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Adverse Feedback Loop in the Bank-Based Financial Systems

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Abstract

This paper examines procyclicality of the financial system. The introduction describes the natural and regulatory sources of procyclicality, focusing on the potential procyclical effect of the current Basel II regulatory framework for banks. It also mentions the regulatory tools for mitigating procyclical behaviour by financial institutions currently being discussed in international forums. Under certain conditions, procyclical behaviour of the banking sector can lead to an adverse feedback loop whereby banks, in response to an economic downswing, engage in deleveraging and reduce their lending to the economy in order to maintain the required capital adequacy ratio. This then further negatively affects economic output and impacts back on banks in the form of, for example, increased loan losses. In the main empirical section of the paper, this effect was simulated on the example of the Czech banking sector. The simulation results suggest that under certain assumptions the feedback loop may play an important role.

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File URL: http://ies.fsv.cuni.cz/default/file/download/id/14150
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Bibliographic Info

Paper provided by Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies in its series Working Papers IES with number 2010/14.

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Length: 16pages
Date of creation: Jul 2010
Date of revision: Jul 2010
Handle: RePEc:fau:wpaper:wp2010_14

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Keywords: procyclicality; feedback loop; bank regulation; deleveragin;

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  1. Eva Ryšavá & Elisa Galeotti, 2009. "Determinants of FDI in Czech Manufacturing Industries between 2000-2006," Working Papers IES 2009/17, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised Apr 2009.
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