Basel II may feed volatility

The main thrust of author, Lea Zicchino's, argument is that under the new capital requirement framework, banks will face a double whammy during periods of economic downturn: at the same time that their loan book deteriorates, they will face increasingly stringent capital requirements as the perceived riskiness of their assets increases. The result may well be a period of credit contraction and a further weakening of growth. In short, the author is concerned that Basel II will increase the procyclicality of capital and credit, which could in turn exacerbate the economic cycle itself.

"If the economy falls into a recession or experiences a weakening in its growth, it will be more likely for banks' capital constraint to be binding and thus for credit to be rationed," the author argues. The reason for this is macroeconomic conditions affect both demand for loans and, under the new framework, banks' capital constraint.

"Since a positive shock induces a decrease in the asset risk-weights, and thus an increase in capital ratios, banks do not necessarily need to raise new capital to expand their loan supply. Analogously, since a negative shock tightens the capital constraint, a reduction in loan demand does not necessarily induce banks to decrease their capital," Zicchino explains.

This key finding is due to the fact that capital requirements are to be made risk-sensitive. According to Zicchino, this may make loan quantities more volatile, meaning bank lending will grow more (for a given level of capital) in good times, but shrink faster in bad times. The author argues that previous researchers may have underestimated this effect.

The BoE - normally not the most vocal and outspoken of central banks - has been a persistent critic of aspects of the Basel II accord. Interestingly, the banking supervision responsibilities in the UK no longer fall under the BoE, having been moved to the Financial Services Authority.

This paper is the latest addition to growing concerns from a number of central banks and academics regarding the macroeconomic impact of the Basel accord. The danger appears to be that in paying so much attention to the 'micro' prudential minutiae of the accord, the supervision experts on the Basel committee have had to downplay broader 'macro' issues, such as the potential for procyclical credit.

Although the Basel II agreement has been signed and will be implemented from 1 January 2007, it is clear that the framework is not to everyone's taste. Given the controversy and political sensitivity that characterised the negotiation of every comma and full stop of the Basel process, it remains to be seen how much scope there is for last-minute fine tuning.