Fed’s Gordy criticises Basel II procyclicality adjustment

The procyclicality ‘smoothing’ adjustment technique likely to form part of the Basel II capital Accord is sub-optimal, according to Michael Gordy, a senior economist in the research and statistics division of the Board of Governors of the Federal Reserve System.

Gordy, speaking in a personal capacity during his keynote address to Risk’s Credit Risk Summit 2002 USA in New York today, said while he favoured smoothing regulatory minimum capital as a means of dealing with the problem of procyclicality, he did not believe altering the advanced risk-based model approach – as currently favoured by the Basel Committee on Banking Supervision, the body overseeing the implementation of Basel II – was the best solution.

Procyclicality is a term used to describe the danger that a risk-based capital rule will force banks to reduce lending during economic downturns, as the risks of their lending increase. This, some fear, would worsen the economic slump.

Regulators are keen to minimise, or ‘smooth’, this impact to ensure banks maintain their traditional role as shock-absorbers during recessions.

While Gordy believes capital regulation is the correct forum to address procyclicality, he expressed concern that smoothing procyclicality at a model level, as proposed by the Basel Committee, will damage the function of internal ratings-based (IRB) metrics for credit risk measurement. Basel regulators plan to reduce the steepness of the risk-weighted asset curve as part of an effort to reduce procyclicality.

Although there are some obvious advantages with this approach – it preserves the integrity of point-in-time ratings and is easy to implement – Gordy fears that it diminishes the value of IRB metrics for risk control.

He favours a counter-cyclical indexing as the best method to address the procyclicality issue, stating, “It causes no dislocation of bank rating systems and information from IRB disclosure.”

Using such an approach, national watchdogs would offer explicit regulatory guidance on capital buffers. For example a regulator could allow its banks to hold less than a minimum 8% of regulatory capital in times of downturn. Gordy stressed that banks would also have to disclose risk-based capital metrics as they would under existing rules without any national regulator intervention. This would ensure other banks could determine for themselves the true strength of their counterparties.

Such an explicit approach would have a strong benefit for the integrity of a bank’s own risk-based capital allocations and would ensure banks could still act as a buffer during economic downturns.