One of the main ideas that emerged as suitable for implementation after the 2008 crisis was to enhance capital and liquidity regulations since both problems were at the origin of the quasi-meltdown of the global financial system after the Lehman collapse. A more robust banking system (in terms of capital and liquidity) would be less subject to crises or at least would not require the magnitude of transfers from taxpayers that was observed. Tighter regulatory standards might also contribute to smaller output fluctuations and to higher welfare gains even apart from banking crises. There are a number of studies (e.g. BCBS, 2010) that point out that better capitalization and higher liquidity of banks reduce the likelihood and the severity of crises; and that regulatory reforms can reduce the amplitude of business cycles, especially using countercyclical capital buffers.

The BIS and the BCBS have been advocating the adoption of countercyclical capital standards. Buffers need not be part of the prudential minimum capital requirement and would be capital in excess of that minimum, so that it is available to absorb losses in bad times. Countercyclical capital buffers would limit (a) the risk of large-scale accidents in the banking system and (b) the amplification of macroeconomic fluctuations during crises.<sup>**7**</sup> The macroprudential rationale is the time-inconsistency argument that risks tend to build up in good times, but their negative consequences materialize only with a lag. This feature reveals the limitations of current risk measurement practices as well as distortions in the microprudential incentives of individual firms.

There is a perception that risk-sensitive minimum capital requirements embedded in Basel II could lead to excessive pro-cyclicality.<sup>8</sup> On the other hand, some have argued that by raising capital requirements in a counter-cyclical way, regulators could help choke off asset price bubbles - such as the one that developed in the US housing market - before a crisis develops. The Turner Review (see Financial Services Authority, 2009) for instance, favored countercyclical capital requirements, as did Brunnermeier and Sannikov (2009), who propose to adjust capital adequacy requirements over the cycle by two multiples - the first related to above-average growth of credit expansion and leverage, the second related to the mismatch in the maturity of assets and liabilities.

At the international level, there has been significant progress toward establishing new standards in this area; the Basel Committee on Banking Supervision developed a countercyclical framework that involves adjusting bank capital in response to excess growth in credit to the private sector, which it views as a good indicator of systemic risk. In a proposal released in September 2010, the Committee suggested the

> **7** “Any effective scheme would need to have a number of features. First, it would identify the correct timing for the accumulation and release of the capital buffer. This means correctly identifying good and bad times. Second, it would ensure that the size of the buffer built up in good times is sufficiently large to absorb losses without triggering serious strains. Third, it would be robust to regulatory arbitrage, including manipulation. Fourth, it would be enforceable internationally. Fifth, it would be as rule-based as possible, acting as an automatic stabilizer. In particular, this would ease the pressure on prudential authorities to refrain from taking restrictive measures in good times. Sixth, it should have a low cost of implementation. Finally, it would be simple and transparent.” Drehmann et al (2010, p.1).

> **8** A series of quantitative exercises conducted by the BCBS has assessed the impact of the cyclicality of capital requirements regimes taking risk-sensitivity into account. One of the methodologies used adjusted for the compression of probability of default (PD) estimates in the internal ratings based approach during benign credit conditions by using PD estimates for a bank’s portfolios in downturns. Using higher PD (for risk) during upturns would provide - by subtraction with actual data - an estimate of cyclical effects.

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