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Mitigating the Procyclicality of Basel II

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  • Repullo, Rafael
  • Saurina, Jesús
  • Trucharte, Carlos

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.

Suggested Citation

  • Repullo, Rafael & Saurina, Jesús & Trucharte, Carlos, 2009. "Mitigating the Procyclicality of Basel II," CEPR Discussion Papers 7382, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:7382
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    References listed on IDEAS

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    More about this item

    Keywords

    Bank capital regulation; Basel II; Business cycles; Credit crunch; Procyclicality;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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