nep-rmg
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