The mitigation role of collaterals and guarantees under Basel II

Under the Basel II framework for capital adequacy of banks, regulatory financial collateral and guarantees (C&G ) can affect lending policy in both a micro and a macro perspective. This paper aims at assessing these effects throught the modelling of the impact of C&G on credit spreads. In doing this we assume the perspective of a bank adopting a Foundation Internal Rating Based approach to measure credit risk and we apply a comparative-static analysis to a pricing model, based on the intrinsic value pricing approach as in the loan arbitrage-free pricing model (LAFP) suggested by Dermine (1996). Our results show that financial collaterals are more effective than guarantees in reducing credit spreads, this differential impact becoming greater as the borrower's rating worsen. Moreover, the effects of C&G on credit spreads can be more effective than an improvement of borrower's rating, this possibly leading to negative outfits on credit industries' allocative efficiency.