miguel fernandez ordonez : procyclicality in the banking activity speech by mr miguel fernandez ordonez, 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 tosovsky, 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.