range of assets because this also restricts balance sheet
expansion”.
Another proposal put forward as an optimal means
of rectifying Basel IIs procyclical effects—as illustrated
through the “amplification of business cycle fluc-
tuations”, involves the utilisation of a “business cycle
multiplier of the Basel II capital requirements that is
increasing in the rate of growth of the GDP”. Under
such a scheme, it is argued, riskier “banks would face
higher capital requirements without regulation exacer-
bating credit bubbles and crunches.”49
Other mechanisms provided under the CRD as
means of mitigating pro cyclicality within the capital
requirements framework include:50
The use of downturn Loss Given Default (LGD)
estimates, PD estimates being based on long data series,
technical adjustments made to the risk weight func-
tion, stress testing requirements and Pillar 2 supervisory
review process. It is acknowledged, however, that more
measures may be required to mitigate die procyclical
effects of the capital requirements framework. Options
provided include those aimed at reducing its cyclical
risk sensitivity, measures which enhance its risk capture,
and the intentional introduction of counter-cyclical
buffers (comprising capital and/or provisions).
2. Financial Stability Forum Recommendations
Aimed at Mitigating Procyclicality
In its report51 on “Addressing Procychcality in the
Financial System”, the Financial Stability Forums rec-
ommendations to mitigate mechanisms that amplify
procyclicality was extended to three areas:52
(i) bank capital framework, ii) bank loan loss provi-
sions as well as iii) leverage and valuation issues.
A summary of the recommendations relating to cap-
ital, as provided in the Report of the Financial Stability
Fcrum is as follows:53
“That the Basel Committee OnBankingSupervision
(BCBS) should strengthen the regulatory capital
framework so that the quality and level of capital
in the banking system increase during strong eco-
nomic conditions and can be drawn down during
periods of economic and financial stress;
That the BCBS should revise the market risk frame-
work of Basel II to reduce the reliance on cyclical
VAR-based capital estimates;
The BCBS should supplement the risk-based
capital requirement with a simple, non-risk based
measure to help contain the build-up of leverage
in the banking system and put a floor under the
Basel II framework;
Supervisors should use the Basel Committee’s
enhanced stress testing practices as a critical part of
the Pillar 2 supervisory review process to validate the
adequacy of banks’ capital buffers above the minimum
regulatory capital requirement;”
“That the BCBS should monitor the impact of the
Basel II framework and make appropriate adjustments
to dampen excessive cyclicality of the minimum capital
requirements;”
“That the BCBS carry out regular assessments of the
risk coverage of the capital framework in relation to
financial developments and banks’ evolving risk profiles
and make timely enhancements.”
3. Risk Management and Governance
“Stress testing is an important risk management tool—
particularly for counter parry risk management.”54
According to the Basel Committee,55 “ as public
disclosure increases certainty in the market, improves
transparency, facilitates valuation, and strengthens mar-
ket discipline, it is important that banks publicly
disclose information on a regular basis that enables mar-
ket participants to make informed decisions about the
soundness of their liquidity risk management framework
and liquidity position.*,The involvement of market par-
ticipants in the process whereby the Committee strives
to facilitate market discipline through the development
of “a set of disclosure requirements which will allow
such market participants to assess key pieces of informa-
tion on the scope of application, capital, risk exposures,
risk assessment processes, and hence capital adequacy
of an institution"5* constitutes a vital means whereby
effective corporate governance could be facilitated.
Recent reports have revealed the lack of knowledge
demonstrated by financial institutions in relation to risks
Volume 30 ∙ Number 9 ∙ September 2011
Banking & Financial Services Policy Report ∙ 31