Banking Regulation Basel II

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Procyclicality in minimum regulatory capital charges for credit risk There is a vast amount of literature available on the additional procyclicality of regulatory capital charges in Pillar 1 of Basel II. In this section, we shall briefly visit this literature and see if any conclusions can be drawn from this, before proceeding to the conclusion and mitigation of these procyclical effects. The majority of the literature, as expected, focuses primarily on the IRB approach, as this aspect of Basel II has drawn the most criticism from financial practitioners and academics alike. The greater part of this literature has found that there is an overwhelmingly substantial rise in procyclicality of minimum regulatory capital charges originating from the IRB approach. Gordy and Howells found that under the IRB approach, volatility in the capital charge, relative to the mean, is between 0.1 to 0.26 (Gordy & Howells, 2004). This follows another study by Kashyap and Stein, which shows that capital charges rose by 70-90% during the years of 1998 to 2002 dependant of the model used to calculate PD’s (Goodhart & Taylor, 2004). The implications of these findings are as follows. The works of these academics highlight the important point that there is higher volatility of capital charges for better quality credits (Goodhart & Taylor, 2004). This is because these credits face a steeper risk curve, as the movement within the ratings scale (from one rating to another) is much greater. Possible Solutions to mitigate procyclicality Now that we have reviewed the literature and empirical evidence on the problem of procyclicality arising from Basel II, we shall see how these problems may be addressed. As already noted, regulatory capital requirements, thr... ... middle of paper ..., Basel: Basel Committee on Bank Supervision. Elizalde, A., 2007. From Basel I to Basel II, Madrid: CEMFI. FSF & BCBS, 2009. Reducing procyclicality arising from the bank capital framework, Basel: BCBS. Goodhart, C. & Taylor, A., 2004. Procyclicality and volatility in the financial system: The implementation of Basel II and IAS 39, London: London School of Economics. Gordy, M. & Howells, B., 2004. Procyclicality in Basel II : Can we treat the disease without killing the patient?, s.l.: Federal Reserve Board. Larson, J., 2011. The Basel Capital Accords, s.l.: University of Iowa Press. Lowe, P., 2002. Credit Risk measurement and procyclicality, Basel: Bank for International Settlements. Moody's Analytics, 2011. An Introduction to TTC Public Firm EDF Credit Measures, s.l.: Moody's . Repullo, R. & Suarez, J., 2007. The Procyclical Effects of Basel II, Madrid: CEMFI.

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