Did Bank Capital Regulation Exacerbate the Subprime Mortgage Crisis?

This contribution is the second in a series of papers on discrete-time modeling of bank capitalregulation and its connection with the subprime mortgage crisis (SMC). The latter was causedby, amongst other things, the downturn in the U.S. housing market, risky lending and borrowingpractices, inaccurate credit ratings, credit default swap contracts as well as excessive individualand corporate debt levels. The Basel II Capital Accord's primary tenet is that banks shouldbe given more freedom to decide how much risk exposure to permit; a practice brought intoquestion by the SMC. For instance, institutions worldwide have badly misjudged the risk relatedto investments ranging from subprime mortgage loans to mortgage-backed securities (MBSs).Also, analysts are now questioning whether Basel II has failed by allowing these institutionsto provision less capital for subprime mortgage loan losses from highly rated debt, includingMBSs. Other unintended consequences of Basel II include the procyclicality of credit ratingsand changes in bank lending behavior. Our main objective is to model the dependence of bankcredit and capital on the level of macroeconomic activity under Basel I and Basel II as well asits connection with banking behavior for the period before and during the SMC