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The Countercyclical Capital Buffer of Basel III: A Critical Assessment
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We provide a critical assessment of the countercyclical capital buffer in the new regulatory framework known as Basel III, which is based on the deviation of the credit-to-GDP ratio with respect to its trend. We argue that a mechanical application of the buffer would tend to reduce capital requirements when GDP growth is high and increase them when GDP growth is low, so it may end up exacerbating the inherent pro-cyclicality of risk-sensitive bank capital regulation. We also note that Basel III does not address pro-cyclicality in any other way. We propose a fully rule-based smoothing of minimum capital requirements based on GDP growth.
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... When economic conditions deteriorate, banks can draw down this buffer to absorb losses and maintain lending. This mechanism helps to smooth the credit cycle, preventing the build-up of systemic risk during booms and supporting lending during busts, thus contributing to financial stability (Repullo & Saurina, 2011). According to Repullo & Saurina (2011), the implementation of countercyclical capital buffers has been shown to reduce the procyclicality of the financial system and enhance its resilience to economic shocks. ...
... This mechanism helps to smooth the credit cycle, preventing the build-up of systemic risk during booms and supporting lending during busts, thus contributing to financial stability (Repullo & Saurina, 2011). According to Repullo & Saurina (2011), the implementation of countercyclical capital buffers has been shown to reduce the procyclicality of the financial system and enhance its resilience to economic shocks. ...
Purpose: The general objective of the study was to investigate the effect of macroprudential policies on financial stability. Methodology: The study adopted a desktop research methodology. Desk research refers to secondary data or that which can be collected without fieldwork. Desk research is basically involved in collecting data from existing resources hence it is often considered a low cost technique as compared to field research, as the main cost is involved in executive’s time, telephone charges and directories. Thus, the study relied on already published studies, reports and statistics. This secondary data was easily accessed through the online journals and library. Findings: The findings reveal that there exists a contextual and methodological gap relating to the effect of macroprudential policies on financial stability. Preliminary empirical review revealed that macroprudential policies were crucial in mitigating systemic risk and enhancing financial stability. It found that tailored approaches, considering specific economic conditions, were necessary for these policies to be effective. Coordination with other regulatory measures and continuous adaptation to evolving financial landscapes were also essential. The research highlighted the importance of robust regulatory institutions and effective enforcement mechanisms, particularly in emerging markets, to address challenges such as regulatory capture and limited institutional capacity. Overall, the study emphasized the need for a dynamic and adaptable macroprudential regulatory framework to maintain a stable and resilient financial system. Unique Contribution to Theory, Practice and Policy: The Financial Stability Hypothesis, Regulatory Capture Theory and Agency Theory may be used to anchor future studies on macroprudential policies on financial stability. The study recommended adopting a comprehensive macroprudential regulatory framework that integrated various tools to address systemic risk. It suggested enhancing theoretical models to understand the dynamic effects of these tools and their combined impact. Practical recommendations included building strong regulatory institutions, improving data collection, and enhancing international cooperation and information sharing. Policy recommendations emphasized clear and transparent frameworks, regular policy reviews, and considering potential unintended consequences. Engaging with stakeholders to address concerns and ensure balanced regulation was also advised to support sustainable economic growth while maintaining financial stability.
... For example, Hamilton (2018) argues that the HP filter produces spurious dynamics that are not based on the underlying data and the data obtained in the middle and at the end of the sample are different. Repullo and Saurina (2011) claim that decision making on the countercyclical capital buffer based on a mechanical application of the Basel gap would lead to reduce capital requirements in bad times and vice versa. Other papers indicate that in certain countries the Basel gap underestimated risks during a period of excessive credit growth and reported negative credit gap (Castro et al., 2016;Lang and Welz, 2017;Lang et al., 2019, Baba et al., 2020. ...
... Alan Greenspan, 2001. 33 Addressing the evolution of risk over time in the financial sector and its pro-cyclical behaviour has become a crucial concern for academics and policy-makers (see Repullo and Saurina (2011) and Repullo, Saurina, and Trucharte (2010)). The Bank for Inter-national Settlements, in its 2009 annual report, defines procyclicality as "the fact that, over time, the dynamics of 32 In a similar approach, Huang, Zhou, and Zhu (2012) propose a new indicator, Distress Insurance Premium (DIP), for measuring systemic risk. ...
The severity and longevity of the recession caused by the 2007 financial crisis has highlighted the lack of a reliable macro-based financial regulation framework. As a consequence, addressing the link between the stability of the financial system as a whole and the performance of the overall economy has become a mandate for policymakers and scholars. Many countries have adopted macroprudential tools as policy responses for safeguarding the financial system. This paper provides a literature review of macroprudential policies, its objectives and the challenges that a macro-based framework needs to overcome, such as financial stability, procyclicality, and systemic risk.
... Repullo & Saurina, 2011). The stock nature of credit and the flow nature of the GDP mean that the impact of economic slowdown becomes apparent slower and more gradually in the amount of credit. ...
Credit supply shocks significantly aggravate the impact of economic recessions. Understanding the underlying reasons why credit market shocks occur and detecting the market turbulences in time can give a decision support tool for the economic policy to intervene more efficiently on the market and to reduce the effect of economic downturns. The goal of the current article is to investigate the factors that signal possible credit shocks by analyzing the quarterly data of 17 European countries over the period 1995-2021. The focus of the article is on the credit given to the nonfinancial corporations. In our analysis, we have built on the credit gap methodology by determining the deviations of the lending activity from its trend, and then we have mod-eled these credit gaps using fundamental macroeconomic indicators, such as the balance of the current account, the ratio of short-and long-term capital investments and government debt. Our conclusion is that in the presence of fundamental disequi-librium in the economy excessive lending creates positive credit gaps that increase the chance of negative credit market shocks. According to our new findings, the existing credit gap methodology can be improved by incorporating real economic factors ; slowing long-term capital investment and increasing the deficit of the current account signal the emergence of a credit gap. We found significant regional heteroge-neity as in Southern European countries, and the credit gaps were more substantial. Among the investigated macroeconomic factors, the governmental indebtedness was especially high in these countries suggesting that countries with high public debt rates are more prone to develop credit gaps. K E Y W O R D S credit gap, current account, economic disequilibrium, government debt, investment slowdown Key Points • Credit gaps signal a possible credit market shock. • Credit expansion in the presence of disequilibrium in fundamental market segments induces credit gaps.
The Oxford Handbook of Banking, 4th edition, provides an overview and analysis of developments and research in banking written by leading researchers in the field. This handbook will appeal to graduate students of economics, banking and finance, academics, practitioners, regulators, and policy makers. The handbook is divided into five parts. Part I, Fundamentals of Banking, comprises six chapters and examines the role of banks in the financial system and real economy, how they function, and their governance. Part II, Traditional and New Challenges to the Banking Model, comprises seven chapters and deals with competition and risk management, liquidity, and the growing importance of FinTechs and BigTechs as well as climate change, financial inclusion, and financial literacy. Part III, Various Models for Delivering Banking Services, covers seven chapters on small business, real estate, and syndicated lending, as well as chapters on community, cooperative, Islamic, and shadow banking. Part IV entitled Regulatory and Policy Perspectives comprises eight chapters and discusses systemic risk and financial crises; central banking; stress testing; macroprudential policy; as well as bank bailouts and bail-ins. Part V, Global, Regional, and Country Perspectives on Banking, includes eight chapters that provide country- and regional-level perspectives on banking systems around the world. Part VI, Editor’s Wrap-Up to Fourth Edition provides a long-term analysis of changes to the banking industry.
This study aims to expand the existing literature on the identification of macroeconomic and socio-economic factors that can be used in predicting bank capital adequacy ratios. The study utilizes regression analysis. Empirical results suggest that there is a negative relation between household income per capita and bank’s capital adequacy ratios, which confirms the hypothesis of pro-cyclical lending. It is also shown that changes in household income affect both total capital and Tier 1 capital adequacy ratios, while the relation with “gap” indicators is not significant in any models.
The banks are at the core of the functioning of economies and the dynamic of the growth of the country. They ensure the activity of financial intermediation between those who have surpluses and those who have the needs of funding. For this, they are in front of several risks including the risk of credit. They are always seeking to ensure their financial stability. The objective of this paper is to study the impact of credit risk on financial stability. The econometric procedure is based on a hypothesis within a model with panel co-integrated for a sample composed of 21 Tunisian banks for an annual frequency going from 2005 to 2019. The results revealed that the relationship between credit risk and the performance of assets is unidirectional. In other words, within the meaning of Granger, the increase in credit risk causes an increase in the production of assets and not the reverse. Moreover, credit risk and the gross domestic product have a bidirectional relationship. These results have led to the conclusion that credit risk is positively linked to the financial stability of the Tunisian banks. To sum up, our findings support the result that there is a two-way relationship between the stability of banks and the total productive assets to the threshold of 1% in short and in the long term. These results confirm the high performance of Tunisian banks and especially the first three banks named in Tunisia, namely the International Bank Arabic of Tunisia (BIAT), the National Agricultural Bank (BNA) and the Attijari Bank (AB).
The pro-cyclical effect of bank capital requirements has attracted much attention in the post-crisis discussion of how to make the financial system more stable. This paper investigates and calibrates a dynamic provision as an instrument for addressing pro-cyclicality. The model for the dynamic provision is adopted from the Spanish banking regulatory system. We argue that, had U.S. banks set aside general provisions in positive states of the economy, they would have been in a better position to absorb their portfolios' loan losses during the recent financial turmoil. The allowances accumulated by means of the hypothetical dynamic provision during the cyclical upswing would have reduced by half the amount of TARP funds required. However, the cyclical buffer for the aggregate U.S. banking system would have been depleted by the first quarter of 2009, which suggests that the proposed provisioning model for expected losses might not entirely solve situations as severe as the one experienced in recent years.
This paper introduces the updated and expanded version of the Financial Development and Structure Database and presents recent trends in structure and development of financial institutions and markets across countries. The authors add indicators on banking structure and financial globalization. They find a deepening of both financial markets and institutions, a trend concentrated in high-income countries and more pronounced for markets than for banks. Similarly, the recent increase in cross-border lending and debt issues has been concentrated in high-income countries, while low and lower-middle income countries have experienced an increase in remittance flows. Low net interest margins, rising profitability and declining stability in high-income countries banking sectors characterize the recent financial sector boom in high income countries leading up to the global financial crisis of 2007.
Do external imbalances increase the risk of financial crises? This paper studies the experience of 14 developed countries over 140 years (1870–2008). It exploits the long-run data set in a number of different ways. First, the paper applies new statistical tools to describe the temporal and spatial patterns of crises and identifies five episodes of global financial instability in the past 140 years. Second, it studies the macroeconomic dynamics before crises and shows that credit growth tends to be elevated and short-term interest rates depressed relative to the “natural rate” in the run-up to global financial crises. Third, the paper shows that recessions associated with crises lead to deeper slumps and stronger turnarounds in imbalances than during normal recessions. Finally, the paper asks to what extent external imbalances help predict financial crises. The overall result is that credit growth emerges as the single best predictor of financial instability. External imbalances have played an additional role, but more so in the pre-WWII era of low financialization than today.
Let me start by thanking the People's Bank of China and the International Monetary Fund for the opportunity to join my colleagues Norman Chan and Philipp Hildebrand. It is particularly appropriate to look at macroprudential policy from an Asian perspective, as central banks in this region have undertaken to use such policies. I have reflected on the Asian experience on other occasions. Today, therefore, I shall take a different tack. I should like to highlight how Basel III provides a solid foundation for a macroprudential framework: it is macroprudential policy in the making. And rather than presenting a dry description of its macroprudential elements, I ask a counterfactual question: could the new standards have made a difference in the course of the recent crisis? This mental experiment can make macroprudential policy come alive. My answer is yes. I shall argue that banks would have faced the recent financial crisis with much stronger capital bases, and would have been better able to draw on them. The financial system would have been much better prepared to withstand the shock of falling housing prices and losses on securitised assets. As a result, the negative feedback from losses to credit supply would have been milder, and governments would have had to provide less support. The aggravation of the business cycle (procyclicality) due to the financial system distress would have been significantly reduced. Before entering the time machine, however, let me emphasise the timeless theme of the responsibility of the authorities. While Basel III brings macroprudential policy into the mainstream of financial supervision, it remains the responsibility of the national authorities to put it into practice. Granted, they will benefit from internationally agreed minimum standards, a shared perspective and common reference points. But make no mistake: the national authorities, not some committee in Basel, will have to implement the policy. They will have to defend their decisions in an uncertain context that will inevitably open them to criticism: it is never easy to take the punch bowl away when the party gets going.
Many observers have argued that the regulatory framework in place prior to the global financial crisis was deficient because it was largely "microprudential" in nature. A microprudential approach is one in which regulation is partial equilibrium in its conception and aimed at preventing the costly failure of individual financial institutions. By contrast, a "macroprudential" approach recognizes the importance of general equilibrium effects, and seeks to safeguard the financial system as a whole. In the aftermath of the crisis, there seems to be agreement among both academics and policymakers that financial regulation needs to move in a macroprudential direction. In this paper, we offer a detailed vision for how a macroprudential regime might be designed. Our prescriptions follow from a specific theory of how modern financial crises unfold and why both an unregulated financial system, as well as one based on capital rules that only apply to traditional banks, is likely to be fragile. We begin by identifying the key market failures at work: why individual financial firms, acting in their own interests, deviate from what a social planner would have them do. Next, we discuss a number of concrete steps to remedy these market failures. We conclude the paper by comparing our proposals to recent regulatory reforms in the United States and to proposed global banking reforms.
In this paper we develop a probability of default (PD) model for mortgage loans, taking advantage of the Spanish Credit Register,
a comprehensive database on loan characteristics and credit quality. From that model, we calculate different types of PDs:
point in time, PIT, through the cycle, TTC, average across the cycle and acyclical. Then, we compare capital requirements
coming from the different Basel II approaches. We show that minimum regulatory capital under Basel II can be very sensitive
to the risk measurement methodology employed. Thus, the procyclicality of regulatory capital requirements under Basel II is
an open question, depending on the way internal rating systems are implemented and their output is utilised. We focus on the
mortgage portfolio since it is one of the most under researched areas regarding the impact of Basel II and because it is one
of the most important of banks’ portfolios.
The debate over the potential procyclicality of bank capital requirements under Basel II has focused overwhelmingly on peak-to-trough variation in minimum regulatory requirements. In this paper, we re-examine the problem from the perspective of market discipline. First, we show that the marginal impact of introducing Basel II depends strongly on the extent to which market discipline leads banks to vary lending standards procyclically in the absence of binding regulation. Second, we evaluate policy options not only by their efficacy in dampening cyclicality in capital requirements, but equally by how well the information value of Basel II market disclosures is preserved.
Policy discussions on the recent financial crisis feature widespread calls to address the pro-cyclical effects of regulation. The main concern is that the new risk-sensitive bank capital regulation (Basel II) may amplify business cycle fluctuations. This paper compares the leading alternative procedures that have been proposed to mitigate this problem. We estimate a model of the probabilities of default (PDs) of Spanish firms during the period 1987–2008, and use the estimated PDs to compute the corresponding series of Basel II capital requirements per unit of loans. These requirements move significantly along the business cycle, ranging from 7.6% (in 2006) to 11.9% (in 1993). The comparison of the different procedures is based on the criterion of minimizing the root mean square deviations of each adjusted series with respect to the Hodrick–Prescott trend of the original series. The results show that the best procedures are either to smooth the input of the Basel II formula by using through-the-cycle PDs or to smooth the output with a multiplier based on GDP growth. Our discussion concludes that the latter is better in terms of simplicity, transparency, and consistency with banks’ risk pricing and risk management systems. For the portfolio of Spanish commercial and industrial loans and a 45% loss given default (LGD), the multiplier would amount to a 6.5% surcharge for each standard deviation in GDP growth. The surcharge would be significantly higher with cyclically varying LGDs.
— Rafael Repullo, Jesús Saurina and Carlos Trucharte
Since bank credit lines are a major source of corporate funding, we examine the determinants of their usage with a comprehensive database of Spanish corporate credit lines. A line's default status is a key factor driving its usage, which increases as firm financial conditions worsen. Firms with prior defaults access their credit lines less, suggesting that bank monitoring influences firms' usage decisions. Line usage has an aging effect that causes it to decrease by roughly 10% per year of its life. Lender characteristics, such as the length of a firm's banking relationships, as well as macroeconomic conditions, affect usage decisions. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.
This paper provides a survey on studies that analyze the macroeconomic effects of intellectual property rights (IPR). The first part of this paper introduces different patent policy instruments and reviews their effects on R&D and economic growth. This part also discusses the distortionary effects and distributional consequences of IPR protection as well as empirical evidence on the effects of patent rights. Then, the second part considers the international aspects of IPR protection. In summary, this paper draws the following conclusions from the literature. Firstly, different patent policy instruments have different effects on R&D and growth. Secondly, there is empirical evidence supporting a positive relationship between IPR protection and innovation, but the evidence is stronger for developed countries than for developing countries. Thirdly, the optimal level of IPR protection should tradeoff the social benefits of enhanced innovation against the social costs of multiple distortions and income inequality. Finally, in an open economy, achieving the globally optimal level of protection requires an international coordination (rather than the harmonization) of IPR protection.