Procyclicality in minimum regulatory capital charges for credit risk
There is a vast amount of literature available on the additional procyclicality of regulatory capital charges in Pillar 1 of Basel II. In this section, we shall briefly visit this literature and see if any conclusions can be drawn from this, before proceeding to the conclusion and mitigation of these procyclical effects. The majority of the literature, as expected, focuses primarily on the IRB approach, as this aspect of Basel II has drawn the most criticism from financial practitioners and academics alike. The greater part of this literature has found that there is an overwhelmingly substantial rise in procyclicality of minimum regulatory capital charges originating from the IRB approach. Gordy and Howells found that under the IRB approach, volatility in the capital charge, relative to the mean, is between 0.1 to 0.26 (Gordy & Howells, 2004). This follows another study by Kashyap and Stein, which shows that capital charges rose by 70-90% during the years of 1998 to 2002 dependant of the model used to calculate PD’s (Goodhart & Taylor, 2004).
The implications of these findings are as follows. The works of these academics highlight the important point that there is higher volatility of capital charges for better quality credits (Goodhart & Taylor, 2004). This is because these credits face a steeper risk curve, as the movement within the ratings scale (from one rating to another) is much greater.
Possible Solutions to mitigate procyclicality
Now that we have reviewed the literature and empirical evidence on the problem of procyclicality arising from Basel II, we shall see how these problems may be addressed. As already noted, regulatory capital requirements, through their impact on earnings and overall capital quantities, are a clear source of the procyclicality problem arising from Basel II’s first pillar. With financial institutions changing their business models from the classic buy and hold model to a riskier originate to distribute model, the deficiencies of this model have also added to the problem of procyclicality in the financial system. From studying the financial crisis, we have observed a few ways in which the capital framework can be reinforced, thus reducing the likelihood of magnifying credit cycles in the economy. This presents us opportunities to introduce countercyclical components into the revised framework that should, in theory, improve the ability of the overall banking system to withstand cycles of increased stress and mitigate the accumulation of excess leverage and credit growth in our system. Our recommendations are as follows.
(1) The Basel Committee should reinforce regulatory capital framework to include a higher level of capital during prosperous economic conditions, as this can act as a buffer and be called upon during times of economic distress
If the capital framework is enhanced, higher levels of capital acquired during periods of robust...