Basel II and pro-cyclicality

The main argument for making regulatory capital requirements more risk-sensitive is to improve allocational efficiency. But this may lead to intensified business cycles if regulators fail to take measures to prevent such an impact. In this first column in a series, David Rowe reviews the rationale for risk-sensitive rules, and how they could magnify business cycles


Allocating credit to those areas promising the highest return relative to the risk is the central economic function of financial markets. This drives dynamic economic efficiency and prevents the massive waste of resources caused by misdirection of society’s limited quantity of savings. Obviously such market decisions are never perfect in hindsight. Experience shows, however, that open and competitive financial markets are the best means of maximising such allocational efficiency.


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