Mitigating the Procyclicality of Basel II

44 Pages Posted: 26 Aug 2009

See all articles by Rafael Repullo

Rafael Repullo

Centre for Monetary and Financial Studies (CEMFI); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Jesus Saurina Salas

Banco de España

Carlos Trucharte

Banco de España

Date Written: July 2009

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.

Keywords: Bank capital regulation, Basel II, Business cycles, Credit crunch, Procyclicality

JEL Classification: E32, G28

Suggested Citation

Repullo, Rafael and Saurina Salas, Jesus and Trucharte, Carlos, Mitigating the Procyclicality of Basel II (July 2009). CEPR Discussion Paper No. DP7382. Available at SSRN: https://ssrn.com/abstract=1462011

Rafael Repullo (Contact Author)

Centre for Monetary and Financial Studies (CEMFI) ( email )

Casado del Alisal 5
28014 Madrid
Spain
+34 91429 0551 (Phone)
+34 91429 1056 (Fax)

HOME PAGE: http://www.cemfi.es/~repullo/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Jesus Saurina Salas

Banco de España ( email )

Madrid 28014
Spain

Carlos Trucharte

Banco de España ( email )

Alcala 50
Madrid 28014
Spain

HOME PAGE: http://www.bde.es

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