Think Flat

The bubble, crash, repeat cycle of the economy is starting to take its toll, and many are wondering what can be done to stem this unhealthy process. Regulation appears to be one solution, and the international banking community points to the Basel II accord as a framework to better manage capital adequacy and market, operational and credit risk—curbing the boom/bust cycle.

 This may be so, and Basel II is no doubt an upgrade over the original Basel Accord, but many critics counter explanations of benefits with cries of “procyclicity”. Procyclicity is the exaggeration of upturns and downturns caused by tenets of, in this case at least, a piece of regulatory policy.

The inherent purpose of Basel II is to aid regulators in determining the appropriate amount capital banks must hold in reserve. The amount of capital cushion necessary is determined by the riskiness of a bank’s lending and investment practices. This is all well and good in boom cycles where assets are perceived and rated to be less risky than they really are (see CDOs), but in a “black swan” scenario, like the credit crunch, things can very quickly go from bad to much, much worse.

Critics point to the fact that capital requirements regulations like Basel II force banks to raise capital when the creditworthiness of their loans and investments are downgraded. Thus, when millions of subprime-mortgages and their derived securities go from high to junk ratings, banks are pushed to sell assets, issue stock, and seek cash infusions from the government. Banks are also less likely to issue new loans (more loans equals more cash needed), hindering economic growth and recovery.

Sounds depressing (literally), but it is important to remember that the root of procyclicity is low capitalization and poor risk management. In credit crunch-like situations, undercapitalized banks are forced to make rash decisions, and cutting lending is usually one such decision. Basel II works to improve risk detection and pushes for the development of early-warning systems, allowing these banks to build up adequate capital before a crunch occurs. Basel II also calls for banks to conduct “stress tests”, measuring capital adequacy in various economic scenarios.

The bottom line is that though it may have some procyclical attributes, Basel II is a regulatory upgrade which will provide a more stringent capital adequacy and risk management framework to the banking industry. It is also still a work in progress, and in late July the Basel Committee on Banking Supervision and International Organization of Securities Commissions proposed a serious of fixes to improve the regulations. In next week’s blog entry, I’ll discuss these reforms and their potential impacts on the banking industry.

For in-depth analyses of other Governance, Risk and Compliance issues, check out our GRC edition of FINsights.