Are risk weights of banks in the Czech Republic procyclical? Evidence from wavelet analysis

Abstract

We analyze the cyclicality of risk weights of banks in the Czech Republic from 2008 to 2016. We differentiate between risk weights under the internal ratings-based and those under the standardized approach, consider the financial cycle, and employ wavelet coherence as a means of dynamic correlation analysis. Our results indicate that the risk weights of exposures under the internal ratings-based approach, including risk weights related to exposures secured by real estate collateral, are procyclical with respect to the financial cycle. We also show that the effect of changing asset quality on risk weights is present for the internal ratings-based approach, in line with our expectations based on regulatory standards. Our results can be employed for the purposes of decision-making on the activation of supervisory and macroprudential instruments, including the countercyclical capital buffer.

Sustainability, Uncertainty, and Risk: Time-Frequency Relationships

“…This underscores how inventive methodologies possess the potential to enrich risk evaluation within credit portfolios, potentially reshaping the landscape of risk management practices [54]. In essence, this convergence highlights the interplay between the analysis of financial dynamics and the regulatory landscape, emphasizing the potential for these insights to shape prudent and informed financial policies and practices [55].…”

The New Era of Capital Regulation Complexity

“…This has significantly increased the complexity of capital regulation in the area of banking sector capital regulation (Gai et al, 2019). 2 3 Moreover, over time, the evolution of risk weights determined by internal models has shown signs of inherent pro-cyclical developments (Andersen, 2011;Brož and Pfeifer, 2021). Inherent procyclicity of internal models (Brož and Pfeifer, 2021) is associated with too short a measurement of the actual cycle in these models.…”

“…2 3 Moreover, over time, the evolution of risk weights determined by internal models has shown signs of inherent pro-cyclical developments (Andersen, 2011;Brož and Pfeifer, 2021). Inherent procyclicity of internal models (Brož and Pfeifer, 2021) is associated with too short a measurement of the actual cycle in these models. While the CRR assumes that the cycle lasts for around 8 years, Borio (2014) shows that the duration of the financial cycle can be up to 20 years.…”

“…not comply with the related requirement). The institution can use its capital buffers to absorb losses 7 or to lend to the real economy. 8 When the combined capital buffer is "used", measures are taken to conserve the institution's capital.…”

“…In doing so, it will boost the capital surplus and create room for loss absorption and lending to the real economy (for details, see Holub, Konečný, Pfeifer and Brož, 2020). 7 Losses in the narrow sense mean a financial loss sustained by the banking sector. Losses in the broader sense can also include a potential decline in the capital ratio caused by growth in risk weights.…”