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There has been much research on the effects and the optimal calibration of the level of capital requirements after the Global Crisis. At the same time, some observers have questioned the current system of risk-weighting based on detailed measurement of risk. Coupled with the level shift of capital requirements in Basel III, are the highest risk weights already discouraging productive investments?
In light of authors‘ theoretical model, this is a potential concern. However, based on a quantitative assessment of the model, the answer to the question above is “probably not much”. Hence, the current risk-based capital requirements may not be far off the mark.
However, the case for flatter risk weights may be stronger for economies which are more bank-dependent relative to the US. For instance, bank finance is more important for Europe where, in many countries, the heavily bank-dependent small and medium-sized corporate segment is central to the economy. Moreover, authors‘ model does not take into account dynamic spillover effects on the productivity of financing innovative but high-risk projects via bank loans. Therefore, authors believe that the theoretical issues they have raised may warrant further research.
Finally, it may be argued that the current Basel IRBA risk weights are already lower for the highest risk borrowers than what purely risk-based risk weights would be. This is because of certain smoothing elements agreed on as part of the IRBA rules already in Basel II. Authors‘ theoretical results may be seen as providing a possible rationale for these features.