Basel II and the Cyclicality of Bank Capital

Within the next several years, implementation of an updated global bank capital accord (Basel II) will commence in a number of countries. The new framework is designed to align bank capital more closely with the likelihood of financial losses and thereby ensure that appropriate levels of capital are held by the banking system. In particular, capital requirements for credit risk will be modified along the lines of how the most sophisticated banks currently calculate capital for their loan portfolios. Since credit risk is strongly related to the business cycle, however, it is useful to examine the degree to which minimum capital requirements for banks are likely to be cyclical. This is achieved by conducting a counterfactual simulation of the proposed rules. When applied to Canadian banking-system data over the period 1984­2003, it is found that minimum required bank capital, as specified by Basel II's first "pillar" for its calculation, will likely fall in level terms. Perhaps more importantly, sensitivity analysis, including that based on different compositions of bank loan portfolios, shows the potential for an increase in the volatility of minimum capital requirements. In addition, changes in minimum required capital and provisions will likely be countercyclical. That is, they will increase during recessions and fall during economic booms. To the extent that these capital requirements influence banks' lending behaviour, there are potential implications for the performance of the economy.