Abstract

In order to survey the mechanisms through which the introduction of Basel II bank capital requirements is likely to accentuate the procyclical tendencies of banking, this paper brings together the theoretical literature on the bank capital channel of propagation of exogenous shocks and the literature on the regulatory framework of capital requirements under the Basel Accords. We conclude that the theoretical models that revisit the bank capital channel under the new accord generally support the Basel II procyclicality hypothesis and that the magnitude of the procyclical effects essentially depends on (i) the composition of banks' asset portfolios, (ii) the approach adopted by banks to compute their minimum capital requirements, (iii) the nature of the rating system used by banks, (iv) the view adopted concerning how credit risk evolves through time, (v) the capital buffers over the regulatory minimum held by the banking institutions, (vi) the improvements in credit risk management and (vii) the supervisor and market intervention under Basel II. The recent events and instability in financial markets all over the world have led the procyclicality issue to enter the agendas of several political international fora and some measures to mitigate procyclicality are being put forward. The bank capital channel literature should now play an important role in evaluating their effectiveness.

Table of Contents

Abstract1

Introduction3

The Bank Capital Channel: Related Theoretical Literature5

Capital Requirements within Banking Regulation7

Banking Prudential Regulation7

Empirical Evidence on the Procyclicality Hypothesis8

Discussion11

Conclusion13

Works Cited15

Bank Capital Requirements: Basel And Regress

Introduction

The Basel Committee on Banking Supervision (BCBS) released, in 2004, the new Basel Capital Accord (usually referred to as Basel II) to address some of the major shortcomings of the previous Basel Accord of 1988 (Basel I), thus fostering stability in the financial system. One of the central changes proposed by Basel II is the increased sensitivity of a bank's capital requirement to the risk of its assets: the amount of capital that a bank has to hold is to be directly connected to the riskiness of its underlying assets. This aspect of the new regulation has raised some concerns, at both academic and policy-making levels, because it may accentuate the procyclical tendencies of banking, in the presence of an imperfect market for bank capital: if, during a recession, bank borrowers are downgraded by the credit risk models in use, minimum bank capital requirements will increase. To the extent that it is difficult or costly for banks to raise external capital in bad times, this co-movement in bank capital requirements and the business cycle may induce banks to further reduce lending during recessions, thereby amplifying the initial downturn (Aguiar, 242).

Banking regulation and, in particular, the procyclical effects of Basel II have gained special interest with the current financial crisis that began in 2007 in the US subprime market, then spreading to broader credit and funding markets. As pointed out by Rosengren (2008, 99), banks play a critical role during periods of financial crisis because they are highly leveraged and regulated institutions, and to maintain their capital ratios after experiencing a large negative capital shock they must ...