How to Reduce the Procyclicality of the Financial System?

After such a long list of reasons why excessive procyclicality can be harmful, it seems natural to focus on what to do about it.

The first important point to realize is that procyclicality cannot be eliminated but only mitigated. This is true for the behavior of the financial system as a whole but also for regulatory tools.

After limiting our expectations to what is achievable, it seems important to evaluate which is the most effective way to do it. One first question is whether measures taken should be rule based or discretionary. The second relates to which regulatory tool is better placed to mitigate procyclicality: provisioning or capital. We shall develop both questions in the next sections.

2.1 Rules versus Discretion ²

Two key choices need to be made in designing the details of a countercyclical regime. The first is how the level of buffers is determined; the second is how the impact is presented. The level of buffer can be defined in either a discretionary or a formula-driven fashion.

Under a discretionary system, the bank regulator will need to judge the appropriate level of required capital ratios in the light of analysis of the macroeconomic cycle and of macroprudential concerns. The discretionary system would have the advantage of allowing a nuanced analysis of macroeconomic and macroprudential conditions to guide decisions: but it would depend crucially on the quality and independence of the judgment made.

Under a formula-driven system, the required level of capital would vary according to some predetermined metric such as the growth of the balance sheet or estimates of lending over the cycle. It would provide a preset discipline not dependent on judgment and not subject to the influence of lobbying, but depending crucially on the possibility of calibrating the business cycle ex ante, an issue to which we will return below. A rules-based system is superior to a discretionary mechanism in situations where the policy maker faces a problem of lack of credibility of its commitment³. In dealing with procyclicality this may result from the expectation of widespread forbearance towards banking problems in the downturn. From this point of view, a rules-based system would be superior.

2.2 Capital versus Provisioning

While broad agreement exists on the procyclicality of the financial system much less is known as to how to reduce such procyclicality. According to one extreme view, booms and busts cannot be prevented; the opposite view is that they can be fully mitigated, while the truth is probably somewhere in between.

The key question is how to have an impact on the financial system without creating unwarranted distortions. In fact, it seems very difficult to persuade bank managers to follow more prudent credit policies during an economic upturn, especially in a highly competitive environment. Even conservative managers might find market pressure for higher profits very difficult to overcome.

Given the importance and the difficulty of the matter, it seems quite obvious that one policy cannot possibly achieve that goal. In fact, financial regulation is only one of the many tools that policy makers can use to mitigate procyclicality. Monetary policy is another obvious candidate, which will not be explored in this article⁴.

For regulations that address procyclicality, there is heightened discussion as to which instrument (provisioning or capital) should be used to mitigate it. As a starting point, it is important to note that provisioning and capital have two different objectives: the former aims at covering expected losses while the latter intends to cover unexpected losses. .

If we consider that excessive growth in credit is the best known early indicator of a banking crisis (or of a default in the micro sphere), one would tend to think that it would generate an expected loss that banks should try to cover once credit grows too fast. In other words, using provisioning as a tool to counteract procyclicality would look more natural.

On the other hand, provisions accumulated during the boom can be used to distribute higher profits in the bust, which is something the regulator may not be inclined to facilitate, whereas capital (or reserves) is not subject to this problem.

In any event, considering that the degree of procyclicality of the financial system is enormous and the difficulty in mitigating it by macroprudential tools according to the Spanish experience (see Section 3.1 below), one should probably think of capital and provisioning measures as complementary.

While provisioning measures are more developed (at least for the case of Spain and only recently by Colombia and Peru), measures to avoid procyclicality in banks' capital requirements are really embryonic or only proxies.

Of the embryonic proposals, a widely discussed one is to modify the current calculation of required capital by introducing a multiplying parameter based on macroprudential criteria (see details in Brunnermeier et al. [2009]).

The Financial Stability Forum (FSF, renamed Financial Stability Board, FSB, after the G-20 summit in April 2009) is focusing on the quality of capital and, therefore, on the composition between core capital, tier 1 capital, and tier 2 capital reserves. It also suggests that in the future less reliance would be placed on VaR measures and more on stress test techniques as determinants of capital adequacy. Finally, the FSB recommends that the monitoring and adjustment of the cyclicality of Basel II should be a continuous task, but does not elaborate on a specific proposal.

With regard to other instruments to reduce procyclicality from the capital side, several possibilities exist. One is introducing limits on leverage, also supported by the FSB among others. Another is setting a capital charge on off-balance sheet credit. This is, again, the case of Spain. In fact, several years ago, when Spanish banks asked for permission to set up Structured Investment Vehicles (SIVs), the Bank of Spain imposed an 8% capital charge against assets in an SIV, since it was considered that banks retained a significant exposure to them, which effectively made these vehicles unattractive to Spanish banks.

Moving to the subject of provisions measures, experiences of their use are few but they do exist. Spain, where dynamic provisioning introduced was in 2000, has the longest experience, followed distantly by Colombia (2007) and Peru (2008). The next section reviews the three experiences and compares them.

In addition to existing experiences, the FSB has been supporting the introduction of dynamic provisioning in several ways. The first was trying to overcome the opposition of accountants to such a measure. In fact, the FSB has recommended international accounting bodies (International Accounting Standards Board [IASB], and Financial Accounting Standards Board [FASB]) to reconsider the incurred loss model, which is seen as the main obstacle against a general adoption of dynamic provisions regulations, and consider the adoption of an “expected loss model”, which would admit dynamic provisioning. In this regard, one of the implications of the financial crisis has been to “shift the balance” between strict application of fair value accounting and pragmatic acknowledgment of expected losses more in favor of the latter. The international consensus seems to be moving towards a generalized adoption of some form of dynamic provisions. More specific proposals concerning provisions are (i) consider the allocation of general provisions in banks' regulatory capital, (ii) reconsider Basel II thresholds for reserves (1.25% in the standard approach and 0.6% in the internal ratings based [IRB] approach) that imply a disincentive for improved provisioning, and (iii) enhance the transparency of provisions in Pillar 3.

To sum up, recent debates in international forums seem to support the adoption of anti-cyclical mechanisms concerning both provisions and capital. While this approach is sensible, taking into account the different nature of expected and realized losses as well as the magnitude of the pro-cyclical forces that need to be counteracted, it is important to ensure the compatibility and coherence of all these measures, especially taking into account that other, related tools are also under discussion: such as leverage ratios, liquidity ratios, and limits to loan to value (LTV) ratios on mortgages. The risk of a series of related regulations having a distorting impact on incentives and resources allocation, thus requiring additional regulations, should be avoided.

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