Mitigating the pro-cyclicality of Basel II

Abstract

"Policy discussions on the recent financial crisis feature widespread calls to address the pro-cyclical effects of regulation. The main concern is that the new risk-sensitive bank capital regulation (Basel II) may amplify business cycle fluctuations. This paper compares the leading alternative procedures that have been proposed to mitigate this problem. We estimate a model of the probabilities of default (PDs) of Spanish firms during the period 1987-2008, and use the estimated PDs to compute the corresponding series of Basel II capital requirements per unit of loans. These requirements move significantly along the business cycle, ranging from 7.6% (in 2006) to 11.9% (in 1993). The comparison of the different procedures is based on the criterion of minimizing the root mean square deviations of each adjusted series with respect to the Hodrick-Prescott trend of the original series. The results show that the best procedures are either to smooth the input of the Basel II formula by using through-the-cycle PDs or to smooth the output with a multiplier based on GDP growth. Our discussion concludes that the latter is better in terms of simplicity, transparency, and consistency with banks' risk pricing and risk management systems. For the portfolio of Spanish commercial and industrial loans and a 45% loss given default (LGD), the multiplier would amount to a 6.5% surcharge for each standard deviation in GDP growth. The surcharge would be significantly higher with cyclically varying LGDs." Copyright (c) CEPR, CES, MSH, 2010.

Regulating Banks in Central and Eastern Europe

“…Their analysis suggests that the Basel II framework could be improved further by increasing the minimum level of capital adequacy and linking it more explicitly to the state of the business cycle. However, other scholars have pointed out that the negative impact of economic downturns on bank lending was exacerbated under Basel II rules, because the risk weights used to calculate capital requirements are based on internal models or external credit agency ratings which tend to be rather volatile (Blum and Hellwig 1995;Repullo et al 2010). For example, during the recent 2008 financial and economic turmoil, banks refrained from lending in order to repair their balance sheets and comply with international capital adequacy standards.…”

“…Furthermore, scholars have established that the emphasis on the individual safety and soundness of banks in Basel I and II has amplified business cycles (Blum and Hellwig 1995;Repullo et al 2010). Capital adequacy regulations affect banks' ability to lend in a recession.…”

Revisiting Basel risk weights: cross-sectional risk sensitivity and cyclicality

“…Studies on this subject can be classified into three categories: first, various papers perform numerical simulations on hypothetical or real world portfolios based on the IRB formula to analyze the peak-to-trough variation of capital requirements (e.g., Kashyap and Stein 2004;Goodhart et al 2004;Altman et al 2005;Gordy and Howells 2006;Saurina and Trucharte 2007;Repullo et al 2010;Andersen 2011). Overall, these studies document a significant variability of the risk weights through the business cycle, particularly for point-intime rating systems.…”

Estimating the distribution of total default losses on the Spanish financial system

“…As suggested in Repullo et al (2010), one way to deal with this issue can be to set a variable confidence level for capital requirements so that in periods with ''high'' ratings they can focus on more extreme probabilities while they may reduce the confidence levels in periods with ''low'' ratings.…”