Miguel Fernández Ordóñez: Procyclicality in the banking activity
Speech by Mr Miguel Fernández Ordóñez, Governor of the Bank of Spain, at the Conference
on Procyclicality and the Role of Financial Regulation, organised by the Bank of Spain and
the Financial Stability Institute, Madrid, 4 May 2009.
* * *
Good morning ladies and gentlemen. First of all I would like to welcome you to the Bank of
Spain. Also, let me thank you all for your presence here today to discuss on one of the most
difficult and relevant topics affecting financial regulation: procyclicality in banking activity.
Let me also thank the BIS Financial Stability Institute, and in particular its Chairman,
Mr. Josef Tošovský, for all the support and good advice received during these last few weeks
during the preparation of this event that we have co-organized.
We are very pleased to have as speakers in this conference a large group of excellent
professionals who are directly involved in financial supervision and regulation. A high level
meeting like this one is a major opportunity to start building up a common and efficient
framework in order to face the procyclicality issue.
Cyclicality can be considered an inherent part of economic activity. Banking activity is no
exception; it is also affected by the upswings and downturns of the real sector cycles. Not
only history proves this, but current events do also. Any doubt about this has been violently
resolved after the summer of 2007. But even if we accept that little can be done to avoid
economic cycles, this should not be an excuse for us, central bankers and supervisors. Our
responsibility is to develop macro-prudential approaches and the appropriate regulatory
measures to help banks reduce the impact of future economic cycles and diminish their
procyclical behaviour. This should be achieved for the sake of financial stability with the
minimum economic and social costs, which is the main objective of supervisory authorities
In fact, banking behaviour can be not only cyclical but procyclical, that is, it can exacerbate
the cyclical behaviour of the real economy. As it has been said many times, there is nothing
more procyclical than a badly managed bank. In good times it incurs in more risks than it
reasonably should through, for example, excessive lending with poor standards. In bad times
it changes its lending policies reducing drastically the loans to the economy and exacerbating
the downturn.
There are several causes that explain this procyclical behaviour but I will focus on the one
that affects us most and towards which all of our work should be devoted: banking regulation
and supervision.
Basel II was seen as a major step towards a better alignment between credit risk incurred by
banks and regulatory minimum capital requirements. This link between risk and capital has
forced supervisors to better understand the main drivers behind credit risk and the
idiosyncrasy of banks' credit models, their risk pricing and general portfolio management.
Basel II, in this way, has motivated supervisors to analyse more deeply all that surrounds
banks' main business with the benefit of a clearer understanding of the underpinnings of
banks' risks.
Needless to say, the introduction of a risk sensitive capital framework is based on the idea
that, as credit conditions deteriorate, minimum requirements must increase and
consequently, more cyclicality is added into the system. Particularly, under the internal
ratings based approach (IRB), capital requirements are an increasing function of the main
credit risk drivers, probability of default (PD), loss given default (LGD), and exposure at
default (EAD), obtained for each loan. The problem is that this formulation may have
distorting consequences in the evolution of regulatory requirements along the economic
cycle. That is, in downturn conditions these risk parameters would deteriorate, leading to
greater capital requirements, whereas in upswings these risk indicators would improve,
resulting in lower regulatory needs.
Nevertheless, the new Basel II Framework itself offers specific guidance that may soften the
cyclical fluctuations in capital requirements. The calculation of risk parameters consisting on
long run averages and the inclusion of a downturn bias in certain estimates would provide
more stable parameters and requirements without abandoning the advantages of a risk
sensitive scheme across different banks. This approach has been the one mostly
implemented in Spanish IRB banks.
This is the guidance Basel II itself offers to mitigate procyclicality but one might think that it is
insufficient. In this case, one of the many additional possibilities currently under discussion to
reduce the potential undesirable effects of Basel II is to scale the capital requirements
obtained through the IRB function by using a countercyclical multiplier.
In order to make this multiplier countercyclical, it would be built as a function of a reliable
economic activity variable (for instance GDP growth rate). As it happens with other
alternatives, its main pros and cons should be carefully assessed. The multiplier is easy to
obtain, transparent (as depends on a reliable macro variable), it has a low implementation
cost and, finally, it would be of a uniform and wide applicability. Among its drawbacks we
found that, first, it implies undertaking an external modification on the capital requirement
figure and, second, that the multiplier is built using a domestic variable, which may make
international comparison very difficult.
No matter what the result of the previous debate is, either the use of counter-cyclical risk
estimations or the use of a capital multiplier, we should explore the use of complementary
measures to attain our final goal of financial stability and to minimise the social costs of
procyclicality; for example, dynamic provisions.
As most of you already know, this type of provision uses historical information on credit
losses to estimate a general provision for homogenous loan portfolios. It reflects a collective
assessment of credit losses at the balance sheet date (i.e. it covers incurred losses not yet
identified in specific individual loans). This provision builds up a buffer during the benign part
of the cycle, which starts to be released when recession comes knocking on banks' doors.
Counter-cyclicality is intrinsic to dynamic provisions and part of its usefulness can be seen in
the resilience shown so far by Spanish banks in the current crisis. Furthermore, its direct
impact on the profit and loss account (reflecting losses at a time when these losses are really
being built up in balance sheets) constitutes a way to make banks more aware of how credit
must be priced, reducing the underestimation of loans risk premia and, to some extent,
compensating the relaxation of credit granting standards in good times. It also delivers the
right information to investors about the financial position of the bank. In all, dynamic
provisioning allows a proper recognition of credit risk.
I must also admit that there are voices raised by some institutions that do not agree with this
view, and particularly, accounting standard setters. In this respect, we should call for further
dialogue between accounting rule setters and supervisors as well as a clarification regarding
roles and objectives of each of them. I really think that our objectives are compatible and that
delivering the relevant information to investors should not be an impediment for supervisors
to ensure the stability of the banking sector by promoting the most adequate measures that
experience and results have proved to be useful.
Very much in line with dynamic provisions, the buildup of capital buffers also deserves room
in our discussions. These buffers, created in periods of good economic conditions and
necessarily associated with the adequate mechanisms to draw them down during
recessions, may come in the form of non-distributable reserves to compensate
economiccycle losses. Nevertheless, the possible advantages and disadvantages of such a measure
should be accurately calculated and appropriately compared to those coming from other
tools that act in the same way but affect the profit and loss account.
We should not forget the interconnection that exists between valuation, leverage and
procyclicality and how these issues should be properly managed under a macro-prudential
perspective. The introduction of supplementary floors to capital requirements under a
risksensitive approach, could be a safety net,. Setting limits on the build-up of leverage in
periods of rapid credit growth can be seen as a way of strengthening the incentives for
correct risk pricing of institutions, as well as a deterrent of excessive risk-taking.
Furthermore, the development of valuation reserves should also be under our consideration
as a way to mitigate the cyclicality inherent in risky and illiquid securities.
Improvement of general stress test practices and their wide implementation, particularly
during the most favorable part of the economic cycle, should also be included in our toolbox
approach to fight against procyclicality. Solid stress test frameworks will allow assessing the
adequacy of buffers, both in their construction and in their applicability over the cycle.
Finally, remuneration schemes may be another tool for dampening the undesired cyclical
fluctuations of banking activity. The assessment of different alternatives for appropriate
remuneration schemes, on the basis of correct incentives and horizons, constitutes the right
starting point from which to explore how excesses or bad alignments may have contributed
to accelerate or amplify disorders within the financial system.
As you have seen, we are not lacking ideas on how to reduce procyclicality. Rather, our main
problem is to select what are the best tools to include in our toolbox. In this sense, I am sure
that your contributions in this seminar will be extremely useful for this purpose.
Now, let me give the floor to Mr. Josef Tošovský, with whom I have the honor to chair this
opening session and to whom I personally thank his presence in this conference.