Internally-Assessed Bank Capital Requirements and Loan Portfolio Spreads

How the choice of more risk-sensitive capital requirements by some banks influences average borrowing costs for their customers remains an open question. By exploiting cross-country manually collected capital requirement data, we find higher portfolio loan spreads in banks that compute a larger share of these requirements for the loan portfolio through internal rating-based (IRB) models. This result is driven by larger IRB adopters operating in credit markets with low competition from banks computing capital requirements with the less risk-sensitive standardized models, by IRB adopters in credit markets where borrowers have more limited funding opportunities, and by IRB adopters in markets characterized by lower levels of political connectedness. Our results contrast with theoretical predictions suggesting that the heterogeneity in risk weights induced by IRB models should reduce average borrowing costs for bank customers. Instead, we show that IRB adopters do not fully incorporate the decrease in capital requirements obtained with these models into their pricing policies when competitive and political pressures are low.