Capital Requirements, Business Loans, and Business Cycles: An Empirical Analysis of the Standardized Approach in the New Basel Capital Accord

Abstract

In the current regulatory framework, capital requirements are based on risk-weighted assets, but all business loans carry a uniform risk weight, irrespective of variations in credit risk. The proposed new Capital Accord of the Bank for International Settlements provides for a greater sensitivity of capital requirements to credit risk, raising the question of whether, and to what extent, the new capital standards will intensify business cycles. In this paper, we evaluate the potential cyclical effects of the ""standardized approach"" to risk evaluation in the new Accord, which involves the ratings of external agencies. We combine Moody's data on changes in U.S. borrowers' credit ratings since 1970 with estimates of the risk profile of business loans at commercial banks from the Survey of Terms of Business Lending, and also a risk profile estimated by Treacy and Carey (1998). We find that the level of required capital against business loans would be noticeably lower under the new Accord compared with the current regime. We do not find evidence of any substantial additional cyclicality in required capital levels under the standardized approach of the new Accord relative to the current regime.