Basel and procyclicality: a comparison of the standardised and IRB approaches to an improved credit risk method

The regulation of bank capital in the form of capital adequacy requirements is itself inherently procyclical; it bites in downturns, but fails to restrain in booms. The more risk-sensitive the regulation, the greater the scope for pro-cyclicality to become a problem, particularly in view of the changing nature of macroeconomic cycles. The simulation exercises performed in this paper suggest that the new Basel II accord, which deliberately aimed at significantly increasing the risk sensitiveness of capital requirements, may in fact considerably accentuate the procyclicality of the regulatory system. Since the experience in the past, also discussed in this paper, suggests that a required hoisting of capital ratios in downturns may be brought about by cutting back lending rather than raising capital, the new capital accord may therefore lead to an amplification of business cycle fluctuations, especially in downturns.