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The New Basel Capital Accord and the Cyclical Behaviour of Bank Capital

  • Mark Illing
  • Graydon Paulin

The authors conduct a counterfactual simulation of the proposed rules under the new Basel Capital Accord (Basel II), including the revised treatment of expected and unexpected credit losses proposed by the Basel Committee in October 2003. When the authors apply the simulation to Canadian banking system data over the period 1984–2003, they find that capital requirements for banks will likely fall in absolute terms even after allowing for the new operational risk charge (bearing in mind that the induced behavioural response of banks to the changed incentives under Basel II is not captured). The impact on the volatility of required bank capital is less clear. It will depend importantly on the credit quality distribution of banks' loan portfolios and on the precise way in which they calculate expected and unexpected losses. Sensitivity analysis, including that based on a range of hypothetical distributions for banks' loan portfolios, shows the potential for a substantial increase in implied volatility. Moreover, if historical relationships are a good indicator of the future, changes in required capital and provisions for commercial and industrial, interbank, and sovereign exposures will likely be countercyclical under Basel II (i.e., capital requirements will increase during recessions). This raises questions about the new accord's potentially procyclical impact on banks' lending behaviour, and the resultant macroeconomic implications.

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Paper provided by Bank of Canada in its series Working Papers with number 04-30.

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Length: 66 pages
Date of creation: 2004
Date of revision:
Handle: RePEc:bca:bocawp:04-30
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  1. Eva Catarineu-Rabell & Patricia Jackson & Dimitrios P.Tsomocos, 2003. "Procyclicality and the new Basel Accord - Banks' choice of loan rating system," OFRC Working Papers Series 2003fe06, Oxford Financial Research Centre.
  2. Seth B. Carpenter & William Whitesell & Egon Zakrajsek, 2001. "Capital requirements, business loans, and business cycles: an empirical analysis of the standardized approach in the new Basel Capital Accord," Finance and Economics Discussion Series 2001-48, Board of Governors of the Federal Reserve System (U.S.).
  3. Rudiger Kiesel & William Perraudin & Alex Taylor, 2001. "The structure of credit risk: spread volatility and ratings transitions," Bank of England working papers 131, Bank of England.
  4. Linda Allen & Anthony Saunders, 2003. "A survey of cyclical effects in credit risk measurement model," BIS Working Papers 126, Bank for International Settlements.
  5. C. H. Furfine & Jeffery D. Amato, 2003. "Are credit ratings procyclical?," BIS Working Papers 129, Bank for International Settlements.
  6. Samu Peura & Esa Jokivuolle, 2004. "Simulation-based stress testing of banks’ regulatory capital adequacy," Finance 0405003, EconWPA.
  7. Carling, Kenneth & Jacobson, Tor & Lindé, Jesper & Roszbach, Kasper, 2002. "Capital Charges under Basel II: Corporate Credit Risk Modelling and the Macro Economy," Working Paper Series 142, Sveriges Riksbank (Central Bank of Sweden).
  8. Edward I. Altman & Andrea Resti & Andrea Sironi, 2002. "The link between default and recovery rates: effects on the procyclicality of regulatory capital ratios," BIS Working Papers 113, Bank for International Settlements.
  9. Dimitrios P Tsomocos & Eva Catarineu-Rabell, 2003. "Procyclicality and the new Basel Accord - Banks` choice of loan rating system," Economics Series Working Papers 2003-FE-06, University of Oxford, Department of Economics.
  10. J.A. Bikker & H. Hu, 2003. "Cyclical Patterns in Profits, Provisioning and Lending of Banks," DNB Staff Reports (discontinued) 86, Netherlands Central Bank.
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