The following post comes to us from Rafael Repullo, Professor of Economics at CEMFI, Madrid, Spain; and Javier Suarez, Professor of Finance at CEMFI, Madrid, Spain.
The basic argument about the procyclical effects of bank capital requirements is well-known. In recessions, losses erode banks’ capital, while risk-based capital requirements, such as those in Basel II, become higher. If banks cannot quickly raise sufficient new capital, their lending capacity falls and a credit crunch may follow. Yet, correcting the potential contractionary effect on credit supply by relaxing capital requirements in bad times may increase bank failure probabilities precisely when, because of high loan defaults, they are largest. Given the conflicting goals at stake, some observers think that procyclicality is a necessary evil, whereas others think that procyclicality should be explicitly corrected. Basel III is a compromise between these two views. It reinforces the quality and quantity of the minimum capital required to banks, but also establishes that part of the increased requirements be in terms of mandatory buffers—a capital preservation buffer and a countercyclical buffer—that are intended to be built up in good times and released in bad times.
In our paper, The Procyclical Effects of Bank Capital Regulation, forthcoming in the Review of Financial Studies, we develop a model that captures the key trade-offs in the debate. The model is constructed to highlight the primary microprudential role of capital requirements (containing banks’ risk of failure and, thus, deposit insurance payouts and other social costs due to bank failures) as well as their potential procyclical effect on the supply of bank credit.
