Introduction
Banks play a very important role in the growth of any economy. Banks provide various financial services such as lending cash and payment of services. One of the most challenging tasks with regard to the issue of managing banks is regulation. Since banks are support structures to the economy, there is the need to ensure that they are highly regulated. However, questions have been raised regarding the right way to regulate these financial institutions. Following the aftermath of the recent global financial crisis and the impact it had on the banking sector, the effectiveness of banking regulation remains questionable. The major debate on bank regulation has been whether the pro-cyclical bank regulation should be adopted (Barth, Caprio & Levine, 2008, p. 76). In isolation, the pro-cyclical bank regulations cannot be effective in regulating the pro-cyclical effects of financial institutions.
Pro-cyclical banks regulations
Economic activities are naturally cyclical. There is evidence of cycles in economic activities. Some of the cycles result in favorable economic situations while others yield bad economic situations. Banking, as an important element of economic activities, is also cyclical. Evidence of the cyclical nature of economic activities abounds (Suarez, 2008, par 3). The recent financial and economic crisis is a good example of the cyclical nature of economic activities. In this case, the cyclical nature of economic activities calls for regulation. It is the responsibility of regulators to ensure that economic cycles do not bring negative effects to people. Regulators have the responsibility of ensuring that banks are able to prevent the occurrence of bad economic cycles. Apart from banks having cyclical nature, they also show pro-cyclical features. Banks can contribute to bad economic cycles. In fact, banks are the most pro-cyclical economic institutions. Banks lead to pro-cyclical effects in various ways. For example, excessive lending in a good economic situation can lead to financial or economic problems. On the other hand, banks can avoid lending money in bad economic situations leading to an economic downturn.
The element of financial risk taken by banks in offering financial services has been of high concern to regulators. It is clear that excessive risk-taking can affect economic cycles. Pro-cyclical regulations are regulations that try to mitigate the pro-cyclical nature of banks. These regulations take into account the fact that banks have a high potential of affecting financial and economic cycles (Suarez, 2008, par 5). Basel 2 model, the new banking approach, is viewed as a solution to challenges in Basel 1 model. Basel 1 model of capital regulation has a flat capital regulation depending on the loan. On the other hand, Basel 2 model is risk-sensitive in the sense that the capital requirements vary with the risk of credit. Although this model is meant to mitigate the pro-cyclical effects of banks, it can cause pro-cyclical effects by itself.
Basel 2 was viewed as a solution to financial market risk. The model provided criteria to regulate capital requirements depending on the risk of credit. The rationale behind introducing Basel 2 model was to make the capital requirements to be proportional to credit risk. This implied that a bank’s minimum capital requirement would rise when there was a higher risk in the market and drop when there is less risk in the market. Although this model can mitigate some pro-cyclical effects, it can also lead to pro-cyclical effects. In case of recession, the regulations can contribute to pro-cyclical effects.
Capital requirements highly contribute to the pro-cyclical effects of banking institutions. Capitals requirement can affect the pro-cyclical effects even in a Basel 1 model. This is especially the case when a bank incurs losses. In such a case, losses would lower a bank’s lending potential and consequently affect economic cycles. The pro-cyclical effects of banking regulation are more evident in the risk-sensitive regulation Basel 2 model. In an Internally Rating Based approach in Basel 2 model, the pro-cyclical effect can occur even when the capital of a bank is not affected. Pro-cyclical regulations can lead to pro-cyclical effects through various contradictions in credit supply.
There are two basic necessary conditions for the contradictory effects of pro-cyclical regulations to occur. The first condition is that the banks must not be able to respond to the capital requirement through additional equity. The second condition is that the borrowers should fail to find other alternative sources of finance. Although these conditions are essential, they are not sufficient for pro-cyclical effects to occur. In addition, the banks may hold capital in excess of the capital required by regulation (Barth, Caprio & Levine, 2008, p. 87). Due to fear of losses the banks can decide to hold excess capital. In addition, the banks can hold capital in order to protect their lending potential in the future. In these situations, the capital buffer may fail to counter the pro-cyclical effects caused by the regulations.
Pro-cyclical regulations are insufficient in addressing the pro-cyclical effects of banking institutions (Suarez, 2008, par 7). The regulations have some contra-productive effects, especially in a recession. The banking institution may hold capital during the recession in order to protect themselves from losses. This, in consequence, could lead to a lack of required finance for economic growth. The banks may also not be able to respond to the capital requirement. On the other hand, the bank’s customers may not be able to access another source of capital. These conditions may slow the economy even further, or lead to an economic downturn.
Solution
Pro-cyclical banking regulations are not a solution to pro-cyclical effects per se. The pro-cyclical effects of the regulation themselves can lead to even worse economic conditions. However, there are solutions to this problem. One solution is to introduce contra-cyclical regulation. These regulations have been found to be very successful in Spain (Saurina, Perez & Ayuso, 2004, p. 57). Contra-cyclical regulations heap to regulate financial and economic cycle by introducing the appropriate measure for every situation. The other alternative is to mitigate the effects of pro-cyclical effects of pro-cyclical bank regulations. One mitigation measure is to smoothen out the inputs of the Basel 2 bank regulation model. The inputs can be smoothened out by use of default probabilities (Suarez, 2008, par 11). Alternatively, the output of Basel 2 regulation can be smoothened through GDP growth multiplies. The other alternative in regulating the pro-cyclical effect of pro-cyclical bank regulation is to adjust the capital requirement depending on GDP growth. In this case, the capital requirement is adjusted through a multiplier that is determined by GDP growth. Apart from contra-cyclical regulations and mitigations to pro-cyclical regulations, banking institutions should emphasize market discipline. Although regulations are important, banking institutions should avoid engaging in risky practices.
Conclusion
The recent financial crisis has called for regulators to rethinks regulations used on banks. Financial institutions play a very important role in the economy. For this reason, regulations should ensure that banks contribute positively to the economy. Although pro-cyclical regulations mitigate some pro-cyclical effects of banks, they can also contribute to pro-cyclical effects. As a solution, contra-cyclical regulation, mitigation to pro-cyclical regulations and market discipline should be considered.
Reference
Barth, J., Caprio, G. & Levine, R. 2008, Rethinking Bank Regulation: Till Angels Govern. New York: Cambridge University Press.
Saurina, J., Perez, D. & Ayuso, J. 2004. “Are capital buffers pro-cyclical? Evidence from Spanish data”, Journal of Financial Intermediation.
Suarez, R. 2008. “The procyclical effects of Basel II”. Web.