Working Paper: CEPR ID: DP7382
Authors: Rafael Repullo; Jess Saurina; Carlos Trucharte
Abstract: This paper compares alternative procedures to mitigate the procyclicality of the new risk-sensitive bank capital regulation (Basel II). We estimate a model of the probabilities of default (PDs) of Spanish firms during the period 1987-2008, and use the estimated PDs to compute the corresponding series of Basel II capital requirements per unit of loans. These requirements move significantly along the business cycle, ranging from 7.6% (in 2006) to 11.9% (in 1993). The comparison of the different procedures is based on the criterion of minimizing the root mean square deviations of each smoothed series with respect to the Hodrick-Prescott trend of the original series. The results show that the best procedures are either to smooth the inputs of the Basel II formula by using through-the-cycle PDs or to smooth the output with a multiplier based on GDP growth. Our discussion concludes that the latter is better in terms of simplicity, transparency, and consistency with banks? risk pricing and risk management systems. For the portfolio of Spanish commercial and industrial loans and a 45% loss given default (LGD), the multiplier would amount to a 6.5% surcharge for each standard deviation in GDP growth. The surcharge would be significantly higher with cyclically-varying LGDs.
Keywords: bank capital regulation; Basel II; business cycles; credit crunch; procyclicality
JEL Codes: E32; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| PDs during economic downturns (F44) | Basel II capital requirements (G28) |
| Basel II capital requirements (G28) | bank lending (G21) |
| GDP growth (O49) | Basel II capital requirements (G28) |
| smoothing procedures (TTC PDs or GDP growth multipliers) (O49) | Basel II capital requirements (G28) |
| GDP growth multiplier (F62) | Basel II capital requirements (G28) |