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The Procyclicality Effects of Bank CapitalRegulation
by Rafael Repullo and Javier Suarez
Discussant: Haibin Zhu
Bank of Japan 2009 International Conference,Tykyo, 27 May, 2009
*The views do not necessarily reflect those of the BIS.

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Summary of the paperz A simple model with deep insights on the procyclicality

issue related to capital regulation– Two-stage, dynamic equilibrium model– Key assumptions:• Uncertainties in loan quality• Frictions in capital-raising by banks• Losses related to capital shortages– Problem to be solved: banks’ optimal capital holding• Time variation of bank capital / capital buffers• Credit rationing– Policy options to mitigate procyclicality

Restrictedz Important contributions to the literature– Minimum capital requirement ≠ actual capital holding• Previous studies (a long list, omitted here) have focusedon the procyclicality in regulatory capital under Basel II• Capital buffer decision is crucial– Procyclicality ≠ cyclical movements in bank credit• Procyclicality is a relative term Æ excessive relative to abenchmark (Basel I, no capital requirement)

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Procyclicality related to capital regulationz Necessary conditions– Capital requirements affect banks’ lending capacity– Borrowers have no alternative funding sourcez In the ongoing international financial and economic crisis– Deleveraging of banks under the pressure of capital
shortage– Funding sources from the capital market (wholesalefunding, debt market, REIT) are equally vulnerable– Greenlaw, Hatzius, Kashyap and Shin (2008): the real
impact of the deleveraging process

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Writedowns & losses Capital raised
70060050040030020010002007.2H 2008.1H 2008.2H

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Recent initiatives in addressing procyclicality
issues in the financial systemz Various proposals: G20, FSF (now FSB), BCBS, Geneva

reportz Policy recommendations on bank capital to mitigate

procyclicality– Option 1: adjustment in capital buffers or adoption ofcomplementary measures• Examples: capital insurance (Kashyap et al, 2008);
leverage requirements (US, Switzerland); dynamicprovisions (Spain)• Inconsistent with the objective of Basel II: to alignregulatory capital with economic capital

Restricted– Option 2: to smooth the input parameters, e.g. use throughthe-cycle risk parameters• Risk measurement: the time variation in underlying risk
• TTC risk parameters are not appropriate for short-termloans• BCBS: to maintain the risk sensitivity of the inputs andfocus on dampening the outputs

Restricted– Option 3: to smooth the outputs• Gordy and Howells (2006): counter-cyclical indexing rule
• This paper: counter-cyclical target default rates• Similar idea: BCBS, FSB, Geneva report, etc• Challenge #1 (objective): what is the optimal tradeoff
between safety and efficiency?
• Challenge #2 (implementation)– The choice of conditional variables– The functional form linking conditional variables andthe minimum capital requirement

Restricted– Illustrative examples• Gordy (2009): BBB corporate bond spreads +symmetric adjustment for small deviations• Goodhart and Persaud (2008): credit growth + one-sideadjustment• Borio and Drehmann (2009): combination of
imbalances in credit and house prices + symmetricadjustment for large deviations• It is not an easy task to develop a robust rule

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Functional form 1

Functional form 2

Functional form 3

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Factor

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Suggestion for extensionsz The simplified model is very helpful for illustrative purpose,but at the cost of practical relevance, particularly thequantitative relevance– Sensitivity analysis will be helpfulz What remains to be addressed (some listed in Section 7)– Loan demand is artificially given– Portfolio composition and risk profile are abstracted– No feedback effect from the banking sector to the real
economy– Borio and Zhu (2008): the capital framework effect ofBasel II (improvement in risk measurement and pricing)