Basel II could reinforce economic cycles more than expected

The Basel II bank capital accord could reinforce economic cycles to a greater extent than expected, according to a working paper issued today by the Bank for International Settlements (BIS), the so-called central bankers’ central bank.

The paper shows that the link between bank loan losses and the probability of the default on loans is likely to bring about a sharp increase in the ‘procyclicality’ effect of the complex Basel II accord. Under the accord, banks will be free to use their own estimates of the severity of the credit risk they face.

Many national regulators have expressed fears that the risk-based Basel II accord, which global banking regulators hope to enforce in late 2006, could exacerbate economic cycles. It is feared that the sensitivity of banks to risk could result in over-lending at the top of economic cycles and sharply reining in lending at the bottom of cycles as banks adjust the amount of protective capital they need to hold.

Today’s paper said bank capital and credit supply might behave even more procyclically than expected, if banks tend to revise their risk estimates upwards in ‘bad’ economic times.

The Basel Committee on Banking Supervision, the architect of the Basel II accord, last month reached agreement on most of the outstanding issues of the accord.

To address the concerns, the committee said Basel II would require banks to carry out “meaningfully conservative” credit risk stress testing under the internal ratings-based (IRB) approach to credit risk. This would help ensure banks hold a sufficient capital buffer under pillar 2 of the three-pillar accord.

Pillar 2 provides for close supervision of banks by regulators, which could require banks to hold more or less capital according to the regulators’ perception of risks faced by the banks. Capital charges are made under pillar 1, while pillar 3 requires banks to disclose more information about their risk management practices.

The Basel Committee also said the procyclicality issue would be discussed in a Basel II overview paper that it hopes to issue on October 1, when it also plans to issue its third Basel II quantitative impact study, or QIS 3.

The BIS paper said that since average credit ratings and default rates are sensitive to business-cycle effects, the IRB approach is more dependent on the economic cycle, increasing capital charges, and restricting bank lending, just when the economy is slowing.

The paper found “a significant correlation between macroeconomic measures and bond rates/defaults; so we might expect that lower recovery rates when defaults are high would exacerbate bank loan losses in those periods”.

When banks using the IRB approach are free to estimate their own severity rates, they might tend to adjust these estimates according to the economic cycle, the paper said.

The study added: “As default rates increase, and [credit] ratings worsen, LGDs [loss given defaults] would be revised upwards, making Basel capital even more procyclical than expected.”