A note on the impact of Basel II on banking and economic crises

In this paper we analyze the impact of the risk sensitivity of capital re-quirements in Basel II during a crisis, both in the real economy and in the banking activity. We argue that Basel II will reduce the probability and sever-ity of banking crises, but it might increase the negative impact of an economic downturn into the real economy. We present a continuous time model to study the effects of a risk sensitive capital requirements rule, such as Basel II, on banks ’ risk taking behaviour. The results show that for low asset values banks switch from high to low risk levels in order to reduce the regulatory risk weights of their assets and, as a consequence, boost their capital ratios. The more risk sensitive the capital requirements rule, the sooner the switch from high risk to low risk assets. We hypothesize that such low risk assets are also characterized by (i) a higher liquidity and (ii) a lower proportion of investment in credit to the industry. After reviewing the literature on the impact of credit crunches and liquidity in both the real economy and the banking sector, we argue that the shift to low risk assets during crises implied by the risk sensitive capital requirements rule of Basel II will increase the liquidity of banks ’ assets, but will reduce the availability of credit to the industry. In an economic downturn the higher liquidity will reduce the probability of a banking crisis through a contagion mechanism. However, the decline in credit availability to firms and businesses, particularly small firms and those with high associated risk weights, will further weaken economic activity through a so-called credit crunch