COMMISSION STAFF WORKING DOCUMENT Accompanying the document REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL on Effects of Regulation (EU) 575/2013 and Directive 2013/36/EU on the Economic Cycle
Date: 2018-04-09
Institutions: Directorate-General for Financial Stability, Financial Services and Capital Markets Union, European Commission
Subjects: bank, credit institution, credit policy, economic analysis, economic cycle, financial requirements, financial risk, financial stability, financial supervision

EN 

  EN 

   EUROPEAN COMMISSION  Brussels, 9.4.2018 SWD(2018) 89 final  COMMISSION STAFF WORKING DOCUMENT Accompanying the document REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL on Effects of Regulation (EU) 575/2013 and Directive 2013/36/EU on the Economic Cycle {COM(2018) 172 final}  
 
 
TABLE OF CONTENTS 

1. Introduction.................................................................................................................. 2 

2. Background……………………………………............................................................2 

3. Methodology............................................ .................................. ..................................5 

4. Assessing the cyclicality of regulatory capital requirements....................................... 7 

5. Measures to address procyclicality ............................................................................. 14 

6. Conclusion……………………………………............................................................ 17 

1 

 
 
 
 
 
 
 
 
 
 
 
1. 

INTRODUCTION 

Article  502  of  Regulation  (EU)  575/2013  of  the  European  Parliament  and  of  the 
Council1requires  the  Commission  to  examine  periodically  whether  risk-sensitive  regulatory 
requirements, as established in that Regulation and in Directive 2013/36/EU of the European 
Parliament  and  of  the  Council2,  create  unintended  procyclical  effects  by  reinforcing  the 
endogenous  relationship  between  the  financial  system  and  the  real  economy  and  thereby 
amplifying  the  real  economic  cycle.  The  Commission  is  required  to  submit  a  proposal  for 
appropriate  corrective  measures,  should  such  procyclical  effects  be  found  The  Commission 
report is the first one under Regulation (EU) 575/2013 and follows earlier and similar reports 
on procyclicality of capital ratio requirements published in 2010 and 2012.3 The Commission 
reports  of  2010  and  2012  emphasised  that  while  there  was  only  limited  evidence  of  a 
procyclical  impact  of  capital  ratio  requirements  on  the  wider  economy,  it  was  important  to 
have counter-cyclical measures in the prudential framework.  

This Staff Working Document accompanies the third Commission report under Article 502 of 
Regulation  (EU)  575/2013  and  presents  more  detailed  evidence  on  whether  capital  ratio 
requirements are procyclical and if so, whether they have an impact on the level of capital that 
banks  actually  hold  or  desire  to  hold.  This  Staff  Document  also  gives  an  overview  of 
measures  to  mitigate procyclicality of capital ratio  requirements which are embedded  in  the 
prevailing regulatory framework. The analysis draws upon a dedicated report by the European 
Banking  Authority  (EBA),  which  encompasses  contributions  from  the  European  Systemic 
Risk  Board  (ESRB),  the  European  Central  Bank  (ECB)  and  authorities  from  EU  Member 
States.4 It further builds on a broader examination of the literature.  

2. 

BACKGROUND 

There  is  broad  consensus  among  regulators  and  academics  that  the  financial  system  is 
inherently unstable and subject to risks which can have severe negative consequences for the 
real  economy  once  they  materialise.  This  is  borne  out  also  by  historical  experience.  The 
global financial crisis, which broke out a decade ago, provided a stark reminder. To counter 
that  financial  instability,  financial  regulation  and  macroprudential  policy  aim  at  limiting 
systemic risk. 

A  key  lesson  of  the  crisis  was  that  in  several  cases  banking  sectors  were  undercapitalised. 
Even  before  the  crisis,  a  risk-sensitive  framework  for  regulatory  capital  had  started  to  be 
introduced  to  ensure  suitable  capital  buffers  would  be  in  place.  With  the  lessons  from  the 
crisis  in  mind,  imposing  sufficiently  high  capital  buffers,  especially  for  banks,  is  generally 
seen  to  increase  banks'  resilience,  which  may  in  turn  reduce  the  probability  of  systemic 

1  

2  

3  
4  

Regulation  (EU)  No 575/2013  of  the  European  Parliament  and  of  the  Council  of  26 June  2013  on 
prudential  requirements  for  credit  institutions  and  investment  firms  and  amending  Regulation  (EU) 
No 648/2012 (OJ L 176, 27.6.2013, p. 1). 
Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the 
activity of credit institutions and the prudential supervision of credit institutions and investment firms, 
amending  Directive  2002/87/EC  and  repealing  Directives  2006/48/EC  and  2006/49/EC  (OJ  L 176, 
27.6.2013, p. 338). 
SEC(2010)754, COM (2012) 400. 
EBA  Report  under  Article  502  CRR, 
https://www.eba.europa.eu/documents/10180/1701905/Report+on+the+Cyclicality+of+Capital+Requir
ements+%28EBA-Op-2016-24%29.pdf   

issued  on  22  December  2016  (EBA-Op-2016-24): 

2 

 
 
                                                 
financial crises and their cost if they do occur.5 On the other hand, higher buffers could entail 
short-term costs in terms of limitations to credit growth to households and firms and possibly 
act  as  a  brake  on  economic  growth.  On  balance,  there  are  long-term  benefits  of  moving 
towards higher capital ratio levels. It would reduce the likelihood of asset fire-sales by banks 
in  periods  of  stress  with  negative  consequences  for  the  wider  economy.  Sufficiently  high 
capital ratio levels thus should promote more stable and durable growth.6 But an unintended 
procyclical bias stemming from capital ratio requirements would be a key externality of the 
financial system which can cause financial stability risks and would therefore be of concern to 
regulators.7. 

Procyclicality  of  capital  ratio  requirements  implies  that  capital  ratio  requirements  become 
looser in an upturn and tighter in a downturn, causing the amplification of fluctuations in the 
economic cycle by the activities of the banking system. The degree of cyclical amplification 
depends on the way in which banks respond to changes in required capital ratios as well as on 
the relative strength of the transmission channels. A procyclical impact could be particularly 
pronounced  if  capital  ratio  requirements  are  at  very  low  levels,  which  potentially  implies 
sharp changes in balance sheet size when losses or gains materialise.8   

A  number  of  explanatory  factors  have  been  brought  forward  to  account  for  the  inherent 
procyclicality  of  financial  regulation.  These  include  information  asymmetries  between 
borrowers and lenders, difficulties in measuring risks over the cycle, the nature of incentives 
for financial sector agents, divergences in the maturity structure of assets and liabilities, and 
the highly interconnected nature of the financial sector, which can exacerbate the transmission 
of shocks. The specific role of risk-weighted bank capital ratio requirements makes them the 
most  likely  identifiable  source  of  procyclicality.  As  credit  and  market  risk  increase  in  a 
downturn,  minimum  capital  ratio  requirements  for  banks  will  also  increase  to  meet  those 
higher  risks  as  the  risk  weight  associated  with  each  loan  is  related  negatively  to  the 
borrower’s  credit  quality.  Banks  may  need  to  raise  additional  capital  to  meet  these  higher 
requirements  at  a  time  when  their  capital  resources  are  being  eroded  by  losses.  In  such 

5  

6  

7  

8  

Basel Committee on Banking Supervision (BCBS), (2010), "Basel III: A global regulatory framework 
for more resilient banks and banking systems".  
See  Admati,  A.  (2016),  "The  Missed  Opportunity  and  Challenge  of  Capital  Regulation",  National 
Institute Economic Review, Vol 235, Issue 1, 2016, which points out that not all types of risky lending 
are equally valuable, implying that near-term reduced lending may be partly beneficial. However, see 
Perotti,  E.,  L.  Ratnovski  and  R.  Vlahu  (2011),  "Capital  Regulation  and  Tail  Risk",  International 
Journal  of  Central Banking,  Vol. 7  No. 4,  December  2011,  who,  on  theoretical  considerations,  argue 
that higher capital buffers may in fact encourage risk taking as banks 'lever up' their capital by taking on 
more risk. On the other hand, Begenau, J. (2016), "Capital Requirements, Risk Choice, and Liquidity 
Provision in a Business Cycle Model", Harvard Business School Finance Working Paper No. 15-072, 
argues  that  under  certain  conditions,  depending  on  the  nature  and  size  of  frictions,  higher  capital 
requirements can lead to more lending in the long run. 
This  has  long  been  recognised  in  the  literature.  See,  for  instance,  Adrian,  T.  and  H.  Shin,  (2010), 
"Liquidity and Leverage", Journal of Financial Intermediation, Vol. 19 Issue 3, July 2010; Altman, E., 
and  A.  Saunders,  (2001),  "An  analysis  and  critique  of  the  BIS  proposal  on  capital  adequacy  and 
ratings",  Journal  of  Banking and Finance, 25  (1); Basel  Committee  on Banking Supervision  (BCBS), 
(2010),  "Basel  III:  A  global  regulatory  framework  for  more  resilient  banks  and  banking  systems"; 
Gordy, M. and B. Howells, (2006), "Procyclicality in Basel II: can we treat the disease without killing 
the  patient?", Journal  of  Financial  Intermediation, Vol.  15; Repullo,  R.,  J.  Saurina  and  C.  Trucharte, 
(2010), "Mitigating the pro-cyclicality of Basel II", Economic Policy, 25 (64). 
Therefore, higher capital ratio levels imply a lower potential impact on balance sheet size when losses 
or  gains  materialise,  which  in  turn  would  limit  the  procyclical  impact.  In  December  2017,  the  Basel 
Committee reached an agreement on floors for capital requirements which has implications for banks 
who use internal ratings based approaches as regards capital requirements for certain exposures, such as 
residential real estate. 

3 

 
 
                                                 
circumstances,  opportunities  for  raising  capital  could  become  scarce  and  costly.9  This  may 
constrain banks' lending capacity to the economy, amplifying the downturn. Similarly, during 
an  economic  upturn  when  defaults  decrease,  the  reduction  in  risk  will  reduce  capital  ratio 
requirements  and  might  thus  lead  to  increased  lending,  boosting  the  economy  further.  This 
intrinsic  procyclicality  should  be  distinguished  from  the  cyclicality  of  capital  ratio 
requirements stemming from the economic cycle.10  

The systemic dimension is of particular concern to regulators. Systemic risk can, arise if there 
are correlated behaviours which compel banks to simultaneously sell similar assets in a crisis, 
leading to an asset-price crash (endogenous risk). These mutually reinforcing interactions tend 
to amplify business cycle fluctuations and can cause or exacerbate financial instability. In this 
respect,  the  diversity  of  business  models  across  the  banking  sector  may  mitigate  such  self-
reinforcing interactions.  
In adjusting to increased capital ratio requirements, banks have a number of options.11 First, 
they  can  raise  equity  which  potentially  has  the  least  procyclical  impact.  Second,  they  can 
retain  earnings,  implying  lower  profits  or  cost  reductions,  and  reduce  dividend  payments. 
Depending  on  the  degree  of  profitability  and  the  stage  of  the  cycle,  this  might  have  a 
relatively benign impact on lending but might imply higher lending spreads. Third, they can 
adjust assets with an impact on lending, for instance as loan portfolios are run down. Fourth, 
they can reduce risk-weighted assets via some combination of shedding riskier loans in favour 
of safer ones or by resorting more to internal models to calculate risk weights. In a period of 
systemic  stress  a  negative  effect  on  the  wider  economy  is  more  likely.  In  such  a  situation, 
banks may have difficulty raising capital and/or may be reluctant to reduce dividend payments 
to avoid stigmatisation from investors. They may therefore opt to deleverage in order to avoid 
breaching capital requirements. 

The  prevailing  framework  for  bank  regulation  which  determines  the  response  of  financial 
institutions  reflects  international  agreements.  In  the  Union,  Regulation  (EU)  575/2013  and 
Directive  2013/36/EUCRD  govern  the  implementation  of  the  so-called  Basel  framework,  a 
comprehensive set of measures developed by the Basel Committee on Banking Supervision, 
to  strengthen  the  regulation,  supervision  and  risk  management  of  the  banking  sector.  The 
Basel III framework is the most recent version of the rules and is still in the process of being 
fully  implemented.  It  maintains  the  risk-based  approach  to  capital  ratio  requirements 
developed in the preceding Basel II framework. Compared to the first vintages of capital rules 
(Basel  I),  the  Basel  II  rules  had  established  a  closer  alignment  of  the  calculation  of  banks' 
risk-weighted  assets  with  actual  risk.  Riskier  assets  should  therefore  be  backed  by  higher 
capital  allowances.  In  recognition  of  the  fact  that  the  risk-sensitive  framework  can  be  a 
potential  source  of  procyclicality,  there  are  provisions  in  Regulation  (EU)  575/2013  and 

9  

10  

11  

Gambacorta,  L.  and  H.  Shin,  (2016),  "Why  bank  capital  matters  for  monetary  policy",  Journal  of 
Financial  Intermediation,  in  press  2016,  show  that  bank  equity  tends  to  be  kept  stable  over  time  as 
banks leverage up and down over the cycle mainly via adjusting debt issuance and/or the distribution of 
retained earnings. On the sources of funding of credit institutions, see EBA (2017), Report on funding 
(https://www.eba.europa.eu/documents/10180/1720738/Report+on+Funding+Plans+-
plans 
+July+2017.pdf) 
report 
(http://www.bis.org/bcbs/publ/d416.pdf).  
The  Study on the  Impact  of the  Capital  Requirements  Regulation  (CRR)  on  the  access  to  finance for 
business  and  long-term  investments,  prepared  by  LE  Europe  for  the  European  Commission  in  May 
2016,  addresses 
the  economy: 
the 
https://ec.europa.eu/info/publications/160505-crr-study_en  
Cohen, B., and M. Scatigna, (2016), "Banks and capital requirements: Channels of adjustment", Journal 
of Banking and Finance, Vol 69, 2016. 

the  broader  question  of 

regulation  on 

impact  of 

monitoring 

(2017), 

BCBS 

Basel 

and 

III 

4 

 
 
                                                 
Directive  2013/36/EU,  consistent  with  the  Basel  framework,  which  aim  at  mitigating  these 
feedback loops. Several capital buffers have been introduced under this framework to ensure 
that  banks  build  up  capital  buffers  outside  periods  of  stress  which  can  be  drawn  down  as 
losses  are  incurred.  These  include  the  Capital  Conservation  Buffer  and  the  Countercyclical 
Capital  Buffer,  which  explicitly  aim  at  increasing  the  resilience  of  the  financial  system 
without altering its risk-based nature. 

3. 

METHODOLOGY 

The pattern of a time series related to capital ratio requirements is considered to be cyclical if 
it  fluctuates  inversely  with  aggregate  real  economic  activity  (the  business  cycle).  Typically, 
the  correlation  sign  will  be  negative  in  that  risk  parameter  levels  and  capital  ratio 
requirements  go  down  in  an  upturn  and  move  up  in  a  downturn.  Procyclicality  will  be 
understood  as  the  existence  of  evidence  on  amplifying  effects  on  changes  in  capital  ratio 
requirements  from  feedback  loops  between  the  real  economy  and  the  financial  system,  in 
particular  if  they  are  driven  by  internal  risk  measurement  approaches  differentiated  by  risk 
category, exposure classes and types of institution. 

The  question  of  procyclicality  of  capital  ratio  requirements  is  in  first  instance  an  empirical 
one. Recent literature surveys find limited and rather inconclusive evidence on the long-run 
impact of changes in capital ratio requirements on the level or growth rate of bank lending, 
even though negative near-term impacts are documented.12 To shed further light on the issue, 
the  EBA  report  examines  evidence  for  the  Union  with  a  narrower  focus  on  the  procyclical 
impact  of  recent  regulation  on  capital  ratio  requirements  for  banks.  To  that  end,  the  EBA 
report uses information available from public sources as well as dedicated bank-specific data 
collected from National Competent Authorities  

The categorisation of financial institutions is relevant to the extent that there are differences 
across types of banks with respect to which regulation may induce procyclicality. In the Basel 
II framework minimum capital ratio requirements are more risk-sensitive and tend to be more 
cyclical  than  under  Basel  I.  This  is  the  result  of  the  higher  risk  sensitivity  of  the  current 
framework, in particular as regards the calculation of capital ratio requirements using internal 
models  under  internal  ratings  based  (IRB)  approaches.  This  basic  characteristic  has  been 
retained in the  Basel III framework, implemented in  EU law via Regulation (EU) 575/2013 
and Directive 2013/36/EU. Depending on the range of model parameters estimated,  one can 
distinguish between so-called foundation IRB and advanced IRB approaches. The foundation 
IRB approach uses internal models to assess the probability of default of certain exposures. In 
the most elaborate versions of internal models used (advanced IRB approach), calculations of 
the  required  capital  allowances  is  done  on  the  basis  of  banks'  own  probability  of  default 
estimates as well as estimates of the exposure at default and loss given default. Banks which 
have received permission to use the internal ratings based approach may permanently apply a 
partial  use  of  the  standardised  approach  (e.g.  for  exposures  to  governments  and  central 
banks). To the extent that probability of default and loss given default are time dependent, a 
cyclical  pattern  of  risk  weights  –  and,  by  extension,  of  capital  ratio  requirements  –  is  more 
likely to be seen with banks that use an internal ratings based approach, rather than with banks 

12  

See, for instance, Martynova, N. (2015), "Effect of bank capital requirements on economic growth: a 
survey", DNB Working Paper, No. 467 / March 2015. The study by LE Europe (see footnote 8), also 
finds  no  clear  evidence  on  a  relationship  between  capital  ratios  and  bank  financing  of  infrastructure 
projects. 

5 

 
 
                                                 
which  rely  on  more  standardised  gauges  of  risk.13  Hence,  there  is  a  presumption  of  a 
procyclical  bias  especially  for  banks  which  heavily  rely  on  internal  ratings  in  terms  of  the 
effect on overall leverage and lending to non-financial sectors. 

Most of the data examined by EBA span the period 2008-2015, covering the global financial 
crisis and its aftermath. This means that, to the extent possible, one would have to disentangle 
any increases in capital ratio requirements due to the protracted downturn from increases due 
to  stricter requirements.  In  addition to aggregate statistics and survey data  – including from 
the ECB Bank Lending Survey– the EBA relies on a sample of 144 individual banks active in 
13 Union and EEA countries and representing some 95% of the Union banking sector's total 
assets.  The  broad  sample  includes  banks  with  different  scales  of  operation,  ranging  from 
international  systemic  banks  to  ones  that  are  active  only  domestically.  It  covers  banks  with 
different business models, including retail and commercial banks, universal banks, as well as 
a  number  of  banks  with  more  specialised  activities,  such  as  covered  bond  issuance  or 
investment  banking.  Around  one  quarter  of  the  banks  in  the  sample  (38  institutions)  are 
categorised  as  large  and  international  active  (so-called  Group  1  banks),  with  the  remaining 
106 categorised as small and/or only active on the domestic market (labelled Group 2 banks). 
14 Most of the banks in the broad sample use the so-called standardised approach for gauging 
credit  and  operational  risk.  Some  of  the  detailed  findings  on  risk  categories  and  the 
composition of minimum required bank capital in the EBA report are limited to banks that use 
internal ratings and that account for the bulk of bank lending in the Union and the euro area. 
In the EBA report, some more in-depth time series analyses are based on a consistent sample 
of  41  banks  from  8  Union  Member  States  (Belgium,  France,  Germany,  Ireland,  Italy, 
Luxembourg, Spain and the United Kingdom). To conclude, the statistical basis provided by 
EBA is broad with a representative coverage, albeit not fully comprehensive.  

Although the EBA data set is comparatively rich, a lack of granular data on the composition 
of  bank  balance  sheets  hinders  the  identification  of  the  various  adjustment  channels. 
Confidentiality criteria are partly the reason for this. In addition, most of the data are on larger 
banks who often undertake significant cross-border activities, while the behaviour of smaller 
institutions  might  not  be  sufficiently  captured.  The  econometric  analysis  is  subject  to  a 
number of additional caveats, such as the lack of data over a whole business or financial cycle 
and other limitations in the coverage and breakdown of the figures. Moreover, the available 
sample period does not span a full financial cycle and encompasses the recent global financial 
crisis,  where  crisis-induced  behavioural  changes  and  policy  interventions  may  well  have 
interacted  with  the  shift  to  higher  capital  ratio  requirements  implied  by  Regulation  (EU) 
575/2013  and  Directive  2013/36/EU.  This  may  have  distorted  bank  behaviour.  There  is  no 
simple solution to the problem of time coverage as the cyclicality of regulatory capital ratio 
requirements in Regulation (EU) 575/2013 and Directive 2013/36/EU is the core concern of 
this report, so it is no option to only focus on the period before the global crisis. 

It is a challenging task to disentangle the exogenous effects on banks’ lending decisions from 
those that may arise due to the risk-sensitive capital ratio requirements. This goes in particular 
for  identifying  the  impact  of  changes  in  bank  capital  on  lending  and  the  economy  as  bank 
capital  itself  tends  to  respond  to  changes  in  bank  lending  and  in  the  macroeconomic 
environment.  Hence,  a  large  part  of  the  variation  in  bank  capital  is  likely  to  result  from 
disturbances to macroeconomic variables (such as economic activity or interest rates) as well 

13  

14 

Cyclical patterns may also arise under the standardised approach. See, for instance, Danielson, J. et al., 
(2001), "An Academic Response to Basel II", LSE Financial Markets Group, Special Paper No. 130. 
A bank is considered a Group 1 bank if its Tier 1 capital is above €3 billion and it is well diversified 
and internationally active. All other banks are classified as Group 2 banks. 

6 

 
 
                                                 
as  from  changes  in  regulation.15  It  follows  that  there  are  caveats  when  analysing  the 
relationship between regulatory capital ratio requirements and the possible procyclical lending 
of  banks.  First,  several  of  the  feedback  loops  between  the  real  and  financial  spheres  of  the 
economy  can  operate  without  a  major  contribution  from  the  banking  sector,  for  instance  as 
regards shocks to creditworthiness of agents in non-financial sectors. Second, changes in loan 
demand could well be unrelated to capital ratio requirements, as could determinants of bank's 
decisions to supply loans. The bank balance sheet channel need not be linear with respect to 
capital  ratio  requirements  to  the  extent  that  desired  capital  buffers  above  the  regulatory 
minimum (which has a bearing on the provision of credit) may well be determined by a host 
of  non-regulatory  drivers.  Also,  the  size  of  voluntary  buffers  will  have  a  bearing  on  how 
directly capital limits steer bank behaviour. Although there is some evidence that banks target 
a  certain  additional  buffer, they could  use  any  extra  capital  over the required  level  to  cover 
any changes to the minimally required thresholds. 

In  order  to  address  such  caveats,  the  analysis  in  the  EBA  report  is  structured  along  various 
complementary dimensions. It first presents an overview of the cyclical properties of overall 
capital  ratios  and  requirements.  It  then  continues  with  micro-level  evidence  to  examine 
whether bank's capital ratio requirements mirror the development of the overall business cycle 
and  further  examines  whether  capital  ratio  requirements  contribute  to  the  amplification  of 
business cycles. Similar approaches can be found in other studies pertinent to the subject. 

4. 

ASSESSING THE CYCLICALITY OF REGULATORY CAPITAL RATIO REQUIREMENTS 

Overall  capital  adequacy  ratio  levels  of  Union  banks  have  continuously  increased  since  the 
onset of the global financial crisis. The increase accelerated since 2014 with the application of 
the  capital  ratio  requirements  laid  down  in  Regulation  (EU)  575/2013  and  Directive 
2013/36/EU. The significant increase in capital has been driven primarily by a rise in banks' 
Common Equity Tier 1 capital ratio requirements.  Capital ratios of banks  using the internal 
ratings  based  approach  were  the  lowest  on  average.  Group  2  banks  had  on  average  higher 
Common Equity Tier 1 ratios than the large international banks in Group 1. According to data 
gathered  by  the  Bank  for  International  Settlements  (BIS),  additional  capital  buffers  also 
increased, including those stemming from second pillar requirements imposed by supervisors 
on  individual  banks  in  view  of  their  risk  profile.16  The  figures  do  not  allow  for  a  fully 
consistent breakdown, mainly because in most cases the level of second pillar requirements is 
not publicly disclosed. That said, it seems that in the wake of the crisis overall capital ratio 
levels in the Union have increased faster than the required regulatory minimum ratios. This is 
in  line  with  findings  for  the  United  States  and  could  be  due  to  a  preference  of  banks  for 
additional room for manoeuvre in their capital buffers in a period of uncertainty.17  

The  increase  in  capital  ratio  levels  of  the  Union  banking  sector  appears  to  largely  reflect  a 
combination of higher minimum capital ratio requirements and a tendency to retain voluntary 
buffers  above  imposed  minimum  levels.  The  cyclicality  of  underlying  internal  rating  based 
risk  parameters,  notably  probability  of  default  and  loss  given  default,  has  not  been  a 
prominent  driver.  Somewhat  surprisingly,  these  risk  parameters  are  found  to  have  remained 
relatively  stable  over  the  sample  period  which  covers  a  major  economic  downturn  in  most 

15  

16  
17  

Kanngiesser, D. et al., (2017), "Estimating the impact of shocks to bank capital in the euro area", ECB 
WP 2077. 
BCBS, (2017), Basel III monitoring report (http://www.bis.org/bcbs/publ/d416.pdf ). 
Corbae,  D.  and  P.  D'Erasmo,  (2014),  "Capital  Requirements  in  a  Quantitative  Model  of  Banking 
Industry Dynamics", Federal Reserve Bank of Philadelphia Working Paper No. 14-13. 

7 

 
 
                                                 
Member  States.  The  EBA  report  speculates  that  the  limited  observed  procyclicality  of  the 
risk-sensitive  risk  parameters  could  be  explained  by  banks'  active  portfolio  reshuffling 
intended  to  keep  capital  ratio  requirements  stable  over  time.  The  evidence  is  discussed  in 
more detail below. 

In contrast to the rise in mandatory and overall capital buffers, total risk-weighted asset ratios 
of European banks declined from 2008 onwards, with some modest pick-up since 2014. Loan 
portfolios mirrored this trend. In particular, loans from euro area-based banks to non-financial 
corporations  decreased  in  the  aftermath  of  the  global  financial  crisis  as  weak  aggregate 
demand weighed on the demand for credit. Some pick-up was only registered towards the end 
of the sample period. The decrease in risk-weighted assets has been larger than the fall in the 
exposures as defined for the leverage ratio, suggesting some rebalancing of bank portfolios. 
The development of risk-weighted exposures was largely due to the trends in credit risk, the 
most important subcategory.  

Broken down by asset class, minimum capital ratio requirements increased the most for equity 
exposures but decreased for securitisation exposures (which only accounts for a small fraction 
of total credit risk exposure). The highest volatility in minimum required capital per exposure 
was  observed  for  particular  subcategories  of  bank  portfolios  (such  as  securitisation,  market 
risk and equity exposures), which account for only a small share of the total balance sheet and 
consequently only exert a muted impact on overall capital ratio requirements. By contrast, the 
largest  exposures  existed  with  respect  to  the  corporate and bank  portfolios,  followed  by  the 
sovereign  portfolios  for  which  minimum  required  capital  was  the  lowest.  These  categories 
exhibited more stable parameters for minimum required capital. 

The  evolution  of  risk  weights,  other  risk  parameters  (probability  of  default  and  loss  given 
default),  exposures  and  leverage  ratios  adds  perspective  to  the  observed  trends  in  bank 
portfolios between end-2008 and 2015. During that period, the average risk weight for credit 
risk  exposure  decreased  somewhat  until  2013  and  only  increased  marginally  thereafter. 
Likewise,  probability  of  default  and  loss  given  default  parameters  also  did  not  show  great 
movements. The share of defaulted exposures was highest for corporate and retail portfolios 
and was consistently lower for sovereign and bank portfolios with the probability of default 
for non-defaulted exposures following an inverse pattern. For corporate and retail portfolios, 
use of the internal ratings based approach has increased significantly for Group 1 banks, while 
it decreased for Group 2 banks. The decline in average risk weights over 2008-2013, notably 
for corporate and retail portfolios, may appear to be counterintuitive as that period covers the 
most intense phase of the global financial crisis and the euro area sovereign debt crisis. It may 
indicate a degree of stickiness of banks' risk weights under the internal ratings based approach 
over the business cycle. This suggests that any upward pressure on risk parameters exerted by 
the unfavourable general economic climate was more than compensated for by the pressure on 
banks to reduce risk exposure and to deleverage, to boost capital ratio levels, or also to reduce 
risk  weights  by  exploiting  the  set-up  of  internal  models.18  It  is  not  possible  to  disentangle 
those effects because capital ratios are endogenous, influenced by monetary policy and credit 
dynamics conditions, as well as by discretionary changes in broader economic policy. The full 
range  of  possible  interacting  factors  is  not  captured  in  most  stylised  and  model-based 

18  

For the European banking sector in the aftermath of the crisis, Kanngieser, D. et al. (2017), use a VAR 
model  which  suggest  that  banks  boosted  capital  ratios  mainly  by  reducing  their  relative  exposure  to 
riskier assets and by adjusting lending to a larger extent, rather than by increase the level of capital and 
reserves outright. On the dynamics in risks weights, total assets and the amount of capital, see also the 
BCBS (2017) Basel III monitoring report. It shows a decrease in risk-weighted assets in Europe over 
the crisis period. 

8 

 
 
                                                 
approaches, which typically assume that observed changes in risk weights are entirely driven 
by changes in credit default probabilities. The treatment of non-performing loans also plays a 
role.  The  migration  of  reported  exposures  from  performing  to  non-performing  may  have 
driven  some  of  the  observed  actual  patterns  of  portfolio  allocations  and  need  not  have 
impacted the profile of risk parameters. 

Overall,  the  evolution  of  bank's  risk  parameters  since  end-2008  does  not  indicate  strong 
cyclical patterns, even in the midst of the crisis. The minimum required capital per exposure 
has  remained  comparatively  stable  while  average  risk  weights  have  mostly  declined  since 
end-2008.  Only  up  to  a  point  could  that  mirror  the  impact  of  the  use  of  internal  models.  It 
could largely reflect a counterbalancing effect between the development of risk measures such 
as probability of default or loss given default on the one hand and cyclical developments in 
exposures  on  the  other.  In  a  downturn,  the  effect  of  a  higher  probability  of  default  may  be 
offset  by  a  reduction  in  exposures,  when  combined  as  inputs  into  the  minimum  required 
capital. This highlights the role of portfolio shifts. In a recessionary period, more exposures 
(typically riskier ones) move from performing to defaulted, with the exposures remaining in 
the  portfolio  being  the  better  ones.  Hence,  as  banks  attempt  to  improve  their  overall  credit 
quality  and  in  particular  curtail  lending  to  riskier  counterparties,  average  credit  risk  would 
tend to improve and the probability of default would decrease. The financial crisis itself also 
probably  played  a  role  to  the  extent  that  it  induced  reallocation  of  assets,  irrespective  of 
changes  in  the  underlying  risk  parameters  per  se.  The  leverage  ratio  increased,  driven  by 
capital increases which more than offset the overall increase in the exposure measure.19 Banks 
may  have  targeted  a  higher  amount  of  assets  eligible  as  collateral  in  central  bank  liquidity 
operations to improve their liquidity position and to be able to benefit from cheap central bank 
funding.  In  the  absence  of  the  crisis,  the  minimum  required  capital  might  have  been  more 
cyclical.  Thus,  while  there  appears  to  be  limited  cyclicality  in  the  overall  aggregate  ratios, 
such dynamics might in fact be procyclical to the extent that borrowers to whom banks do no 
longer lend have difficulty finding alternative financing. 

The EBA report extends the analysis on the basis of aggregate capital data and risk parameters 
by  an  econometric  analysis  for  a  broad  sample  of  banks,  mostly  using  internal  ratings 
approaches, spanning 15 semi-annual observations from the second half of 2008 to the second 
half  of  2015.  The  regression  approach  used  aims  at  capturing  statistical  linkages  between 
banking  and  macroeconomic  variables.  The  business  cycle  is  represented  through  different 
country-specific variables capturing the dynamics of the real economy.20  

A first set of regressions examines possible drivers of cyclicality of minimum required capital 
broken down by the contributions of credit risk,  market risk and operational risk. Aggregate 
bank variables display a reaction to values of industrial production with a lag of two periods 
and  a  contemporaneous  measure  of  economic  sentiment.  The  statistically  significant  results 
imply  a  negative  relationship,  meaning  that  minimum  required  capital  tends  to  decrease  as 
economic  conditions  improve  and  vice  versa.  This  result  holds  for  total  minimum  required 
capital as well as the constituent subcategories. A specific dummy variable was introduced to 
capture  the  possible  impact  of  the  introduction  of  Basel  III  rules  as  mirrored  in  Regulation 
(EU)  575/2013  and  Directive  2013/36/EU,  with  potential  shifts  in  the  mean  level  of 
regulatory  required  minimum  capital.  The  effect  of  Basel  III  did  mostly  not  prove  to  be 

19  
20  

BCBS, (2017), Basel III monitoring report (http://www.bis.org/bcbs/publ/d416.pdf).  
These include industrial production – which is thought to track real economic activity better than real 
GDP does; an industrial production index for the euro area, domestic  unemployment rates; a forward 
looking indicator of overall economic sentiment (ESI), and consumer confidence indices. 

9 

 
 
                                                 
statistically  significant  and  thus  does  not  signal  a  pronounced  one-off  shift  or  procyclical 
impact in capital ratio requirements due to the introduction of new regulations. 

From  various  alternative  regression  specifications,  it  appears  that  changes  in  exposures, 
notably  exposure  at  default,  rather  than  estimated  overall  risk  parameters,  drive  cyclical 
patterns in bank capital. That finding strongly confirms the role of portfolio rebalancing as a 
prime driver of the observed trends in assets and risk weights. There is no difference between 
risk-based and standardised approaches in this respect. That said, a smaller subset of the data 
allows to identify the contributions from so-called Credit Conversion Factors (which notably 
are used  to capture  off-balance sheet items)  and  Credit  Risk Mitigants (for  instance used  to 
assess the impact of guarantees and credit derivatives) and suggests that their impact mainly 
accounts  for  the  cyclical  response  of  exposure  at  default  values  to  the  real  economy.  This 
could  well  be  due  to  the  fact  that  borrowers  are  likely  to  draw  down  unused  credit  lines 
(which are mirrored in Credit Conversion Factors) as economic conditions worsen, while the 
inherent  cyclicality  of  collateral  values,  margins  and  haircuts  reflected  in  Credit  Risk 
Mitigants  would  tend  to  drive  up  exposures.  Hence,  any  cyclical  dynamics  of  transmission 
channels  from  the  regulatory  framework  to  bank  capital  would  not  necessarily  be  due  to 
variations in risk parameters. Also, the empirical evidence does not seem to support the notion 
that banks which use internal ratings based approaches are more prone to cyclical dynamics in 
their capital ratio levels.  

These  findings  are  broadly  supported  from  a  portfolio-level  analysis,  but  with  some 
qualifications. For reasons of coverage, the portfolio data include regressions for exposures of 
banks using internal ratings approaches for minimum required capital based on credit risk as 
well  as  other  risk  factors  for  four  main  portfolios:  bank,  corporate,  retail  and  sovereign 
exposures.  In  line  with  the  results  at  the  bank  level,  minimum  required  capital  and  risk 
measures would be expected to increase during downturns, and thus be negatively correlated 
with  coincident  business  cycle  indicators.  For  bank  and  corporate  portfolios,  minimum 
required  capital  was  found  to  correlate  negatively  with  economic  sentiment  and  industrial 
production  indicators.  This  confirms  the  expectation  that  these  portfolios  would  be  most 
directly linked to the business cycle. For the retail portfolio, a correlation was found with the 
lagged unemployment rate as an alternative business cycle indicator. Again, this seems to be 
in  line  with  prior  expectation,  to  the  extent  that  retail  lending  should  be  mirroring  more 
closely  conditions  in  the  labour  market  which  respond  to  the  overall  economic  cycle  with 
some  delay.  For  the  sovereign  portfolio,  no  clear  statistical  relationship  did  emerge.  This 
could  be  due  to  the  smaller  number  of  observations  for  sovereign  portfolio  items,  but  may 
also  be  due  to  the  rather  idiosyncratic  pattern  of  public  debt  management  and  the  role  that 
fiscal policy often tries to play in dampening cyclical swings (albeit with variable lags).  

Estimates  of  how  portfolio-specific  capital  ratio  requirements  are  impacted  by  risk  factors 
broadly  confirm  the  transmission  channel  from  the  latter  to  capital  ratio  requirements.  By 
contrast, further regressions of portfolio-specific risk factors (probability of default, loss given 
default, exposure at default, as well as risk weights) on business cycle indicators do not give 
conclusive results. Measures of probability of default and loss given default mostly appear to 
be  unrelated  to  any  of  the  business  cycle  indicators.  For  bank  and  corporate  portfolios,  the 
link to business cycle indicators is stronger for exposure at default. Similar results emerge for 
risk  weights.  This  is  line  with  the  bank-level  results,  which  indicate  that  the  impact  of  the 
business  cycle  is  strongest  on  exposures  rather  than  on  risk  weights.  In  all,  these  results 
suggest  some  procyclical  effect  of  the  macro  economy  on  banks  variables,  notably  on 
minimum  required  capital.  That  said,  the  reported  coefficient  values  are,  while  still 
statistically  significant,  moderate  in  absolute  size.  Therefore,  the  strength  of  any  feedback 
effects  would  appear  to  be  limited.  Model  specifications  including  additional  portfolio-

10 

 
 
specific control variables mostly yield insignificant coefficients. This may well be due to the 
difficulty of controlling for loan demand effects and portfolio reshuffling effects due to shifts 
to  less  capital-intensive  exposures,  which  may  prevent  any  actual  procyclical  effects  from 
becoming  visible.  In  addition,  some  evidence  of  a  structural  break  in  the  regulatory  regime 
due to the transition to the Basel III framework imposed through Regulation (EU) 575/2013 
and  Directive  2013/36/EU.  This  transition  would  feed  into  the  interaction  between  bank 
capital and the real economy. Even so, it is difficult to distinguish level effects from a more 
lasting  procyclical  impact  of  the  regulatory  requirements  introduced  by  Regulation  (EU) 
575/2013  and  Directive  2013/36/EU,  also  in  view  of  the  short  observation  period  since  its 
introduction.  

The results from the statistical analyses in the EBA report have to be treated with some degree 
of caution. This is partially due to the limited sample size (when performed on more detailed 
breakdowns  of  the  data).  They  may  reflect  the  specific  period  examined,  which  was 
characterised  by  strong  swings  in  real  activity,  substantial  crisis-induced  financial  losses, 
public  capital  injections  and  a  strong  regulatory  drive  to  increase  capital  buffers.  The  high 
level of aggregation of the bank level data used may also imply a lack of empirical precision. 
However,  the  findings  are  broadly  consistent  with  those  obtained  from  the  evidence  on 
aggregate capital ratios. They indicate weak cyclical patterns in bank capital ratio levels. This 
also  resonates  with  findings  in  the  academic  literature  that  capital  buffers  above  minimum 
requirements  tend  to  decrease  when  business  activity  goes  up,  implying  higher  risk-taking 
during economic upswings, whereas lending is curtailed in downturns.21  

A further approach taken in the EBA report combines results from the ECB's Bank Lending 
Survey  and  Survey  on  Access  to  Finance  of  Enterprises  (SAFE)  with  micro-econometric 
evidence  from  the  EBA  bank  panel  data.  The  qualitative  survey-based  information  reveals 
clear  trends  over  the  last  decade.  Credit  standards  tightened  markedly  at  the  onset  of  the 
global financial crisis, followed by a slump in credit demand. Credit standards overall were 
subsequently eased, especially since end-2014, while loan demand recovered also. As to the 
perception of how capital ratio requirements might contribute to the amplification of business 
cycles, since 2011 the ECB Bank Lending Survey has been asking banks about the effects of 
(upcoming)  specific  capital  regulations.  Respondents  generally  agree  that  there  are  links 
between  banks'  capital  management  policies  and  their  loan  granting  process  and  that 
regulatory provisions play an important role. However, survey results do not allow for a clear 
the  adoption  of  Regulation  (EU) 
distinction  between 
575/2013/Directive  2013/36/EU,  crisis-related  effects,  and  other  determinants  of  credit 

loan  supply  effects  due 

to 

21 

See, for  example, Ayuso,  J.,  et  al., (2004), "Are  capital  buffers  pro-cyclical?:  Evidence  from  Spanish 
panel  data",  Journal  of  Financial  Intermediation,  Vol.  13  Issue  2;  Bikker,  J.,  and  P.  Metzemakers, 
(2004),  "Bank  provisioning behaviour  and procyclicality",  Journal  of  International  Financial  Markets, 
Institutions and Money, Vol. 15 Issue 2; Lindquist, K., (2004), "Banks’ buffer capital: how important is 
risk", Journal of International Money and Finance, Vol. 23 Issue 3; Jokipii, T., and A. Milne, (2008), 
"The  cyclical  behaviour  of  European  bank  capital  buffers",  Journal  of  Banking  and  Finance,  Vol.  32 
Issue 8; and Stolz, S., and M. Wedow, (2011), "Banks’ regulatory capital buffer and the business cycle: 
Evidence for Germany", Journal of Financial Stability, Vol. 7 Issue 2. These results do not lend support 
to a different suggestion highlighted in different strand of the literature, which pointed to the possibility 
that  in  a  stronger  risk-based  regulatory  framework  banks  may  actually  decide  to  insure  against 
perceived more cyclical minimum required capital by letting capital buffers move with the cycle; being 
higher  in  upturns  and  vice  versa.  On  this,  see  Heid,  F.,  (2007),  "The  cyclical  effects  of  the  Basel  II 
capital requirements", Journal of Banking and Finance, Vol. 31 Issue 12; Zhu (2008), Jokivuolle, E., et 
al.,  (2009),  "Credit  Allocation,  Capital  Requirements  and  Procyclicality",  Bank  of  Finland  Research 
Discussion Paper No. 23/2009; and Repullo, R., and J. Suarez, (2009), "The Procyclical Effects of Bank 
Capital Regulation", European Banking Center Discussion Paper No. 2010-05S.  

11 

 
 
                                                 
dynamics. Consistently respondents see 'expectations of general economic activity' and a host 
of more specific supply and demand factors as more important in affecting cyclicality in loan 
exposures than regulatory capital ratio requirements. Such drivers include the risk appetite of 
banks,  the  outcome  of  stress  tests,  specific  Pillar  II  requirements,  cost  of  funding,  interest 
rates,  market  confidence,  and  perceived  growth  opportunities.  The  treatment  of  derivatives, 
impairments, write-offs of loans could be a specific relevant feedback mechanism. Write-offs 
tend  to  be  more  cyclical  than  regulatory  capital  ratio  requirements  for  performing  loans.  In 
fact, reclassification of overdue loans could lead to re-assessments of risk parameters which 
could induce feedback effects on lending. 

The SAFE survey provides additional qualitative information on enterprise loans to the Bank 
Lending Survey data. The SAFE data were fed into purpose-built ECB models to identify the 
impact  of  a  credit  supply  shock  on  loan  growth.22  The  model  results  broadly  confirm  the 
findings  from  the  BLS  as  regards  the  time  profile  for  access  to  finance.  Credit  supply  was 
very tight during the acute phase of the global financial crisis and the sovereign debt crisis, 
and  has  since  improved  considerably  on  the  back  of  gradual  economic  conditions  and 
monetary policy easing. However, the improvement in access to bank financing initially was 
mostly  for  large  firms,  whereas  SMEs  and  in  particular  small  firms  only  benefitted  from 
improved  access  to  finance  as  the  recovery  firmed.  The  result  of  simulations  in  a  Dynamic 
Stochastic  General  Equilibrium  economic  model  with  a  capital-constrained  banking  sector 
and  calibrated  to  the  development  in  internal  ratings  based  risk  weights  for  a  corporate 
portfolio,  give  some  support  to  the  notion  of  a  stronger  amplification  of  the  business  cycle 
under  a  regulatory  regime  where  capital  ratio  requirements  vary  over  time  with  borrower 
default  probabilities.23  The  main  feedback  mechanism  in  the  model  works  through  banks 
increasing their capital buffers in response to unexpected losses. 

The SAFE survey data, supported by modelling approaches, thus indicate that the regulatory 
requirements  in  Regulation  (EU)  575/2013  and  Directive  2013/36/EU  may  have  had  some 
procyclical impact. Any such effect is however difficult to disentangle from other factors and 
in all it seems as if since 2008 crisis-related effects have been a major force in shaping bank 
credit supply. It must be emphasised that the impact of one-off increases in the capital buffer 
due to recapitalisation needs24 and increases in the required capital ratio levels in view of new 
regulation is a different phenomenon from the procyclicality of existing requirements. Recent 
years  witnessed  the  transition  towards  Basel  III  minimum  requirements,  which  is  due  to  be 
completed  by  2019.  Banks  responded  to  higher  imposed  minimum  capital  ratio  levels  by  a 
shift towards higher actual regulatory capital ratio levels. Shortfalls were reduced and while 
the  statistics  do  not  allow  for  a  clear  calculation  of  the  level  of  voluntary  additional  capital 

22  

23  

24 

See:  Altavilla,  C.,  et  al.,  G.  (2015),  “Loan  supply,  credit  markets  and  the  euro  area  financial  crisis”, 
ECB  Working  paper,  No.1861;  Darracq-Paries,  M.,  and  R.  De  Santis,  (2015),  "A  non-standard 
monetary  policy  shock:  The  ECB's  3-year  LTROs  and  the  shift  in  credit  supply",  Journal  of 
International  Money  and  Finance,  Vol.  54;  Hempell,  H.,  and  C.  Kok,  (2010),  “The  impact  of  supply 
constraints  on  bank  lending  in  the  euro  area  –  credit  induced  crunching”,  ECB  Working  Paper  No. 
1262. 
See Darracq Pariès, M., et al. (2011), “Macroeconomic propagation under different regulatory regimes: 
An estimated DSGE model for the euro area”, International Journal of Central Banking, Vol. 7. 
For recapitalisations see EBA, 9 Feb 2012: http://www.eba.europa.eu/documents/10180/587401/Press-
release-EBA-9-02-2012_1.pdf. See BCBS (2017) Basel III monitoring report on the marked reduction 
in  reported  shortfalls  in  capital  among  European  reporting  banks.  Because  requirements  under  the 
second pillar are mostly non-disclosed it is not possible to exactly compute the difference between the 
actual level of buffers and the required minimum level across all categories.  

12 

 
 
                                                 
reserves, it is likely that voluntary buffers above the minimum imposed have increased.25 The 
size of the imposed structural increase in capital ratio requirements is such that the aggregate 
impact  on  bank  behaviour  of  this  one-off  adjustment  probably  dominates  any  cyclical 
impulses from endogenous adjustments to capital ratio requirements. 

Adjusting  to  new  regulatory  constraints  requires  capital  and  liquidity  planning  by  the 
institutions  affected.  This  can  work  through  (a  combination  of)  the  various  adjustments 
channels:  raising  equity,  reducing  dividend  payments,  retaining  earnings,  asset  side 
adjustments and changes in the calculation of risk weights. The overarching concerns is that 
in periods of systemic stress banks would deleverage and curtail lending to the economy, in 
view of difficulties with raising capital and a possible reluctance to curtail dividend payments.  

Empirically,  it  is  difficult  to  disentangle  the  different  transmission  channels,  as  only  the 
overall net impact on bank behaviour is observed. As argued above, over the period examined 
one-off  adjustments  rather  than  a  procyclical  response  are likely  to  have  been  the  dominant 
phenomenon.  The  period  since  introduction  of  Regulation  (EU)  575/2013/Directive 
2013/36/EU  has  been  short  compared  to  the  typical  duration  of  a  financial  cycle,  which 
militates  against  drawing  strong  conclusions.  Yet  the  macro  and  micro  data  and  the 
simulations in the EBA report, as well as data from the Bank for International Settlements on 
the implementation of the Basel III framework, supplemented with reporting by EBA on the 
funding sources of banks, confirm the role of portfolio shifts in the adjustment process. Banks 
tend to adjust their portfolios by altering the composition rather than the volume of loans and 
other assets, for example by substituting towards lower risk weighted assets. This is consistent 
with a resulting drag on credit to the real economy.26 In international comparison, European 
banks  had  relatively  weaker  profit  ratios  to  fund  adjustments.  The  extent  of  the  adjustment 
depends on the extent to which banks’ actual capital ratios differ from their revised target.27 

The pattern emerging  is consistent with  the difficulties in access to  finance observed across 
Union  Member  States.  They  were  the  most  pronounced  in  countries  hardest  hit  by  the 
financial  crisis  and  are  noted  especially  for  the  financing  of  small  and  medium-sized 
enterprises – a source of particular concern in terms of holding back the recovery.28 Several 
studies  cite  evidence  of  decreases  in  loan  growth  in  the  short  run  associated  with  the 
imposition  of  higher  capital  ratio  levels  between  2009  and  2012  and  confirm  that  portfolio 
shifts within banks appear to have played a large role in adjusting to changes in the regulatory 
requirements.29  This  notwithstanding,  it  appears  that  the  structural  adjustment  to  higher 

25  

26  

27  

28  

29  

In  the  study  by  LE  Europe  (see  footnote  8),  stakeholder  groups  surveyed  shared  the  view  that  the 
recapitalisation requirements in CRR/CRD have increased the resilience of the European banking sector 
even  though  respondents  were  more  critical  of  the  additional  supervisory  capital  requirements 
stemming from supervisory stress tests (Pillar II add-ons), and macro prudential buffers.  
On this, see for instance: BCBS (2017) Basel III monitoring report; and EBA (2017) Report on funding 
plans. 
See, for instance, Francis, W., and M. Osborne, (2012), "Capital requirements and bank behavior in the 
UK:  Are  there  lessons  for  international  capital  standards?",  Journal  of  Banking  and  Finance,  Vol  39, 
2012.  They  find, on  the basis  of UK  evidence largely preceding  the global  financial  crisis that banks 
tended to minimise the costs of complying with capital requirements by adjusting lower quality capital 
and altering the average risk weights of their portfolios. 
European Semester 2016 Thematic factsheet – Small and medium sized enterprises' access to finance: 
https://ec.europa.eu/info/files/european-semester-thematic-factsheet-small-and-medium-sized-
enterprises-access-finance-2016_en  
See  Maurin,  L.,  and  M.  Toivanen,  (2012),  "Risk,  Capital  Buffer  and  Bank  Lending:  A  Granular 
Approach to the Adjustment of Euro Area Banks", ECB Working Paper No. 1499; Cohen, B., and M. 
Scatigna,  (2016),  "Banks  and  capital  requirements:  Channels  of  adjustment",  Journal  of  Banking  and 
Finance,  Vol  69,  Mesonnier,  J.,  and  A.  Monks,  (2014),  “Did  the  EBA  capital  exercise  cause  a  credit 

13 

 
 
                                                 
 
capital ratios for banks in the wake of the crisis has not been a separate source of major credit 
retrenchment  in  the  Union  on  top  of  other  determinants  of  loan  demand  and  supply.  While 
this  could  imply  some  procyclicality  of  the  adjustment  for  corporate  loans  (especially  for 
SMEs which have less access to internal funding than large corporations do), such a response 
is difficult to be separately identified in the data. 

To  sum  up,  the  evidence  is  mixed  and  the  experience  is  too  short  or  limited  to  draw  firm 
conclusions on a possible clear procyclical impact of the regulatory framework laid down in 
Regulation (EU) 575/2013 and Directive 2013/36/EU. This concerns in particular the impact 
of  buffer  requirements  on  credit  intermediation.  Moreover,  the  experience  is  too  short  with 
reference  to  the  duration  of  a  typical  financial  cycle  to  assess  the  effect  of  specific 
requirements  which  are  novel  to  the  framework.  This  is,  for  instance,  the  case  for  the 
countercyclical capital buffer. If not well calibrated and timely activated and released, it might 
not  achieve  its  purpose  of  bolstering  resilience.  At  present,  in  only  a  few  cases  have 
countercyclical buffers been activated or are in place with non-zero levels. To date, there is 
also  no  significant  experience  with  releasing  them  when  the  cycle  has  turned.  From  a 
somewhat  broader  perspective,  leverage  requirements  and  the  establishment  of  the  Banking 
Union may also be relevant. Indeed, resolution through bail in of leveraged institutions could 
induce portfolio adjustments. Yet the experience with the leverage requirements has been too 
short to muster sufficient empirical evidence on any procyclical effects. 

5. 

MEASURES TO ADDRESS PROCYCLICALITY 

In  2013,  the  Union  adopted   Regulation  no  575/2013  and  Directive  2013/36/EU.  On 
November  2016,  the  Commission  adopted  a  proposal  on  amendments  to  the  capital 
requirement  regulations  to  incorporate  the  remaining  elements  of  the  regulatory  framework 
agreed  within  the  Basel  Committee  on  Banking  Supervision  (BCBS)  to  improve  banks' 
lending capacity to support the Union’s economy and to further facilitate the role of banks in 
achieving  deeper  and  more  liquid  Union  capital  markets.30  On  20 September  2017  the 
Commission published a proposal on the review of the Union system of financial supervision, 
with  a  number  of  further  proposed  targeted  improvements.  The  Commission  advocated 
targeted  adjustments  to  the  composition  and  organisation  of  the  European  Systemic  Risk 
Board and its coordination with Union bodies and institutions. The Commission's review has 
shown  that  overall  the  macro-prudential  toolkit  is  broadly  effective  and  is  able  to  address 
financial stability risks.31 

The  rules  laid  down  in  Regulation  (EU)  575/2013  and  Directive  2013/36/EU  incorporate  a 
number  of  measures  that  may  mitigate  procyclicality  in  bank  lending:  higher  capital  ratio 
requirements, countercyclical and capital conservation buffers, the introduction of a leverage 
ratio, and reduced dependency on credit rating agencies for prudential requirements and stress 
tests. To the extent that the combination of measures is successful in bolstering the resilience 

crunch in Euro area?”, Banque de France Working Paper No. 491; Aiyar, S., et al., (2012), "How does 
credit supply respond to monetary policy and bank minimum capital requirements?", Bank of England 
WP 508. See also the LE Europe study, see footnote 8, which finds larger effects on bank lending flows 
for banks with smaller capital cushions, in line with findings of Buch, C., and E. Prieto, (2014), "Do 
Better Capitalized Banks Lend Less? Long-Run Panel Evidence from Germany", International Finance, 
Vol. 17 Issue 1. 
http://europa.eu/rapid/press-release_MEMO-16-3840_en.htm.  
http://europa.eu/rapid/press-release_MEMO-17-3322_en.htm. 

30  
31  

14 

 
 
                                                                                                                                                         
 
of the financial sector, it may also help in mitigating the financial cycle and thus dampening 
cyclical feedbacks. 

5.1  Application  of  the  capital  ratio  requirements  laid  down  in  Regulation 
(EU) 575/2013 and Directive 2013/36/EU 

As de-leveraging of credit in international banks in response to regulatory requirements set by 
national  supervisors  may  occur  outside  home  jurisdictions,  the  full  implementation  of  the 
single rule book should reduce regulatory arbitrage. In particular, it might mitigate procyclical 
effects  of  ring-fencing  of  capital  and  asymmetric  de-leveraging  in  "host  countries",  that  is 
excessive credit retrenchment by internationally active banks in countries outside their home 
jurisdiction.  That  is  supported  by  the  different  pillars  of  the  Banking  Union,  comprising 
common resolution and deposit insurance provisions. 

5.2  Capital Conservation Buffer and Countercyclical Capital Buffer 

One  key  regulatory  response  to  the  perceived  procyclicality  of  bank  lending  is  the 
introduction  of  a  Capital  Conservation  Buffer  and  a  Countercyclical  Capital  Buffer.  These 
extra buffers, built up over good economic times, can be released in an economic downturn to 
enable banks to absorb their losses in an orderly way that does not lead to costly increases in 
the price of credit, which can aggravate recession. They should mitigate both the existing lack 
of  responsiveness  of  regulatory  requirements  to  risk  build-up  at  the  macro  level  and  their 
cyclicality.  Since  dynamics  can  be  very  different  across  different  markets,  the  buffers  are 
determined  on  a  national  base.  Common  guidance  for  setting  countercyclical  capital  buffer 
rates has been developed by the European Systemic Risk Board.32 

As  many  Member  States  are  still  recovering  from  the  recessionary  shock  of  the  global 
financial crisis, only in few of them do Countercyclical Capital Buffer rates currently exceed 
0%.  Similarly,  Capital  Conservation  Buffers  have  been  built  up,  but  to  date  there  is  no 
experience in the Union with releasing such buffers.33 In addition, as regards sectoral financial 
stability risks related, for instance, to real estate, the Countercyclical Capital Buffer affects all 
corporate and retail exposures and can currently not be targeted to sectoral exposures. In view 
of this, reflections are ongoing in Basel and in the Union on the merits of introducing sector-
specific buffers to address the cyclical nature of some specific risks and to avoid some of the 
inaction bias inherent to the broad scope of the Countercyclical Capital Buffer. 

 5.3  Risk weights for specific exposures and other supervisory measures 

The  current  rules  foresee  specific  macro-prudential  measures,  for  instance  in  the  form  of 
requirements on risk weights, to counter risks from specific exposures, such as real estate. In 
particular,  under  Article  124  of  Regulation  (EU)  575/2013  competent  authorities  may  set  a 
higher  risk  weight  or  stricter  criteria  on  exposures  secured  by  immovable  property  on  the 
basis of financial stability considerations. Similarly, Article 164 of Regulation (EU) 575/2013 
allows competent authorities to set higher minimum values for exposure weighted loss given 

32  
33  

Recommendation (ESRB/2014/1). 
To date, only the UK announced a decrease in the Countercyclical Capital Buffer rate, in July 2016 to 
0%. The rate was announced to be set 0.5% in March 2016, but it would have entered into force only in 
March 2017. 

15 

 
 
                                                 
default  for  exposures  secured  by  immovable  property  in  their  territory  on  the  basis  of 
financial stability considerations. Article 458 of Regulation (EU) 575/2013 allows authorities 
to  adjust  risk  weights  for  targeting  asset  bubbles  in  the  residential  or  commercial  property 
sector  or  to  take  measures  such  as  adjusting  the  level  of  the  own  funds  or  the  level  of  the 
Capital Conservation Buffer, with a bearing on the capital base of banks. However, national 
flexibility measures under Article 458 can only be applied if other macroprudential tools laid 
down in Regulation (EU) 575/2013 and Directive 2013/36/EU cannot adequately address the 
risk identified. 

The EU regulatory framework comprises further measures which can mitigate the impact of 
cyclical risks on banks. These include provisions in Articles 181 and 182 of Regulation (EU) 
575/2013  on  risk  parameters  associated  with  rating  grades  or  pools,  which  require  banks  to 
use  estimates  that  are  appropriate  for  an economic  downturn  if  those  are  more  conservative 
than the long-run average. This is in the spirit of recommendations by the Basel Committee 
on Banking Supervision for banks using internal ratings models to adopt a through-the-cycle 
approach  in  calculating  capital  ratio  requirements  for  credit  risk.  Such  an  approach  would 
dampen changes in required capital ratio level in response to changes in cyclical conditions. 
Moreover, as regards institution-specific second pillar capital ratio requirements, supervisory 
authorities  can  take  into  account  cyclical  risks  to  enhance  the  resilience  of  specific 
institutions. 

In addition, the implementation of other regulatory requirements have a bearing on mandatory 
capital  levels,  for  example,  the  banking  book  standards  (IRRBB)  and  IFRS  9  accounting 
standards.  34  The  EU  Supervisory  Review  and  Evaluation  Process  may  impact  capital 
requirements  as  do  resolution  provisions  and  loss  absorbency  requirements  such  as  the 
Minimum  Requirement  for  own  funds  and  Eligible  Liabilities  (MREL)  and  the  total  loss-
absorbing capacity thresholds for global systemically important banks. 

5.4  Leverage ratio 

The  Leverage  Ratio  is  an  additional  non  risk-based  capital  requirement  conceived  as  a 
credible supplementary measure to the risk-based capital ratio requirements. In the Union, the 
Leverage  Ratio  is  being  implemented  in  line  with  Basel  III  requirements,  meaning  that  the 
Leverage  Ratio  is  calculated  by  dividing  Tier  1  capital  by  the  bank's  average  total 
consolidated assets (sum of the exposures of all assets and non-balance sheet items), the banks 
being expected to maintain a leverage ratio in excess of 3%. It would help to limit excessive 
bank  lending  during  the  upswing  of  an  economic  cycle  when  banks  have  momentum  to 
expand balance sheets without an appropriate increase in capital.  

The theoretical and empirical literature underlines the link between procyclical leverage and 
financial instability. Empirically, banking sector leverage has been procyclical at an aggregate 
level  in  almost  all  Union  Member  States,  tending  to  fall  in  credit  booms  and  rising  in 
downturns. A static leverage ratio limit would therefore address the procyclicality of banking 
leverage during an upturn. Furthermore, it would operate as a backstop to the procyclicality of 
risk-weighted  capital  ratio  requirements.  Indeed,  it  ensures  that  capital  moves  in  proportion 
with  total exposure, while aggregate risk weights  and risk-weighted capital  requirement can 
vary over time, according to the different phases of the cycle.  

34  

On the potential procyclical impact of IFRS 9 and how to address it see European Systemic Risk Board, 
Financial stability implications of IFRS 9, July 2017,  
https://www.esrb.europa.eu/pub/pdf/reports/20170717_fin_stab_imp_IFRS_9.en.pdf. 

16 

 
 
                                                 
5.5  Credit ratings  

Credit ratings, obtained through specific credit rating agencies or internal rating models, also 
play an important role in the determination of the actual capital ratio level of banks. External 
ratings  are  closely  correlated  with  the  economic  cycle,  implying  that  capital  ratio 
requirements linked to external ratings will also follow a cyclical pattern, at least at the level 
of  individual  exposures.  In  view  of  this,  Regulation  (EU)  575/2013  encourages  the  use  of 
internal ratings and strengthens provisions on how external ratings can be used.35 For banks 
using  an  internal  ratings  based  approach,  it  requires  independent  risk  assessment  capability 
and creates incentives to better manage credit risk. A through-the-cycle approach could help 
smooth the impact on capital ratio requirements.  

5.6 

Stress tests  

Stress test can be seen as another, albeit indirect, instrument to help avoid undue procyclical 
responses of credit institutions to meet capital ratio requirements during periods of financial 
stress. In the aftermath of the crisis, micro-prudential stress tests were used promptly to assess 
the capital needs of individual banks. Such stress tests are helpful in informing how buffers 
can be set, also above minimum requirements. The supervisory review and evaluation process 
allows the results of stress tests to be used to devise supervisory measures, including capital 
ratio requirements. However, they have significant limitations in the face of macro-prudential 
policy concerns. The static balance-sheet approach is not well suited to stress-testing exercises 
that  run  over  a  longer  horizon  of  several  years.  In  practice,  banks  can  react  to  adverse 
conditions by deleveraging, which in turn would have significantly different macro-financial 
consequences  affecting  the  economic  environment.  To  exploit  fully  the  potential  of  stress 
tests, banks therefore have to take into account systemic risk associated with common shocks 
to the financial system. This means assessing capital ratio requirements and macro-prudential 
policy  in  a  consistent  manner,  taking  into  account  interactions  within  the  banking  sector  as 
well as interactions with the financial and non-financial sectors and the real economy.36 

6. 

CONCLUSION 

While  a  procyclical  impetus  from  capital  ratio  requirements  is  widely  acknowledged  in  the 
literature as a potential source of risk, the empirical evidence is not conclusive as regards its 
actual strength for banks in the Union. There is no empirical evidence of a strong procyclical 
bias  of  the  current  framework  which  would  affect  the  non-financial  sector  in  the  Union 
economy.  This  inconclusiveness  may  be  driven by  the  available  data  not  covering  an  entire 
cycle,  the  lack  of  more  granular  data  that  would  allow  for  distinguishing  the  behaviour  of 
different  types  of  banks,  the  challenge  to  control  for  portfolio  rebalancing  effects,  the 
difficulty to disentangle loan supply and demand effects, and the difficulty to disentangle the 

35 

36  

At  the  international  level,  in  October  2010  the  Financial  Stability  Board  (FSB)  issued  principles  to 
reduce  authorities’  and  financial  institutions’  reliance  on  CRA  ratings  (see  http://www.fsb.org/wp-
content/uploads/r_101027.pdf?page_moved=1).  

The ECB is exploring so-called macro-prudential stress tests to incorporate the systemic risk dimension. 
See: Dees, S., et al., (2017), "STAMP€: Stress-Test Analytics for Macroprudential Purposes in the euro 
area", www.ecb.europa.eu/pub/pdf/other/stampe201702.en.pdf. 

17 

 
 
                                                 
 
impact of other post-crisis reforms and extraordinary policy measures throughout the sample 
period.  

Against the background of the weak evidence on  the existence of procyclical effects due to 
the  rules  laid  down  in  Directive  2013/36/EU  and  Regulation  (EU)  575/2013,  there  is  no 
reason  at  this  juncture  to  propose  significant  alterations  to  the  prevailing  regulatory 
framework for bank capital. The higher capital ratios achieved in recent years by construction 
imply  that  the  procyclical  impact  of  a  given  loss  will  be  weaker.  The  Union  financial 
regulatory  framework  has  various  tools  at  its  disposal  to  deal  with  the  impact  of  any 
procyclical effects. These  include the capital conservation buffer, the countercyclical capital 
buffer,  the  leverage  ratio,  adjustments  to  risk  weights  for  specific  exposures  and  other 
supervisory measures. 

Looking ahead, the impact of the Union regulatory capital ratio requirements on the economic 
cycle should be monitored regularly and the potential impact, effectiveness and efficiency of 
counter-cyclical  instruments  should  be  further  analysed.  It  will  be  important  to  gather 
evidence  on  a  continuous  basis  of  any  procyclical  bias  stemming  from  capital  ratio 
requirements  becoming  stronger.  Concrete  proposals  to  change  the  current  set-up  should  be 
based on such evidence becoming available to the greatest extent possible. 

18