Academic journal article Economic Perspectives

Cyclical Implications of the Basel II Capital Standards

Academic journal article Economic Perspectives

Cyclical Implications of the Basel II Capital Standards

Article excerpt

Introduction and summary

One of the central changes proposed as part of the new Basel II regulatory framework is the concept of internal-rating-based (IRB) capital requirements. (1) Under the IRB approach, the amount of capital that a bank will have to hold against a given exposure will be a function of the estimated credit risk of that exposure. Estimated credit risk in turn is taken to be a predetermined function of four parameters: probability of default (PD), loss given default (LGD), exposure at default (EAD), and maturity (M). Banks operating under the "Advanced" variant of the IRB approach will be responsible for providing all four of these parameters themselves, based on their own internal models. Banks operating under the "Foundation" variant of the IRB approach will be responsible only for providing the PD parameter, with the other three parameters to be set externally by the Basel committee. (2)

It is clear that there are many potential benefits to further refining the existing risk-based capital requirements. As compared with the "one-size-fits-all" approach embodied in the original Basel I framework, IRB capital requirements should reduce pricing distortions across loan categories, as well as the accompanying incentives for banks to engage in various forms of regulatory capital arbitrage. At the same time, this new approach to capital regulation raises some concerns. One concern that has been voiced repeatedly--but has been subject to relatively little formal analysis is that the new capital standards will exacerbate business cycle fluctuations. In brief, the idea is that in a downturn, when a bank's capital base is likely being eroded by loan losses, its existing (non-defaulted) borrowers will be downgraded by the relevant credit-risk models, forcing the bank to hold more capital against its current loan portfolio. To the extent that it is difficult or costly for the bank to raise fresh external capital in bad times, it will be forced to cut back on its lending activity, thereby contributing to a worsening of the initial downturn.

Our aim in this article is to take a closer look at this "cyclicality" aspect of the Basel II capital regulations. There are two primary components to our analysis. First, we start by developing a conceptual framework, which can be used to ask questions about the optimality of the proposed regulations. Our main conclusion here is that the Basel II approach of having a single time-invariant "risk curve"--that maps credit-risk measures (such as the PD) into capital charges--is, in general, suboptimal. From the perspective of a social planner who cares not just about bank defaults per se, but also about the efficiency of bank lending, it is more desirable to have a family of risk curves, with the capital charge for any given degree of credit-risk exposure being reduced when economy-wide bank capital is scarce relative to lending opportunities (as in, for example, a recession). (3)

Of course, this is only a theoretical argument, and it leaves unanswered one key empirical question: How big might the costs associated with the imperfect Basel II approach plausibly be? Although this question is hard to answer fully, we attempt to make some progress on it in the second part of our analysis. We do so by simulating the degree of capital-charge cyclicality that would have taken place over the four-year interval 1998-2002 had the Basel II regulations been in force during this period.

Although several other recent papers have undertaken similar exercises, we make an effort to be relatively comprehensive, along several dimensions. (4) First, recognizing that banks may use different types of credit-risk models to arrive at parameters such as the PD, we do all of our simulations with two distinct categories of models: 1) a model based on Standard and Poor's (S&P) credit ratings; and 2) a model developed by the consulting firm KMV, which is based on a Merton (1974) option-pricing approach to estimating default probabilities. …

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