Tools for Mitigating the Procyclicality of Financial Regulation

Mario Quagliariello, European Banking Authority

basel-iii-beyond-book

This article was first published as a chapter in Basel III and Beyond, by Risk Books.

6.1 Introduction

This chapter deals with the issue of procyclicality in the financial sector. First, it describes how capital regulation can amplify the natural fluctuations of bank intermediation. Second, it provides a comprehensive overview of the measures adopted by the Basel Committee on Banking Supervision (BCBS) for mitigating procyclicality as well as tackling the shortcomings of the Basel II framework.

The nature of credit markets and their imperfections make banks’ activity inherently cyclical. Unquestionably, a certain degree of cyclicality is expected and somehow desirable since it reflects the link between the banking and the nonfinancial sectors. Cyclicality turns into a policy concern – procyclicality – when it contributes to the amplification of economic cycle fluctuations and undermines the stability of the financial system. Indeed, the crisis has shown with dramatic clarity to what extent flawed regulatory frameworks and poor supervision can reinforce the cyclicality of the financial sector. In the aftermath of the crisis, when recessionary conditions spread worldwide, it

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