Procyclicality

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See also Basel 3 and Basel Committee on Banking Supervision.

Contents

BIS countercyclical capital buffer proposal

The Basel Committee on Banking Supervision has issued for consultation a proposal for a countercyclical capital buffer regime.

The Committee welcomes comments on all aspects of this proposal by Friday 10 September 2010. Comments should be submitted by post (Secretariat of the Basel Committee on Banking Supervision, Bank for International Settlements, CH-4002 Basel, Switzerland) or email (baselcommittee@bis.org). All comments will be published on the Bank for International Settlements' website unless a commenter specifically requests anonymity or confidential treatment.

Introduction

The agreement of the Group of Central Bank Governors and Heads of Supervision, set out in its 7 September 2009 press release, included a commitment to introduce a framework for countercyclical capital buffers above the minimum requirement. Subsequently, the Basel Committee agreed that a building block approach should be adopted to organise the work on procyclicality. The aim of this approach was to align the development of tools to address procyclicality according to a specific set of objectives. The four key objectives identified by the Committee were set out as follows in the December 2009 Consultative Document Strengthening the resilience of the banking sector:

  1. dampen any excess cyclicality of the minimum capital requirement;
  2. promote more forward looking provisions;
  3. conserve capital to build buffers at individual banks and the banking sector that can be used in stress; and
  4. achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth

The December 2009 Consultative Document included a proposal for a capital conservation buffer to address the third objective above and set out some potential elements of a regime to address the fourth objective. The Macro Variables Task Force (MVTF) was formed to further develop a proposal to address the fourth objective with the goal of providing a fully detailed proposal for review by the Basel Committee at its July 2010 meeting. The proposal takes into consideration the formal feedback on a summary of the broad concept of a countercyclical buffer contained in the December Consultative Document.

This consultative document is structured as follows:

  • Section 1 describes the primary objective of the proposed buffer and presents a short overview of how it would operate in practice.
  • Section 2 sets out a more detailed description of certain key elements of the proposal.

The annexes discuss how the proposed buffer can be integrated with the capital conservation buffer, describe how the credit-to-GDP guide should be calculated and provide the supporting empirical evidence used to develop the proposal.

ECB's position on countercyclical capital buffers

This document provides the Eurosystem’s replies on the Consultation Document by the European Commission on its Countercyclical Capital Buffer (CCB) proposal.

The position is based on two main principles: first, the CCB is considered to be an important element of a wider macro-prudential policy framework. Therefore, the buffering mechanism should be designed and calibrated so as to become an effective policy measure in promoting financial stability and enhancing the resilience of the financial system in periods when excessive credit growth is associated with the build-up of systemic risk.

Second, the CCB should play a role in promoting a single market for financial services in the EU.

This principle calls for a harmonised implementation among Member States in order to ensure a level playing field for internationally active banks and banking groups. In this context, the European Systemic Risk Board (ESRB) and the European Banking Authority (EBA) should play a key role in ensuring consistent and effective implementation of the CCB across Member States.

Procyclicality and the role of financial regulation

Source: Jean-Pierre Landau, Deputy Governor of the Bank of France on procyclicality BIS, May 4, 2009

Remarks by Mr Jean-Pierre Landau, Deputy Governor of the Bank of France, at the Bank of Spain's conference on Procyclicality and the Role of Financial Regulation; Madrid, 4 May 2009.


"Strictly speaking, procyclicality refers to the tendency of financial variables to fluctuate around a trend during the economic cycle. Increased procyclicality thus simply means fluctuations with broader amplitude.

Such a simple description seldom fits the behaviour of financial systems in real life. More likely, following a shock, the path of asset prices and evolution of financial aggregates will display various and highly irregular forms of volatility, with possible non linearities and discontinuities (a good example being liquidity freezes). These are characteristic features of complex systems. "Once such a system is destabilized, it moves away from the linear regime and experience non linear behaviour such as path dependance … sustained oscillations … and regime shifts"1.

Indeed, financial systems can be seen as complex systems2. They are based on interdependence between multiple actors and counterparties. Transmissions occur through networks whose structure and architecture is constantly changing through financial innovation and regulatory arbitrage. Also, financial systems are "human" systems. Their behaviour is shaped by the way human beings react to shocks in their environment. Herd behaviour has long been known to be an essential feature of financial markets. More subtly, individual reactions, by themselves rational, can, by the virtue of their mutual interaction, produce strong amplification effects3.

A broader definition of procyclicality would thus encompass three components, which cannot easily be distinguished in real life:

  • (1) fluctuations around the trend
  • (2) changes in the trend itself and
  • (3) possible cumulative deviations from equilibrium value.

This points to the policy challenges regulators face. They have to try and identify when pure cyclical fluctuations morph into something different: either a change in the trend itself or the start of a cumulative process.

What are the mechanisms at work?

Analytically, it is useful to distinguish between procyclicality of capital and procyclicality of leverage.

Procyclicality of capital is easy to understand. When conditions are good, financial institutions are profitable and their strong capital base allows them to take larger positions in the markets. This mechanism has been amplified by mark to market accounting4.

In a mark to market environment, an increase, for instance, in asset prices quickly translates into stronger capital for financial institutions.

This, in turn, triggers additional demand for assets and a further increase in their prices. This kind of "inverted demand curve", where demand increases with prices, potentially creates powerful feed back loops.

Procyclicality in leverage is more subtle. It has been shown that financial institutions' balance sheets expand and contract with the economic cycle5. Many different mechanisms are at work:

  • First, risk management techniques: tools used to measure and value risk, such as VaR are naturally and strongly procyclical, especially when constructed with very short data series. Risk management practices hardwired to valuations (such as margin calls) strongly amplify fluctuations in leverage and may lead to fire sales and "one sided" markets.
  • Another mechanism6 relates to the dynamics of short term money markets : when liquidity is perceived as abundant, there is strong incentive for dealer-brokers to engage in maturity transformation through strongly leveraged positions.
  • Finally, risk appetite itself moves along the economic cycle. Animal spirits obviously play a role. Also, valuation gains and losses may encourage risk taking or trigger sharp pull-backs.

The role of margin requirements and haircuts in procyclicality

Abstract: Terms and conditions on secured lending transactions, as well as the changes to the eligible pool of collateral securities and the applicable haircuts on them, affect the access to credit and risk-taking behaviour of leveraged market participants. The study group report on The role of margin requirements and haircuts in procyclicality under the chairmanship of David Longworth of Bank of Canada reviews market practices for setting credit terms applicable to securities lending and over-the-counter derivatives transactions with a view to assess how these practices may contribute to financial system procyclicality. The report recommends a series of policy options, including some for consideration, directed at margining practices to dampen the build-up of leverage in good times and soften the systemic impact of the subsequent deleveraging.

Download the paper here.

Basel Committee counter-cyclical proposals tie buffers to economic indicators

The Basel Committee on Banking Supervision finished its quarterly meeting last night and has today published a key consultation document on counter-cyclical capital that would see banks build up additional capital in booms to be drawn down in a recession.

Capital buffers were always a central objective of the reforms to the Basel II capital framework, as regulators had been asked by the Group of 20 leading economies to correct the pro-cyclical effects of the current regime, which has seen banks rein in credit to the real economy to meet rising risk-based capital requirements during the crisis.

But the Basel Committee's package of proposals published in December lacked any detail on counter-cyclical capital because committee members had failed to reach consensus on how a capital buffer regime would work. According to one committee member, central bankers within the committee had advocated tying the buffer to macroeconomic variables, but supervisors felt such an approach may not work internationally and wanted something simpler.

The Basel Committee's 36-page proposal appears to be a compromise between the two views, as the buffer would be tied to macroeconomic indicators but national authorities would be given the power to determine when a capital buffer should be mandated. The committee suggests authorities should force banks to build up buffers when "excess aggregate credit growth is judged to be associated with a build-up of system-wide risk". It suggests such a buffer may only be necessary once every 10 to 20 years, but large cross-border banks may need to hold a smaller buffer more frequently.

To ensure international consistency, the committee outlines a single methodology for determining the necessity of a buffer, based on the gap between private sector credit and GDP. When that gap reaches a certain level, it is taken as an indicator of excess credit growth that may be associated with a build-up of systemic risk and necessitate the introduction of buffers.

The committee recognises the methodology is not always a fail-safe indicator of the need for a capital buffer, and stresses authorities will be expected to apply judgement to the setting of the buffer in their jurisdiction, but the assessment must be based on five principles set out in the document.

The buffer proposals are open for comment until September 10, leaving time for the Basel Committee to make any adjustments and finalise the proposals by year-end.

This week's meeting also included discussions on the committee's other proposals on capital, liquidity and leverage, as well as a review of industry comments, the quantitative impact study and the economic impact assessment. Concrete recommendations on the completion of the package will be presented to a meeting of the committee's oversight board of central bank governors and heads of supervision on July 26. Those recommendations are likely to include amendments to the original proposals on the basis of the impact assessments and industry feedback.

The committee is continuing to work on the role of contingent capital and is expected to publish proposals within the next two months on capital that would convert from debt to equity when a bank goes into administration. Contingent capital that converts when an entity remains a going concern is more complex, as it requires the definition of a trigger point for conversion – something regulators are still grappling with.

According to one committee member, it is not yet clear whether the contingent capital proposals will be finalised by the end of this year, but this week's meeting was a positive step towards completing the rest of the package.

"The overriding view at the conclusion of the meeting was really quite encouraging. We made very good progress and based on that progress, we have put together some recommendations that now will be endorsed or considered further by the governors and heads of supervision," he says.

Procyclicality, US finreg and capital requirements

From the BIS Consultative Document:

The countercyclical buffer proposal set out in this document is designed to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. It should be viewed as an important internationally consistent instrument in the suite of macroprudential tools at the disposal of national authorities. It should be deployed when excess aggregate credit growth is judged to be associated with a build-up of system-wide risk to ensure the banking system has a buffer of capital to protect it against future potential losses.

This (proposed capital buffer regime) should help to reduce the risk of the supply of credit being restrained by regulatory capital requirements that could undermine the performance of the real economy and result in additional credit losses in the banking system.

In addressing the aim of protecting the banking sector from the credit cycle the proposal may also help to lean against the buildup phase of the cycle in the first place. This would occur from the capital buffer acting to raise the cost of credit and therefore dampen its demand, when there is evidence that the stock of credit has grown to excessive levels relative to the benchmarks of past experience. This potential moderating effect on the buildup phase of the credit cycle should be viewed as a positive side benefit rather than the primary aim of the proposal.

As such, the buffer is not meant to be used as an instrument to manage economic cycles or asset prices. Where appropriate those may be best addressed through fiscal, monetary and other public policy actions. It is important that the buffer decisions be taken after an assessment of as much of the relevant prevailing macroeconomic financial and supervisor information as possible and bearing in mind that the operation of the buffer may have implications for the conduct of monetary and fiscal policies. The differences between recent official U.S. policy positions and elements of the BIS proposal are dramatic.

The Fed has always maintained that monetary and regulatory policies are separate and distinct. The BIS proposal makes it clear that regulatory policy affects GDP and other macro-economic variables and that regulatory policy must be coordinated with monetary and fiscal policy. The BIS proposal does not assert that regulatory and monetary policies are interchangeable, but does take the position that they can complement or conflict with each other. In the neat world of silos in which U.S. central bankers operate, this is a revolutionary development.

Until the crisis, U.S. monetary policy was guided by the Taylor Rule. There was no provision to adjust any policy based on the growth of any monetary or credit aggregate (except possibly for periods of Quantitative Easing). The BIS proposal is premised on the idea that an unusually high level of debt relative to GDP is cause to adjust fiscal and monetary policy. In short, the BIS proposal allows a role for credit aggregates in setting monetary policy while Fed policy has not.

The Fed view that interest rates should not be used for financial stability appears to have prevailed. But, has it? The BIS capital buffer proposal doesn't call for changes in official rates, but the proposed BIS capital buffer is expected to work by raising the cost of credit, thus dampening the demand for credit much as raising interest rates would.

The Fed, in part, rejected using monetary policy for financial stability on the grounds that monetary policy was too blunt an instrument. The countercyclical capital requirements also appear to be an equally blunt policy instrument. However, given that the countercyclical capital requirements only affect regulated financial institutions, they will provide an incentive for the emergence of yet another shadow banking system. There will be additional incentive for market participants to devise and promote institutions and practices that lie just outside the regulatory boundary. Regulated firms will have an increased incentive to practice arbitrage. It can be argued that the BIS proposal is simultaneously too blunt and not blunt enough.

During the final debate over FinReg, the Administration countered the charge that the law should have imposed capital requirements with the argument that capital requirements were best left to the BIS. The BIS countercyclical capital proposal does not specify the levels for the buffer requirement. Furthermore, it leaves discretion over when and how to apply the buffer requirement to the national authorities.

A cynic might say that the authorities have found out how to kick the can around in a circle even as they are taking it furter down the road. However, the awkward compromises and omissions in the Dodd-Frank FinReg law suggest that having Congress setting capital requirements may not be such a good idea. Furthermore, the level and structure of future capital requirements will continue to be the subject of much debate..."

References

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