Kasinomics

Pro-Cyclicality - Discussion of the problem and possible solutions

How to define pro-cyclicality

Procyclicality is used in the context of discussing the effects of Basel II on the financial system. A simplified definition of pro-cyclicality is:

International rules have encouraged banks to act more aggressively when the economic cycle is in the middle of an upswing, when some argue that is precisely when they should be putting money away for a rainy day. The global economy has become more volatile as a result. Source: Thisismoney.co.uk

Claudio Borio, Craig Furfine and Philip Lowe express the same statement in more sophisticated words:

Financial developments have reinforced the momentum of underlying economic cycles, and in some cases have led to extreme swings in economic activity and a complete breakdown in the normal linkages between savers and investors.

These experiences have led to concerns that the financial system is excessively procyclical, unnecessarily amplifying swings in the real economy.

In turn, these concerns have prompted calls for changes in prudential regulation, accounting standards, risk measurement practices and the conduct of monetary policy in an attempt to enhance both financial system and macroeconomic stability. Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“

José Viñals, Director General International Affairs at the Banco de Espagna, reminds us that a certain procyclicality of the financial system is wanted, but excessive procyclicality can be a burden:

In the financial sphere, a certain degree of procyclicality is a natural, sensible and desirable outcome as it reflects the extent to which the financial sector is influenced by developments in the real economy and viceversa. The issue is nevertheless to what extent there is an excessive degree of procyclicality. The financial system is excessively procyclical when it unnecessarily amplifies swings in the real economy and/or reduces the stability and soundness of the financial sector. Source: José Viñals in “Procyclicality of the financial system and regulation“

Indicators of pro-cyclicality

According to Claudio Borio, Craig Furfine and Philip Lowe periods of growth are often associated with:

• significant increases in the ratio of credit to GDP
• large increases in equity and property prices
• decreasing bond spreads between corporate and government securities
• credit rating agencies failing to predict changes in the probability of crises
• unaltered bank provisions
• increasing bank profitability and increasing bank equity prices

Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“

Causes of Pro-Cyclicality in the financial system

Nancy Masschelein, from the National Bank of Belgium, has listed various sources of pro-cyclicality. Source: Nancy Masschelein in “Monitoring pro-cyclicality under the capital requirements directive : preliminary concepts for developing a framework“

1. Fluctuations in the quality of banks’ and borrowers’ balance sheets.An increase in bank profits during periods of growth supports the extension of credit, while decreasing bank profits due to defaulted loans reduce this extension of credit. At the same time, a recession causes declining profits, increases demand for new credit and increases the interest rates.Claudio Borio, Craig Furfine and Philip Lowe have labelled this the Incentive Explanation. Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“
2. Information asymmetries between borrowers and lenders.During periods of growth, the value of collateral rises and borrowers with riskier projects can find lending. Under recessions, due to the decreased value of collateral, even borrowers with very profitable projects will find it difficult to obtain funding. These cyclical effects are especially relevent for borrowers which are more prone to asymmetric information effects (such as SMEs).Claudio Borio, Craig Furfine and Philip Lowe call this explanation the Financial-accelerator-explanation. Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“.
3. Inappropriate responses by participants in the financial system and lack of institutional memory.Euphoric expectations which arise from an investment boom driven by the business cycle or a disaster myopia which shows in a reduced subjective probability of a major shock if the last shock has already a few years past, is another source of excessive lending by banks during periods of growth.Allen N. Berger and Gregory F. Udell raise the problem of a lack of institutional memory. Source: Allen N. Berger and Gregory F. Udell in”The Institutional Memory Hypothesis and the Procyclicality of Bank Lending Behavior“
   

   Under the institutional memory hypothesis, as time passes since the last “learning experience” with problem loans – the last time that the bank suffered a loan “bust” – loan officer skills decline.

   Part of this decline in lender ability is attributable to a proportional increase in inexperienced lenders who have never had such a “learning experience.”

   Part of the decline in lender ability is also due to the atrophying skills of experienced loan officers as time passes since they last addressed significant loan problems.

4. New financial innovative instruments.The use of new financial instruments facilitated the spreading and the diversification of credit risks and increased the possibilities of hedging. In favourable circumstances, banks can easily transfer credit risk using innovative credit risk transfer (CRT) products, which could induce banks to increase lending as credit risk can be transferred.

Regulation and pro-cyclicality

The most important dimension of pro-cyclicality that is being adressed in the remaind of this article is regulation. Minimum capital requirements imposed by regulators to reduce systemic risk from collapse of systemically important financial intermediaries may force banks to reduce lending in an recession, increasing the above pro-cyclical mechanisms of the financial system.

George G. Pennacchi warned that Basel II increases the sensitivity of a bank’s capital requirement to the risk of its assets and creates incentives which make bank lending more procyclical.

During recessions, loan losses reduce bank capital and, even if capital requirements are insensitive to risk, a capital-deficient bank must increase its capital ratio. In addition, recessions tend to raise the default risk of loans, and Basel II’s more refined risk-based standards would further pressure banks to strengthen their capital ratios. This response of capital ratios to default risks can reduce banks’ incentives to lend during a recession and worsen economic activity. Thus, capital requirements as envisioned under Basel II increase macroeconomic instability.Source: George G. Pennacchi, Journal of Financial Intermediation “Risk-based capital standards, deposit insurance, and procyclicality“

Besides miminum capital requirements, there are other ways that regulation can increase pro-cyclicality. Philipp Turner has listed them and discussed their relevance. Source: Philipp Turner in “Procyclicality of Regulatory Ratios?“

1. Timing of tightening of capital rulesDuring and immediately after a financial crisis, policy-makers have large incentives to tighten bank regulation which further curtails bank lending. Turner says that this problem is not that revelant in practice, most countries allow a phase-in period for the tightening of prudential ratios or in dealing with generalised problems.
2. Regulatory bias in favour of short-term lendingUnder Basel I, international interbank lending of up to one year maturity had a 20% risk-weight irrespective of country, but lending of more than one year to non-OECD countries carried a 100% risk weight which would make bank lending to emerging markets “too” short term. According to Turner, Data does not suggest that this effect is important, nevertheless Basel II adresses these ambivalent distinctions.
3. Cyclicality of minimum capital ratiosThis will be discussed later in this article in relation to bank provision and IAS 39, but the general idea is that because of certain minimum capital rations banks will reduce lending to meet the required minimum capital rations, if they have not made sufficient provisions for losses.
4. Cyclicality of capital ratios due to the use of external credit ratingThis will also be discussed later in relation to the impact of Basel II on risk management in banks, but the general idea is that an increased reliance on external credit rating in determining risk weights can lead to the necessity for increased capital ratios in times of recession.

Basel II, Credit Rating Agencies and Pro-Cyclicality

According to José Viñals the philosophy of modern monetary politics and approaches to financial stability incorporated in Basel II is quite similar:

• both are forward-looking in nature and have a medium-term horizon
• both have an anticipatory character that seeks prevention rather than cure
• both attempt to incorporate market views through the role played by expectations and market discipline.

He argues that Basel II reduces pro-cyclicality by improving banking supervision.

By contributing to a better assessment and management of risks, Basel II should reduce the scope for surprises and thus for procyclicality.Source: José Viñals in “Procyclicality of the financial system and regulation“

The influence of Basel II on the real economy would work along the following mechanism

Basel II would increase the risk-sensitiveness of minimum capital requirements which, in turn, would lead to higher cyclicality of the overall regulatory capital and to more procyclical capital. Consequently, this would be reflected onto more procyclical lending and onto a higher degree of procyclicality in the real economy.Source: José Viñals in “Procyclicality of the financial system and regulation“

The influence on Basel II on the real economy through capital requirements is the reliance on external credit assessment for calculating risk weights. Philip Turner states that under Basel I, risk weight for sovereign and corporate debt were based on OECD membership wich was not sufficiently responsive to risk. Basel II relies more on “credit assessment agencies”, so not only credit-rating agencies, but also export insurance agencies, credit registers, market data.

However, credit rating agencies are often more backward-looking rather than forward-looking, their assessments are strongly negatively correlated with the real effective exchange rates, even though depreciation in the wake of a crisis should not lead to a downgrade but to a recognition of medium-term strenght due to a more competitive exchange rate.Source: Philipp Turner in “Procyclicality of Regulatory Ratios?“

Eva Catarineu-Rabell, Patricia Jackson and Dimitrios P Tsomocos more specifically identify the choice of rating system as an important element in pro-cyclicality:

The proposed new Basel Accord, in contrast to the Current Accord, makes provision for time varying risk weights for individual loans. Although the Basel Committee will set fixed weights for loans with a given probability of borrower default, banks will choose the probability of default band into which a loan will be slotted.

It then becomes very important how the banks carry out this ‘slotting’. When banks assess a borrower’s probability of default the assessment can be based on current economic conditions (where the rating will be conditioned on the point in the cycle) or can take into account the effect on the borrower of a possible adverse change in the climate. [...] The new element under Basel II is the additional procyclicality which will come from the latter element. [...]

Strongly procyclical capital requirements could cause severe macro economic effects by creating credit crunches in recessions, thereby exacerbating the economic downturn. They could also encourage excessive lending in booms. An important policy issue is therefore whether banks would choose to adopt more stable ratings across the cycle, which would moderate the procyclical effects, or whether they would adopt ratings conditioned on the point in the cycle even though this could lead to an inability to meet demands for credit in a downturn.Source: Eva Catarineu-Rabell, Patricia Jackson and Dimitrios P Tsomocos in “Procyclicality and the new Basel Accord–banks’ choice of loan rating system“

Procyclicality, bank provisions and IAS 39

In addition to the minimum capital requirements, the role of bank provision is important. Turner argues that the ideal response to procyclicality is for banks to make adequate provisions for possible loan losses. Often however, he says, tax laws limits the tax deductibility of precautionary provisioning because loan loss provisions increase internal funding for the bank only to the extent that they reduce taxes. Furthermore, securities authorities like the SEC have argued that precautionary provisioning distorts financial reports and may mislead investors. The building up of provisions may conflict with the demand for well-document accounting. Philipp Turner in “Procyclicality of Regulatory Ratios?“

More specificially, the introduction of International Accounting Standard 39 requiring fair-value accounting make bank provisions more pro-cyclical, as José Viñals discusses:

IAS39 adds to procyclicality in the financial system through the introduction of fair-value accounting. [...] There is also a serious risk that, if the new rules are interpreted too rigidly, they could discourage, complicate and even prevent the implementation of some solutions to the procyclicality problem such as forward-looking provisioning.

Consequently, IAS39 might not only exacerbate procyclicality but also make it more difficult for regulatory policy to deal with procyclicality. In particular, Basel II is mainly about capital (to cover unexpected losses) and thus does not deal in depth with provisions (e.g. to cover expected losses, as in the case of forward-looking provisions). In turn, IAS39 contemplates only ‘incurred losses’ as far as provisions are concerned. Hence, under a rigid interpretation, IAS39 would not be compatible with a system of forward-looking provisions.

Solutions for Pro-Cyclicality

The problem of pro-cyclicality reflects a deeper problem of financial regulation. On the one hand, financial regulation for banks under Basel II was made more sensitive to the business cycle by relying on external credit assessment (in pillar 1 of Basel II) and fair-value-accounting (in pillar 3 of Basel II). The motivation behind these changes was to move away from the often arbitrary risk-weights assigned in Basel I. However, with more risk sensitivity of financial regulation, banks amplify the business cycles and contribute to systemic risk. In other word, the methods to avoid systemic risk are contributing to increase systemic risk.

There are a handful of proposals to change various aspects of Basel II. George G. Pennacchi, for example, suggests moving to a risk-based deposit insurance system which encourages less procyclicality of bank loans then risk-based capital ratios. In a policy brief from the FSA, the authors discuss between adjusting “Pillar 1″ or “Pillar 2″ approach to counter procyclicality. “Pillar 1″-approach would be the modification of rating methodologies for capital requirements, “Pillar 2″-approach would mean relying increasingly on procyclicality stress tests to increase, if necessary, regulatory capital. The authors argue that the “Pillar 2″-approach is politically more feasible while the “Pillar 1″-approach would make more sense.

Several authors call for a more comprehensive approach to tackle the problem. In a speech given by William R White, Economic Adviser and Head of Monetary and Economic Department of the Bank for International Settlements, advocates a “new macrofinancial stability framework” which encourages regulators and central banks to resist the pro-cyclicality of the financial system.

Such a system would pay attention to the impact of systemic shocks, a close cooperation between central bankers and regulators in assessing the build-up of systemic risks, and a countercyclical use of policy instruments. Monetary policy and regulation would push in the same direction: credit tightening in times of growth and credit expansion in recession would go together with a biased regulatory policy of risk spreads (for expected losses), provisioning (for subsequent changes in expected losses), and capital (for unexpected losses) being increased in good times and decreased in bad times. He proposes to alter the capital required for credit risk with a formula based on estimates of system-wide increases in exposure. The formula could make use of the rate of growth of aggregate credit and asset prices from longer-term trends.

White advocates a international agreement for such a framework and improving risk management procedures under Basel II. The biggest impediment against moving towards such an international agreement, assuming consensus on the causes of the crisis and availability of the appropriate tools, is the act to will. Policy makers face the bureaucratic inertia and vigorous lobbying (against reacting) from the many people being made rich by the crisis. Central bankers face the problem that counter-cyclical regulation and tightened credit could strangulate an economy more than necessary. Regulators face the problem of not having long cultural tradition of concern for macroprudential issues and not seeing the big-picture of macro-financial stability. White suggests to include an automatic response to the procyclical tendencies of the financial system. (See also Whites paper “Procyclicality in the financial system: do we need a new macrofinancial stabilisation framework?” and the similar suggestions by Claudio Borio, Craig Furfine and Philip Lowe).

Conclusion

Business cycles are a necessary characteristic of an open economy. The fact that the financial systems moves along with the business cycle is a necessesary consequence of the fact that the actions of the financial system reflect the underlying changes in the real economy.

Regulators, central banks and policy-makers have a natural tendency to dampen the business cycle: through the use of fiscal, monetary and regulatory policy. To some extent it is however not possible to get rid of both things at the same time: financial instability and pro-cyclicality.

Financial stability rests on using the information about the state of risk provided by the market, but at the same time pro-cyclicality is increased by relying to heavily on the market for providing information about risk. Pro-cyclicality and financial stability are two sides of the same coin.

See also

• Concepts and Measurement of Risk - Article by Borio, Furfine, Lowe
• Project: Mapping the Financial Governance
• Overview of 2008 FSF Report on Financial Stability
• Discussion of 2008 FSF Report on Financial Stability
• Trilemma in financial supervision - Schoenmaker, Oosterloo
• Intergovernmentalism in Financial Regulation
• IADI - International Association of Deposit Insurers
• Deutsche Bank - Banking and Stock Glossary
• Bill Cara: Finance Ministers vs. Central Bank Governors
• BCBS - Basel Committee on Banking Supervision