Loan Pricing under Basel II in an Imperfectly Competitive Banking Market

Abstract

The new Basel Capital Accord (Basel II), published in its final form in June 2006, established new and revised capital requirements for banks. In this paper we analyze and estimate the possible effects of the new rules on the pricing of bank loans. We do that for the two approaches for capital requirements (Internal and Standardized) available to banks and make a distinction between retail (mainly households) and corporate customers. Our loan equation is based on a model of a banking firm facing uncertainty operating in an imperfectly competitive loan market. We use Israeli economic data and data of a leading Israeli bank, including probability of default of its retail and corporate customers. The main results indicate that high quality corporates and retail customers will enjoy a reduction in loan interest rates in (large) banks which, most probably, will adopt the IRB approach. On the other hand high risk customers will benefit by shifting to (small) banks which, most probably, will that adopt the Standardized approach.