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Countercyclical capital regulation: should bank regulators use rules or discretion?

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  • Michal Kowalik

Abstract

One of the key features of the U.S. economy?s slow recovery from the 2007-09 recession has been abnormally low bank lending to households and corporate businesses. While demand for loans may be sluggish, much of the slowdown may stem from banks? reluctance to lend. Before resuming normal lending activity, banks must first replenish capital levels that were depleted during the financial crisis. ; Many analysts have pointed out that existing bank capital regulation can contribute to banks? reluctance to lend during recessions and into recoveries. That is, the capital requirements have a procyclical effect on lending. They make it more difficult for banks to finance loans in recessions when they would help stimulate the economy. ; In response to this problem, the Dodd-Frank Financial Reform and Consumer Protection Act of 2010 (Dodd-Frank) and the recent revision of the international Basel Accord, Basel III, mandated changes to make capital requirements countercyclical. The changes should counteract the procyclical effect of capital regulation by requiring banks to hold higher capital ratios during booms. Thus, during downturns banks would be in a better position to absorb rising losses and sustain lending to support economic growth. ; Whether countercyclical capital requirements will provide more lending in recessions depends on how they are implemented. Yet, little discussion among policymakers has focused on implementation. ; Kowalik examines the primary options for implementing countercyclical capital requirements: using a fixed rule or giving the regulatory authorities discretion in deciding when and how to act. He finds that the rule-based approach has more advantages than the approach based on discretion.

Suggested Citation

  • Michal Kowalik, 2011. "Countercyclical capital regulation: should bank regulators use rules or discretion?," Economic Review, Federal Reserve Bank of Kansas City, vol. 96(Q II).
  • Handle: RePEc:fip:fedker:y:2011:i:qii:n:v.96no.2:x:1
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    2. Mr. Itai Agur & Mr. Sunil Sharma, 2013. "Rules, Discretion, and Macro-Prudential Policy," IMF Working Papers 2013/065, International Monetary Fund.
    3. Connel Fullenkamp & Ms. Celine Rochon, 2014. "Reconsidering Bank Capital Regulation: A New Combination of Rules, Regulators, and Market Discipline," IMF Working Papers 2014/169, International Monetary Fund.
    4. Pierluigi Bologna & Anatoli Segura, 2017. "Integrating Stress Tests within the Basel III Capital Framework: A Macroprudentially Coherent Approach," JThe Journal of Financial Regulation, Oxford University Press, vol. 3(2), pages 159-186.
    5. Daniel Detzer, 2012. "New instruments for banking regulation and monetary policy after the crisis," European Journal of Economics and Economic Policies: Intervention, Edward Elgar Publishing, vol. 9(2), pages 233-254.
    6. Smith, Scott & Fuller, Debra & Bogin, Alex & Polkovnichenko, Nataliya & Weiher, Jesse, 2016. "Countercyclical capital regime revisited: Tests of robustness," Journal of Economics and Business, Elsevier, vol. 84(C), pages 50-78.
    7. Ida-Maria Weirsøe Fallesen, 2015. "The Challenges of the EU Banking Union - will it succeed in dealing with the next financial crisis?," Bruges European Economic Policy Briefings 36, European Economic Studies Department, College of Europe.
    8. Scott Smith & Jesse Weiher, 2012. "Countercyclical Capital Regime – A Proposed Design and Empirical Evaluation," FHFA Staff Working Papers 12-02, Federal Housing Finance Agency.
    9. Deepal Basak & Mr. Yunhui Zhao, 2018. "Does Financial Tranquility Call for Stringent Regulation?," IMF Working Papers 2018/123, International Monetary Fund.
    10. Allen, D.E. & Powell, R.J. & Singh, A.K., 2016. "Take it to the limit: Innovative CVaR applications to extreme credit risk measurement," European Journal of Operational Research, Elsevier, vol. 249(2), pages 465-475.

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