Procyclicality of the Financial System and Simulation of the Feedback Effect

This article examines procyclicality of the financial system. The introduction describes the natural and regulatory sources of procyclicality, focusing on the potential procyclical effect of the current Basel II regulatory framework for banks. It also mentions the regulatory tools for mitigating procyclical behaviour by financial institutions currently being discussed in international forums. Under certain conditions, procyclical behaviour of the banking sector can lead to a feedback effect whereby banks, in response to an economic downswing, reduce their lending to the economy in order to maintain the required capital adequacy ratio. This then further negatively affects economic output and impacts back on banks in the form of, for example, further growth in non-performing loans. In the main empirical section of the article, this effect was simulated on the example of the Czech banking sector using the current stress-testing system and a single adverse scenario. The simulation results suggest that under certain assumptions the feedback effect may play an important role.