The procyclical effects of Basel II

Rafael Repullo, Javier Suarez, 14 July 2008

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The global charter that regulates banks’ capital requirements – known as Basel II – aims to make each bank’s capital holdings proportional to its potential credit losses.1 The idea was to reduce the incentives for excessive risk-taking and the opportunities for regulatory arbitrage supposedly offered by the old regime – Basel I.

Even before the Subprime crisis, there was widespread concern about the possibility that the risk-sensitivity of the new requirements may amplify business cycle fluctuations, forcing banks to restrict their lending when the economy goes into recession (Kashyap, and Stein 2004).

In recent research, we assess the impact of Basel II on banks’ cyclical lending capacity taking into account that banks will possibly respond to the new regulatory environment by modifying their buffers of capital held in excess of the regulatory minima. Our analysis suggests that, despite their attempt to reduce the procyclical effects by increasing their buffers, Basel II implies a much larger contraction in credit supply than Basel I when the economy enters a recession.

We also show that there are some easy fixes that would drastically ameliorate the problem. These would involve some wise adjustments in the cyclical profile of the levels of solvency (or “confidence”) targeted by the regulators.

Can bank regulation be procyclical?

Even under the essentially flat capital requirements of Basel I, bank capital regulation has the potential to be procyclical because bank profits may turn negative during recessions, impairing banks' lending capacity. Additionally, the Internal Ratings Based Approach (IRB) of Basel II makes capital requirements an increasing function of banks' estimates of their loans’ probability of default and loss given default, which are both likely to increase during downturns. This might substantially exacerbate the negative impact of recessions on banks’ supply of credit and, thereby, on the economy as whole, hence the concern on the procyclicality of Basel II.

However, there are some necessary conditions for capital requirements to have contractionary effects:

  • Some banks must find it difficult to respond to the accumulation of losses or higher capital requirements by issuing new equity.
  • The borrowers of the constrained banks must be unable to switch to other sources of finance.

If these conditions hold, capital requirements may be responsible for an aggregate contraction in the supply of credit – a credit crunch – during recessions.

Relationship banking and capital buffers

Are these conditions likely to hold? The informational features of banking relationships suggest so.

If lending makes banks privately informed about their borrowers, then informational asymmetries are likely to plague the market for seasoned equity offerings, making urgent recapitalisations prohibitively costly. As the Basel II Accord notes, “it may be costly for banks to raise additional capital, especially if this needs to be done quickly or at a time when market conditions are unfavourable” (paragraph 757c). Intuitively, the market for seasoned equity offerings might be what economists describe as a “market for lemons”—after a negative shock, the banks with lower quality borrowers would be more interested in issuing equity than the banks with higher quality lending relationships, resulting in prices for new equity that are unattractive to the latter, collapsing the market or engendering large price discounts.

The informational contents of bank relationships also implies that borrowers may become dependent upon the banks with which they maintain a relationship, as they might be locked in by the switching costs and stigma faced when switching to another bank (especially if they come from a bank in trouble).

However, banks involved in information-intensive lending relationships tend to appropriate rents from their continued lending and may hold buffers of capital, in excess of the minimal regulatory requirements, in order to reduce the effect of negative shocks on their lending capacity. So the key question is whether the losses and additional capital requirements associated with recessions will overwhelm banks’ precautionary capital buffers? Answering that question requires a model of how banks will behave under Basel II.

In our recent paper, we build a dynamic equilibrium model of relationship banking in which business cycle fluctuations affect borrowers’ default rates. Assuming that equity financing is more costly than deposit financing, we show that capital requirements increase equilibrium loan rates but have an analytically ambiguous effect on capital holdings. On the one hand, the higher prospects of ending up with insufficient capital necessitates holding larger buffers; on the other hand, higher capital requirements reduce the profitability of future lending and thus a bank’s interest in preserving its future lending capacity.

We use numerical simulations in order to assess which effect will dominates under the Basel II requirements. For our simulations, we assume that credit losses conform to the single risk factor model that rationalizes the formula of the IRB capital requirements of Basel II. Importantly, under such a model, capital requirements have an exact value-at-risk interpretation: required capital is such that it can absorb the potential losses of a loan portfolio over a one-year horizon with a probability of 99.9%.2

Results

Under realistic parameterisations, Basel II leads banks to hold buffers that range from about 2% of assets in recessions to about 5% in expansions. The procyclicality of these buffers reflects the fact that banks are concerned about the upsurge in capital requirements that takes place when the economy goes into a recession. We find, however, that these equilibrium buffers are insufficient to neutralise the effects of the arrival of a recession, which may cause a very significant reduction in the supply of credit – ranging from 2.5% to 12% in our simulations, depending on the assumed cyclical variation of the default rates.

There are significant differences between Basel I and Basel II. Under the flat (risk-insensitive) capital requirement of Basel I, the same banks would keep slightly countercyclical buffers and the economy would suffer very small credit crunch effects. However, the probabilities of bank failure under Basel I are substantially greater than under the new risk-sensitive approach. This suggests that designing the optimal policy involves evaluating a trade-off between the importance of long-term solvency of the banking sector and the short-term effects on the availability of credit. Yet, we show that a minor policy adjustment would allow regulators to make progress on both fronts.

Policy response: adjusting the cyclical profile of confidence levels

Small cyclical adjustments to the confidence levels set by the regulator could ameliorate the procyclical impact of Basel II. If the regulator replaced a constant confidence level with a cyclical profile of confidence levels, it would be possible to keep the long-term average confidence at its current level—99.9%—while lowering the target during periods of economic distress in which current regulations might induce a painful credit crunch.

Using our model, we evaluate the effects of some specific cyclical adjustments that would reduce the confidence level to 99.8% during periods of high default and raise it above 99.9% during prosperous periods. Our simulations suggest that these approaches would achieve significant gains in terms of alleviating credit rationing without incurring major costs in terms of banks’ solvency. Such cyclical adjustment would preserve the value-at-risk foundation of the Basel II requirements, while addressing the very real concern that risk-sensitive capital requirements – in their present form – may exacerbate credit crunches.

References

Gordy, M. (2003). “A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules,” Journal of Financial Intermediation, 12, 199-232.
Kashyap, A., and J. Stein (2004), "Cyclical Implications of the Basel II Capital Standards," Federal Reserve Bank of Chicago Economic Perspectives, 1st Quarter, 18-31.

Footnotes

1 In 2004, after years of discussion, the Basel Committee on Bank Supervision reached an agreement, known as Basel II, which introduces a major revision of the original agreement on International Convergence of Capital Measurement and Capital Standards of 1988. Its most tangible change is the enriched treatment of credit risk in bank capital requirements.

2 See Gordy (2003) on the use of the single factor model as a foundation for the capital requirements of Basel II.

Topics: Financial markets
Tags: bank capital regulation, Basel II, Credit crunch

Professor of Economics and Director of CEMFI and CEPR Research Fellow
Professor of Finance at CEMFI, Madrid and CEPR Research Fellow