Procyclicality in Regulation and Macroprudential Policy Jan Frait.

Procyclicality in Regulationand Macroprudential Policy

Jan FraitJan Frait

I.Procyclicality and Provisioning

Procyclicality

• Financial system procyclicality means the ability of the financial system to amplify fluctuations of economic activity via procyclicalit patterns in financial institutions’ lending and other activities.

• The procyclical behaviour of financial markets transmits to the real economy in amplified form through easy funding of expenditures and investments in good times and financial restrictions leading to declining demand in bad times.

• Procyclicality have increased over the last few years due to (i) the greater use of leverage in the financial and real sectors, (ii) closer ties between market and funding liquidity e.g. through increased use of collateral in secured financing, (iii) increased contagion effects in integrated markets as well as (iv) the (unintended) effects of some regulations, including accounting standards. (EFC WG Report 2009)

To provision or not to provision

• Debate about the instruments that might reduce the potential procyclicality of regulations is not a new one.

• Borio and Lowe (2001) – To provision or not provision• paper written just prior to the setting and implementation of new set of regulations,• describes a conflict between the interests of supervisors and accountants, • financial supervisors have tended to emphasise the role that provisions can play

in ensuring that banks maintain adequate buffers against future deteriorations in credit quality,

• accounting authorities have stressed the importance of provisions in generating fair and objective loan valuations.

• The accountants won the battle … but after a few years we got back to the start again.

To provision or not to provision, to buffer or not to buffer

• After the crisis - to provision or not to provision, to build capital buffers or not to build capital buffers• bank supervisors have always been more supportive of general provisioning

regimes and reserves than have accounting and securities authorities• this time the supervisors may use the opportunity, but it is not so easy to win a

war … • Procyclicality may be caused by broad spectrum of factors going much beyond

accounting and capital regulation framework of financial institutions‘ regulation.


• In general principle, banks should set aside provisions to cover their expected losses while their capital should primarily be used to cover unexpected losses.

• There generally exist several provisioning systems differing in either when the provisions are created and entered in the accounts or what event triggers provisioning.

• Currently prevailing practice is “specific” provisioning. • specific provisions are fixed against losses on predominantly individually

assessed loans and start at the moment an evident event occurs; • specific provisioning is backward looking (i.e. it identifies risk ex post).

• General provisions • are usually set against losses from portfolios of loans and can be forward looking

(i.e. they identify credit risk ex ante)


• The key argument for forward-looking provisioning is the inherent tendency of banks to relax excessively lending standards during economic upturns and tighten them excessively during downturns • the risks are underestimated during upturns leading to credit booms with loans

extended with prices set too low,• subsequent downturn leads to re-pricing under the impact of higher default rate,

prices are too high, potentially ending in credit crunch. • Forward-looking provisioning should therefore help to ensure correct pricing of

expected credit risk (via margins) emerging at time when the credit is extended.


• The international accounting standards currently in force (IAS 39) allow banks to provision only for loans for which there is clear evidence of impairment (i.e. backward-looking provisioning).• specific provisions are created and entered in the accounts only after credit risk

comes to light (which usually occurs in times of recession),• In the general/dynamic/through-the-cycle provisioning systems provisions are also

created when credit risk comes into being (i.e. to a large degree in times of boom) • banks provision against existing loans in each accounting period in accordance

with the assumption for expected losses:• at times when actual losses are smaller than assumed a buffer is created which

can then be used at times when losses exceed the estimated level… • This looks straighforward, but in practice it is not so.

Provisioning in Spain

• Spain used „traditional“ provisioning up to 2000:general provisions (GP) reflected estimate of average expected loss from total loans: GP = g*ΔL , where L stands for total loans and g for the parameter (between 0.5%

and 1%),while specific provisions (SP) were set in a standard way: SP = e*ΔM, where M stands for impaired loans and e for the parameter (between

10% and 100%). total provisions: TP = g*ΔL + e*ΔM.

• In 2000, additional compotent was added – statistical provisions: Total provision (TP) = Specific (SP) + General (GP) + Statistical (StP)


• Banks sorted loans to six homogenous categories with different risk coefficient s (defined by supervisor as average specific provision rate over the whole cycle).

• StP = Lr – SP, where Lr is a latent risk s*L, where s stands for the coefficient of a historical average specific provisions (between 0% and 1.5% in the standard approach),

SP < Lr (low impaired loans) StP>0 (building up of the statistical fund),

SP > Lr (high impaired loans) StP<0 (depletion of the statistical fund), balance of the statistical fund: StF = StPt+StFt-1, with a limit:

0 ≤ StF ≤ 3 * Lr


• System had to be modified with effect from 2005 due to the IRFS – statistical provisions were hidden in newly defined general provisons:Total provision (TP) = Specific (SP) + General (GP)SP: unchanged,

GP:• banks must make provisions against the credit growth according to parameter

which is the average ratio of estimated credit losses (“collective assessment for impairment” in a year neutral from a cyclical perspective) and parameter which is the historical ratio of average specific provision (coefficient s in previous version),

• 1st component reflects losses in the past, 2nd reflects specific provisions in the past relative to current ones (dynamic component),

• limits for fund set as 0,1% ≤ GF ≤ 1,5% of total loans.

t

iitiit

iit SPLLGP

6

1

6

1


• Developments in provisioning funds in Spain after 2000 – developments of provisions‘ components

IMÉNEZ, G., ONGENA S., PEYDRÓ, J., SAURINA, J. (2012): Macroprudential policy, countercyclical bank capital buffers and credit supply: evidence from the Spanish dynamic provisioning experiments. Barcelona GSE Working Paper Series, No. 628.


• Spanish authorities considered a new system IFRS compatible (IASB not).• Fund was set in good times, buffer was created prior to current crisis

• NPLs 200% covered at the beginning of 2008 (EU average 60%), • nevertheless, at the end of 2008 only 100% covered, later on not covered …• never sure whether the fund will suffice ... still better that nothing.

• Spanish system viewed as accounting tool – though BdE considers it as part of toolbox for macroprudential supervision.

• BdE does not think it distorts accounting statements: • Banks are required to disclose the amount of the dynamic provision, apart from

the specific provision.• Thus, users of accounting statements can “undo” the impact of the dynamic

provision on the P&L.


• Spanish system was rather simple – a kind of pre-dynamic provisioning:• not optimal, just one of potential solutions, • doubts whether it really restricts excessive lending, • can hardly be adopted in current recessionary conditions, • unilateral attempts to do so might do more harm than gain – see Brunnermeier,

M. et al. (2009),

II.Loan loss provisioning in selected European banking

sectors: Do banks really behave in a procyclical way?

16

Goals of the research

• Motivation: • One of the most important factors behind the financial crisis is

that they were simply lending too much and too easily in good times, i.e. their lending behaviour was procyclical ...

• … and recent loss of confidence in reported state of banks‘ balance sheets in the euro area brought to the attention not only the quality of loans but also the adequacy of provisions set against the loans classified as non-performing (at default).

• Focus: • The main focus is behaviour of banks regarding provisioning

against impaired financial assets through the financial cycle.• Not a fully-fledged research, but more a policy analysis looking

at regulatory and accounting issues: asking whether through-the-cycle provisioning regime could serve as one of the possible regulatory responses to the ongoing financial crisis.

17

Why provisioning matters

• We look empirically at the issue of procyclical behaviour of the bank-based financial systems to find out the extent to which the banks behave procyclically in provisioning under existing regulatory framework (via extension of Frait and Komárková, 2009).

• Provisioning is important not only because banks‘ provisions serve as a buffer against expected loan losses, but also they provide significant information on how banks are pricing credit risk.

• We can find number of studies focusing on the provisioning in Asian and emerging economies. However, there is limited information on banks’ provisioning in European countries after the IRFS (international accounting standards) adoption including the period of crisis.

• We try to fill the gap to some extent and in addition, we attempt to cross-check the information based on publicly available data from the EU banks with tests run with supervisory data on the Czech banking sector.

18

Why empirical analysis of provisioning matters?

• One of the instruments for analysing the degree of procyclicality in banks’ behaviour is analysis of provisioning over the business cycle. • If it confirms that banks have a tendency to provision in a highly

procyclical way, there is a case for a policy reaction, i.e. for setting through-the-cycle provisioning regime (for a proposal see for example Wezel et al., 2012).

• We believe that understanding the true extent of procyclicality in provisioning is crucial factor in designing any regime of this sort.

19

Do the Czech banks provision procyclically? I

• There is a negative relationship between GDP growth and the ratio of loan loss provisions to total loans in the Czech Republic for the period 1998–2011.

• This relationship, which afterall should be a logical consequence of the prevailing IFRS-based provisioning system, is subjected to an empirical analysis.

• Does it reflect procyclical behaviour? If yes, how strong are the non-procyclical features of banks‘ behaviour?

Loan loss provisions/total loans and GDP growth (Czech Republic, 1Q1998–4Q2011)

Source:CNB, CZSONote: y-axis: GDP growth in %; x-axis: ratio of provisions to loans in %; onlyloans provided to real economy are included.

-6

-4

-2

0

2

4

6

8

0 2 4 6 8 10 12 14

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Do the Czech banks provision procyclically? II

• The creation of provisions – especially those directly linked to impaired loans (“specific provisions”) – can be affected by changes in the macroeconomic environment, the solvency of counterparties to lending transactions, the regulatory and taxation rules in force and, last but not least, by the chosen behaviour of a particular bank in a given environment.

• To reveal the potential procyclical behaviour of Czech banks, we applied the model developed by Bikker and Metzemakers (2003), modified in order to analyse the behaviour of the banking sector of a single country.

• Using the model we try to describe banks’ dependence on the business cycle when provisioning. • We determine whether there is a significant relationship between bank

provisioning (the left-hand side of the equation) and proxies for the business cycle and regulations (the right-hand side of the equation).

21

Variables:(i) macroeconomic: the growth rate of real GDP per capita (ΔlnGDP),

the unemployment gap (UNEMPL_gap);(i) bank-specific: the ratio of loan loss provisions to average total assets (LLP/TA),

real credit growth (ΔlnLOANS), the ratio of total loans to average total assets (LOANS/TA), pre-tax earnings (EARN/TA), the ratio of equity capital to average total assets (CAP/TA);

(ii) other: „t“ denotes time and „i“ the individual banks, TA stands for the average total assets for the two periods (0.5(TAt+TAt-1)).

titizi

titittti

TACAPTALOANS

LOANSTAEARNgapUNEMPLGDPTALLP

,,7,6

,5,4321,

)/()/(

ln)/(_ln)/(

Do the Czech banks provision procyclically? III

22

Do the Czech banks provision procyclically? IV

• The growth rate of real GDP and the level of unemployment are used in the equation to proxy the business cycle. • If banks behave procyclically, the rate of economic growth will be

negatively correlated with provisioning, because an economic downturn is usually followed by growth in the volume of provisions.

• The unemployment rate follows GDP growth with a lag and affects banks’ earnings indirectly, it should be positively correlated

• It was included in the model because unlike GDP, which “only” indicates the degree of change in the business cycle, the level of unemployment shows the actual phase of the cycle.

23

Do the Czech banks provision procyclically? V

• The other factors in the equation are the real loan growth and the ratio of total loans to average total assets, which we included in order to capture credit risk associated with lending activity. • Both these variables should tend to be positively associated with loan loss

provisions (lower credit quality i.e. higher credit risk, higher risk absorber). • In some studies provisioning expenses vary negatively with loan growth,

consistent with, i.e. provisions are declining even as surges in new loans might indicate increased riskiness.

• In a latter case, significant increase in the loan growth rate (indirectly growth in credit risk) may reflect over-optimistic expectations about future economic developments and future earnings.

• Over-optimistic expectations and misestimation of credit risk, in turn, may result in a low growth rate of provisions relative to loan growth.

24

Do the Czech banks provision procyclically? VI

• Another variable in the model is pre-tax profit to average total assets. • Regulatory constraints on capital and other considerations can motivate the

bank to smooth out earnings over time.• Provided income smoothing, provisioning should be positively correlated with

profits. • The final variable included is the ratio of equity capital to average total assets. The

relationship between provisioning and capital can be either negative or positive. • If a bank takes into account its equity ratio when provisioning, the relationship

between the variables is negative. If the bank decides that its capital buffer is large enough to cover any loan losses arising, as is usual at times of credit expansion, its provisioning may be low.

• By contrast, a positive relationship would suggest that provisions and capital are more or less independent of each other. The bank thus sets aside loan loss provisions no matter how large its capital buffer is.

25

Do the Czech banks provision procyclically? VII

• In case of the Czech Republic we used for estimation of procyclicality in provisioning quarterly „supervisory“ data for the period 1Q1998–4Q2011 from the balance sheets and income statements of 15 banks at the end of 2011.

Panel regression results for loan loss provisions: Czech banks Variables Coefficients Robust Std. Errors tGDP growth -0.00414 0.00244 -1,70*Unemployment gap 0.00391 0.00275 1.42*Pre-tax profit 0.98022 0.05945 16.49***Loans growth -0.00044 0.00038 -1.17Loans/TA 0.01020 0.00479 2.13**Capital/TA -0.14771 0.02129 -6.94***c -0.00269 0.02069 -0.13No. of observations 795R2 - within (between banks) 0.9459 R2 - overall 0.9664R2 - between (over time) 0.9963 rho 0.2328F (6,14) 499.19 Prob > F 0.0000Note: The data were statistically significant at the ***1%, **5% or *10% level. The statistical tests indicated that it wasappropriate to use a panel regression with fixed effects. We tested the panel data for non-stationarity using the Hadri panelunit root test.

26

Do the Czech banks provision procyclically? VIII

• Almost all variables, both macroeconomic and bank-specific, had statistically significant effect on the size of the loan loss provisions, only the coefficient on loan growth was insignificant. • As expected, the coefficient on GDP growth was negative, indicating that

provisioning is higher during economic downswings and lower during upswings. • Positive coefficient on the unemployment gap suggests that provisioning

depends on a stage of cycle and lacks forward-looking assessment of cycle-related risk.

• The results suggest that banks tried to smooth their income (or optimise their taxes) in the period under review by provisioning.

• Positive coefficient for the relationship between provisioning and the ratio of total loans to average total assets confirms a generally positive effect of expected credit risk on level of provisions. Banks tend to behave prudently to some extent.

27

Do the Czech banks provision procyclically? IX

• The final relationship under review is that between the equity capital to average total assets ratio and provisioning. • These variables are negatively correlated, supporting the assumption discussed

above that banks are influenced in their provisioning by their capital ratio. In other words, banks set aside fewer provisions to cover their expected losses when their capital buffer is larger.

• To sum up, the results confirmed the assumptions regarding the procyclical provisioning behaviour of banks, even though there are features in behaviour that mitigate procyclicality to some extent. • (i) positive and relative high coefficient of the pre-tax profit = the income

smoothing or tax optimization, • (ii) positive coefficient of loans to total assets = prudential behaviour confirmed;• … but banks set aside fewer provisions to cover their expected losses when

their capital buffer is larger (negative capital/TA coeff.).

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Do the European banks provision procyclically? I

• For comparison the paper analyzes the cyclical patterns of bank loan loss provisions followed by large commercial banks from selected countries of Europe. An empirical panel analysis covers 9 economies, namely Austria, Belgium, Germany, Denmark, France, Hungary, Sweden, Slovakia and the Czech Republic. • Data come from two sources: bank-level data are taken from the Bankscope

database (loans/average total assets, loan growth, capital/average total assets, loan loss provisions/average total assets and equity before taxes/average total assets) and macro-economic data (real GDP growth per capita, unemployment rates and inflation) from the Eurostat database.

• The data are available on an annual basis for a period of 12 years (from 1999 to 2010). Our sample is dominated by German, Denmark, French and Swedish banks.

• A panel OLS regression based on equation 1 is estimated and country dummies are included in the regression (not reported).

29

Do the European banks provision procyclically? II

Panel regression results for loan loss provisions: All selected banks Variables Coefficients Robust Std. Errors t

-0.00410 0.00011 -3.77***(-0.00047) (0.00012) (-3.84)***

0.00040 0.00033 1.22(0.00034) (0.00035) (0.62)

0.86109 0.24780 3.47***(0.88300) (0.24521) (3.6)***

0.00000 0.00001 0.41(0.00000) (0.00014) (0.62)-0.01253 0.00887 1.41*

(-0.01285) (0.00880) (-1.46)*-0.16235 0.05276 -3.08***

(-0.17087) (0.05149) (-3.32)***0.00631 0.00382 1.65*

(0.00770) (0.00420) (1.83)*

480432

0.5076 0.2640(0.5290) (0.2850)

0.0471 0.5334(0.0280) (0.51941)

F (6,39) 8.69 Prob > F 0.0000F (6,35) (8.38)Note: The data were statistically significant at the ***1%, **5% or *10% level. The statistical tests indicated that it wasappropriate to use a panel regression with fixed effects. We tested the panel data for non-stationarity using the Hadri panelunit root test. Values without CZ banks are in parenthesis.

GDP growth

Unemployment gap

Pre-tax profit

Loans growth

Loans/TA

Capital/TA

c

rho

R2 - overall

No. of observations

R2 - within (between banks)

R2 - between (over time)

30

Do the European banks provision procyclically? III

• The results suggest that bankers from selected countries create on average lower provisions in good times and are then forced to increase them during cyclical downturns (see the negative significant coefficient on the real GDP growth rate).

• We also find significant positive relationship between the ratio of loan loss provisions and bank earnings. This suggests that banks in our sample have followed an income-smoothing pattern on average.

• The loans to assets ratio has, contrary to expectations, an undesirable negative coefficient, while the real loan growth rate is insignificant.

III.Proposals for taming procyclicality in

accounting

Existing proposals for taming procyclicality

• Through-the-cycle expected loss provisioning (TELP) – EU Commission consultation to further changes in CRD from July 2009:• Based on through-the-cycle expected loss – forward looking estimation of losses

that should be covered by TELP. • TELP designed in line with Spanish approach – baseline method uses both α and β

parameters, more simple method considers parameter β only. • Prudential measure of a „corrective kind“ which nevertheless has impact on the

accounting. • Proposal does not address the issue of consistency between IFRS and CRD. • TELP potentially in conflict with regulatory concept of expected loss in Basel II.

• IRB institutions (only) apply models to set expected losses and their coverage by provisions is tested (if provisions not sufficient, difference deducted from regulatory capital).

• Proposal by Commission to use it via CRD supported neither by industry nor by supervisors.


• Expected loss approach (IASB, June 2009)• Facing criticism of the existing framework and the conclusions of a report produced

by the Financial Stability Forum’s Working Group on Provisioning, the International Accounting Standards Board (IASB) suggested a move to the expected loss (EL) approach in June 2009 as part of the IASB’s project on replacing IAS 39 Financial Instruments Measurement and Recognition.

• A major deviation from incurred loss approach - no trigger for an impairment test required

• it should reflect better the economic reality of banks’ lending activities than the incurred loss approach in that it requires an earlier recognition of expected credit losses,

• it should help to avoid ‘incurred but not reported losses’. • The present value of the expected future cash flows is measured using an initial

internal rate of return calculated on the basis of cash flows actually expected at inception (taking into account expected credit losses), and not on the basis of contractually agreed cash flows.


• Expected loss approach (IASB, June 2009) cont. • Initial internal rate of return will thus be lower than the contractual rate, with the

difference representing the risk premium charged to the borrower in order to cover the statistically foreseeable risk of non-recovery.

• Difference between cash flows received that represent contractual interest and interest recognised as revenues on the basis of the (lower) internal rate of return would be recognised in the balance sheet as a credit expected loss provision.

• Subsequent or additional impairment loss is recognised through continuous re-estimation of credit loss expectations. Reversal of impairment loss is recognised in profit or loss when there is a favourable change in credit loss expectations.

• EL approach may be quite complex and could generate excessive subjectivity and credibility/transparency issues.

• Any expected loss model has to rely on judgement supported by a set of indicators.

• But the quest for a precise model of this sort can give rise to undue complexity.


• In June 2010, the Basel Committee on Banking Supervision (BCBS, 2010b), came up with its own proposal, in which provisions are based on best estimates of expected credit losses built over the life of the loan at the balance sheet date considering the loss experience over the complete economic cycle. • Provisions are generally built up progressively by allocating a share of the

interest income over the life of the loan or loan portfolio to an allowance account at the time interest income is recognised.

• The BCBS also argued for the use of a simplified average loss rate, which would represent expected credit losses by loan type derived from historical experience based on some measure of actual losses and adjusted for current conditions.


• Initially, there were expectations that the existing approach would be replaced quite soon by the forward-looking countercyclical provisioning methodology being developed by the BCBS and the IASB. However, the pace of preparation of the new approach has become rather slow.

• In addition, the debate on impairment accounting subsequently became dominated by the initiative of the IASB and the U.S. Financial Accounting Standard Board (FASB) for reaching a common approach based on expected losses and amortised costs. • They issued a joint proposal in January 2011 (IASB, 2011) as a

"supplementary document" to their original proposals which can be viewed as a step towards the common approach.

• The proposal would require an entity to determine an impairment allowance based on internal risk management decisions to split financial assets to a “bad book” or “good book,” depending on the degree of uncertainty about the collectability of the assets’ cash flows.


• IASB and FASB:• An entity would be required to immediately recognize lifetime expected

losses for assets in the “bad book.” • For assets in the “good book,” an entity would recognize the higher of: a

portion of lifetime expected credit losses determined under a time-proportional approach; and credit losses expected to occur within the foreseeable future (not less than 12 months).

• Later on, the IASB and FASB’s deliberations moved to a three bucket approach to capture the pattern of deterioration in credit quality. • In this approach, loans are classified into three categories depending upon

their credit risks characteristics and any change in credit risk since origination.

• The level of provisions recorded would be expected to increase as credit deteriorates over time.


• IASB and FASB cont.:• Assets will begin in Bucket 1 and the measurement of impairment will be

based on 12 months of expected losses. • Assets will shift to either the Bucket 2 or Bucket 3 if and when credit

deteriorates. The measurement of impairment in Bucket 2 and 3 will be based on lifetime expected losses.

• In the Bucket 2, expected credit losses are not identifiable for individual loans whereas in the Bucket 3 expected credit losses are individually identifiable.

• The boards agreed that the impairment model will allow for migration of credit in both directions. In addition, they agreed that the probability of default should be the predominant characteristic for determining the collectibility of cash flows.

• The IASB and FASB joint proposal brings accounting rules more in line with the proposal put forward by the Basel Committee• But it got stuck …


• In an updated reaction to a new proposal from the IASB, the Basel Committee (BCBS, 2011a) expressed its support for an approach that requires the recognition of adequate levels of provisions on the balance sheet to absorb all expected credit losses. • Not reflecting an adequate level of an allowance for expected credit losses

on the balance sheet could result in overstating the related asset balances as well as the yield on those assets in any given period in the income statement.

• This could be potentially misleading to investors, other users and other market participants, while also raising the safety and soundness concerns of prudential authorities.

• The BCBS underlines that incorporating a broader range of available credit information than presently included in the incurred loss model should result in an earlier identification of credit losses.

IV.Capital buffers

Capital buffers: nothing new

• Borio and Lowe (2001) revisited• One possibility … is a clearer treatment of the relationship between provisions and

regulatory capital … • set provisions so that they cover an estimate of the net embedded loss in a bank’s

loan portfolio, • capital could then be calibrated with respect to the variability in those losses (their

“unexpected” component). (p. 46)• Another approach … supervisors could supplement capital requirements with a

prudential provisioning requirement … • instead of having the annual statistical provisioning charge deducted from a

bank’s profit and loss statement, have it added to the bank’s regulatory capital requirement for unexpected losses. (p. 48)


• Economic cycle reserve (ECR) – UK Turner review• An additional non-distributable reserve which would set aside profit in good years to

anticipate losses likely to arise in future.• A formula driven method would simple and non-discretionary similarly to Spanish

system:• a buffer of the order of magnitude of 2 – 3 % of RWAs at the peak of the cycle,• reserve could vary according to some predetermined metric such as the growth

of the balance sheet or estimates of average through-the-cycle loan losses.• A discretionary method would be entity-specific, tailored to the peculiarities of each

bank’s portfolios.


• Economic cycle reserve (ECR) – UK Turner review cont. • The approach has a macro-prudential defensive focus and is meant to be

accounting neutral• it is to be shown only as a movement on the balance sheet, rather than on the

P&L (is intended to be built and drawn by appropriation of retained earnings),• but there are very strong arguments that it should also appear somewhere on

the P&L,• allowing bottom line profit and earnings per share (EPS) to be calculated both

before and after its effect, and thus providing two measures of profitability, the ‘traditional’ accounting figure and a second figure struck after economic cycle reserving.

• Capital buffers under Basel III and CRD4 (conservation, countercyclical, systemic risk, SIFI) – now at the most advanced stage due to its attractiveness to the regulators and supervisors.

• Procyclicality of Basel II was widely debated prior its implementation. • There was a clear understanding that risk-sensitive regulatory capital

requirements tend to rise more in recessions and grow less during expansions, laying the ground for potentially pro-cyclical effects.

• The authors of the framework therefore pretended that they included some mitigating factors to dampen the potential pro-cyclical effect of Basel II's increased risk-sensitivity.

• Although improved risk management was one of the arguments for the introduction of Basel II, it now appears that neither regulatory capital nor economic capital has been set adequately to capture actual risk, particularly the risk contained in the trading book.


• High (perceived) costs of scraping Basel II down was reflected in the desire of regulators/supervisors to continue relying on Basel II framework in dealing with procyclicality.

• First, they hoped, after the current crisis, micropolicies might become easier for implementation including „ initially theoretical“ tools within current Basel II-Pillar 2:• Internal Capital Adequacy Assessment Process, Supervisory Review and

Evaluation Process • Stress testing with scenarios and methodology from supervisors• Backward testing of PDs and LGDs, downturn LGDs, conservative margins, tests

of adequacy of provisions ... • Second, they struggled to add some procyclicality-mitigating factors into the

concept.


CEBS proposal

• CEBS (CEBS, 2009) proposed practical tools for supervisors to assess under Pillar 2 the capital buffers that banks have to maintain under the Basel II/CRD framework (focusing on procyclicality of banking book of IRB banks).

• CEBS was considering the use of mechanisms that adjust probabilities of default (PDs) estimated by banks, in order to incorporate recessionary conditions.• Current PD: the long-term average of the default rates (either at the grade or portfolio

level).• Downturn PD: the highest PD over a predetermined time-span. • The scaling factor is: SF = PD_downturn / PD_current (close to 1 in a recession and

higher than 1 in expansionary phases).• The size of the buffer decreases in recession and increases in an upswing.• CEBS says proposal might easily be adapted in a Pillar 1 context, but ...

Countercyclical capital buffers

• BCBS‘s Countercyclical Capital Buffer proposal • The CCB proposal is designed to ensure that banking sector capital

requirements take account of the macro-financial environment in which banks operate.

• The primary aim is to use a buffer of capital to achieve the macroprudential goal of protecting the banking sector from periods of excess credit growth that have often been associated with the build up of system-wide risk.

• Protecting the banking sector in this context is not simply ensuring that individual banks remain solvent through a period of stress. Rather, the aim is to ensure that the banks in aggregate has the capital on hand to maintain the flow of credit in the economy without its solvency being questioned, when the financial system experiences stress after a period of excess credit growth.

• This focus on excess aggregate credit growth means that jurisdictions are likely to only need to deploy the buffer on an infrequent basis, perhaps as infrequently as once every 10 to 20 years.

Countercyclical capital buffers

• The starting point is Basel III new regulatory capitalization minimums:1. New common equity ratio (Core Tier1, CT1) of 7%, split between a 4.5%

minimum requirement and a conservation buffer of 2.5%.2. A countercyclical buffer of up to 2.5% of common equity, implemented

according to national circumstance.

3. A supplementary, non-risk-based leverage ratio, to be tested at 3%.4. Systemically important banks to carry loss-absorbing capacity “beyond the

standards announced”.• The CCB is thus presented as an add-on to the capital conservation buffer, effectively

stretching the size of the range in which restrictions on distributions of profits are applied.

Where will this lead?

• There is a risk that combination of redrafted Basel II combined with capital buffering, leverage limits and expected-loss-provisioning will produce something unexpected …

• There is a visible lack of coordination of authorities in terms of simultaneous considerations of both regulatory and accounting aspects.

• D. Tarullo (2008): „ … there is a strong possibility that the Basel II paradigm might eventually produce the worst of both worlds—a highly complicated and impenetrable process (except perhaps for a handful of people in the banks and regulatory agencies) for calculating capital but one that nonetheless fails to achieve high levels of actual risk sensitivity”...

• Still, if the cycle is driven by overly optimistic expectations, only combined effect of several other policies could do the job.

Procyclicality in Regulation and Macroprudential Policy Jan Frait.

Documents

financial supervisors

specific provisioning

general provisions

specific provisions

financial restrictions

forwardlooking provisioning

war procyclicality

provisioning systems