Specialising in Risky Mortgages: Unintended Consequences of Basel II
Since Basel II was introduced in 2008, two approaches to calculating bank capital requirements have co-existed: banks' internal models, and a less risk-sensitive standardised approach. Using a unique dataset for the UK mortgage market, 2005-2015, and novel identification, we provide the first empirical evidence that this leads smaller lenders to specialise in higher risk lending, leading to systemic concentration of risk. Adopting internal model leads to reduced interest rates for lower- risk loans, and a corresponding portfolio shift. A 1pp reduction in risk weights causes a 1.3bp reduction in interest rates. Our results are relevant to live policy debates.
Area: Banking
Keywords: risky mortgages; Basel II
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