Procyclicality In The Banking Sector

2.3 Procyclicality in the banking sector

Banks behavior is procyclical in nature. When economic growth is down there are less profitable investment opportunities and therefore lower credit demand. The risk of default is higher which results in higher loan losses and risk-weighted assets (downgraded loans) that are paid out of the capital buffers. The interconnectedness of banks and low thrust in banks result in contamination of problems between banks and bank runs when one bank defaults.
2.4 Procyclicality of regulatory capital

The procyclical amplification of financial shocks throughout the banking system and from there to the whole economy causes the crisis to be more severe. It is mentioned that the banking sector should serve as a

In Basel I banks were allowed to count loan loss provisions as tier 2 capital. The effect was that banks were inclined to make provisions more easily to increase their buffers. In Basel II this issue was addressed by only including loan loss provisions up to 1,25% of risk-weighted assets in tier 2 capital (BCBS,2006). In Basel III more forward-looking provisioning is promoted. The accounting standard IFFRS 9 replaces IAS 39 and introduces an expected loss approach. This will increase the decision usefulness and relevance of financial reporting for stakeholders. Research finds that the current used incurred loss model amplifies the cyclicality and therefore makes an economic downturn more severe (BCBS, 2011). Regulatory requirements are largely based on IFRS/GAAP financial numbers so accounting decisions can have impact on the capital ratios. It is argued that fair value provisioning stripped down the capital buffers of bank during the financial crisis. Empirically no evidence is found that fair value accounting increased the procyclicality of regulatory capital (Badertscher, Burks and Easton,

It should reduce pricing distortions between loan types, where low risk loans are driven out the market by charging the same risk mark up and regulatory capital arbitrage. Contrarily, it is argued that these capital requirements are more procyclical. Borrowers are downgraded when economic growth declines by one of the two credit-risk models resulting in loan losses paid out of capital buffers. This forces banks to hold more capital against potential loan losses. Because it is assumed that raising equity or other external capital is costly when banks are capital constraint, they cut lending and thereby amplify the economic downfall. A suggestion is that the capital charge for a credit-risk exposure is reduced when bank capital is scarce compared to lending opportunities (Kashyap and Stein, 2003). The Basel Committee (BCBS, 2009) was already aware of this issue and therefore implemented some safeguard in Basel II. This encompassed the use of long term data horizons in estimations of PD, introduction of loss-given-defaults (LGD) estimates and the appropriate calibration of the risk functions, which convert loss estimates into regulatory requirements. Additionally, stress test must be conducted by banks that consider downward migration of credit portfolios during economic downturns (BCBS,