Department of Mathematics and Applied Mathematics, North-West University, Potchefstroom 2531, South Africa
Copyright © 2009 M. A. Petersen et al. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.
This contribution is the second in a series of papers on discrete-time modeling of bank capital
regulation and its connection with the subprime mortgage crisis (SMC). The latter was caused
by, amongst other things, the downturn in the U.S. housing market, risky lending and borrowing
practices, inaccurate credit ratings, credit default swap contracts as well as excessive individual
and corporate debt levels. The Basel II Capital Accord's primary tenet is that banks should
be given more freedom to decide how much risk exposure to permit; a practice brought into
question by the SMC. For instance, institutions worldwide have badly misjudged the risk related
to investments ranging from subprime mortgage loans to mortgage-backed securities (MBSs).
Also, analysts are now questioning whether Basel II has failed by allowing these institutions
to provision less capital for subprime mortgage loan losses from highly rated debt, including
MBSs. Other unintended consequences of Basel II include the procyclicality of credit ratings
and changes in bank lending behavior. Our main objective is to model the dependence of bank
credit and capital on the level of macroeconomic activity under Basel I and Basel II as well as
its connection with banking behavior for the period before and during the SMC.