DP3917 Loan Pricing Under Basel Capital Requirements
|Author(s):||Rafael Repullo, Javier Suarez|
|Publication Date:||May 2003|
|Keyword(s):||bank regulation, capital requirements, credit risk, internal ratings, loan defaults, margin income|
|JEL(s):||E43, G21, G28|
|Programme Areas:||Financial Economics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=3917|
We analyse the implications for the pricing of bank loans of the reform of capital regulation known as Basel II. We consider a perfectly competitive market for business loans where, as in the model underlying the internal ratings based (IRB) approach of Basel II, a single risk factor explains the correlation in defaults across firms. Our loan pricing equation implies that low-risk firms will achieve reductions in their loan rates by borrowing from banks adopting the IRB approach, while high-risk firms will avoid increases in their loan rates by borrowing from banks that adopt the less risk-sensitive standardized approach of Basel II. We also show that only an extremely high social cost of bank failure might justify the proposed IRB capital charges for high-risk loans, partly because the margin income from performing loans is not counted as a buffer against credit losses, and we propose a margin income correction for IRB capital requirements.