TROUBLESHOOTING BASEL II: THE ISSUE OF PROCYCLICALITY

A widespread concern about Basel II capital requirements is that it might amplify business cycle fluctuations, forcing banks to restrict their lending when the economy goes into recession. Under the IRB approach of Basel II, capital requirements are increasing functions of the probability of default (PD), loss given default (LGD) and exposure at default (EAD) parameters estimated for each borrower, and these inputs are likely to rise in economic downturns. In this paper, we compare two alternative procedures that are designed to somehow moderate the procyclical effects induced by Basel II - type capital regulation. The starting points of our analysis consist Jokivuolla, Kiema and Vesala (2009) and Repullo and Suarez (2009), who both examined the impact of regulatory capital's procyclical effects. It's vital to note remarks of Caprio (2009), that is, making regulatory capital levels countercyclical could worsen the state of an economy during a recession. As we do not have access to the Romanian Central Credit Register database, we compute a model-economy that stands as a proxy for the Romanian firms' sector. Our simulated Romanian economy can be characterised by all Romania-specific macroeconomic controls. Then we estimate a model of PDs during the period 2000 - 2010, and based on the estimated probabilities of default we compute the corresponding series of Basel II capital requirements. After the diagnosis of procyclicality, we analyze two procedures that try to mitigate the cyclical effects of capital regulation: smoothing the output of the Basel II formula, and smoothing the input, by construction of through-the-cycle (TTC) PDs. The comparison of the different procedures is based on the criterion of minimizing the root mean square deviations of each adjusted series. Our results show that the best ways to moderate procyclicality are either to smooth the input of the Basel II formula by using through-the-cycle PDs, or to smooth the output with a multiplier based on GDP growth. We conclude that the GDP-based smoothing may be more efficient than the use of TTC PDs in terms of simplicity and transparency. In terms of the GDP adjustment, regulatory capital levels should increase with approx. 1,31% during an economic growth period and decrease with 4,03% during a recession, in order to mitigate the cyclical effects induced by Basel II - type capital regulation.Basel II, procyclicality, regulatory capital, probability of default, credit-crunch

Monetary and Fiscal Policy in a Large Asymmetric Monetary Union - A Dynamic Three-Country Analysis

This paper analyzes the dynamic effects of anticipated monetary and fis- cal policies in a large monetary union, which is characterized by asym- metric interest rate transmission. We explicitly solve the asymmetric three-country model using the decomposition methods of Aoki (1981) and Fukuda (1993). Anticipated monetary and fiscal expansions lead to negative international spillovers and to intertemporal reversals in the re- lative effectiveness of policy on member country outputs. Intertemporal international coordination of monetary policies between Euroland and the US is able to stabilize the output adjustment processes induced by an anticipated unilateral fiscal expansion. --Monetary Union,Fiscal Policy,Monetary Policy,Policy Coordination

"Finance in a Classical and Harrodian Cyclical Growth Model"

This paper is an extension of an earlier working paper ("Finance and the Macroeconomic Process in a Classical Growth and Cycles Model," Levy Institute Working Paper No. 253). The basic structure of the model remains unchanged in that it is based on a social accounting matrix (SAM) with endogenous money. Investment in circulating capital adds to output and investment in fixed capital adds to potential output. Driving the model's fast adjustment process, which describes the disequilibrium adjustment between aggregate demand and supply, is the dual disequilibria relationship in which the excess of monetary injections over desired money holdings fuels spending in the markets for goods and services. This excess also spills over into the bond market and lowers the interest rate. The model's slow adjustment process entails adjustments in fixed investment so that actual and normal (desired) capacity utilization fluctuate around each other. Over the long run investment is internally financed and regulated by the rate of profit. The current paper has three innovations. First, inventory investment is treated explicitly. Second, the SAM itself has been split into a current and capital account, thereby making it easier to derive the balance sheet counterpart of the flow matrix. Third, the paper discusses the stability properties of the 4 x 4 nonlinear differential equation system that describes the fast adjustment process. The key to stability is the negative feedback effect of business debt on investment. In the 4 x 4 case, a necessary condition for stability is that the reaction coefficient h2 on the debt term in the circulating investment equation be positive; a necessary and sufficient condition is that h2 ³h2* where h2* is some critical value. In crossing this critical value, the system undergoes a Hopf bifurcation. Finally, if the model is reduced to a 3 x 3 system by considering a budget deficit that is wholly bond financed, then necessary and sufficient conditions for stability can be derived using the "modified" Routh-Hurwitz conditions. These stability conditions, in this case, imply that h2 > 0

Finance in a Classical and Harrodian Cyclical Growth Model

This paper is an extension of an earlier working paper ("Finance and the Macroeconomic Process in a Classical Growth and Cycles Model," Levy Institute Working Paper No. 253). The basic structure of the model remains unchanged in that it is based on a social accounting matrix (SAM) with endogenous money. Investment in circulating capital adds to output and investment in fixed capital adds to potential output. Driving the model's fast adjustment process, which describes the disequilibrium adjustment between aggregate demand and supply, is the dual disequilibria relationship in which the excess of monetary injections over desired money holdings fuels spending in the markets for goods and services. This excess also spills over into the bond market and lowers the interest rate. The model's slow adjustment process entails adjustments in fixed investment so that actual and normal (desired) capacity utilization fluctuate around each other. Over the long run investment is internally financed and regulated by the rate of profit. The current paper has three innovations. First, inventory investment is treated explicitly. Second, the SAM itself has been split into a current and capital account, thereby making it easier to derive the balance sheet counterpart of the flow matrix. Third, the paper discusses the stability properties of the 4 x 4 nonlinear differential equation system that describes the fast adjustment process. The key to stability is the negative feedback effect of business debt on investment. In the 4 x 4 case, a necessary condition for stability is that the reaction coefficient h2 on the debt term in the circulating investment equation be positive; a necessary and sufficient condition is that h2 ³h2* where h2* is some critical value. In crossing this critical value, the system undergoes a Hopf bifurcation. Finally, if the model is reduced to a 3 x 3 system by considering a budget deficit that is wholly bond financed, then necessary and sufficient conditions for stability can be derived using the "modified" Routh-Hurwitz conditions. These stability conditions, in this case, imply that h2 > 0.

Monitoring pro-cyclicality under the capital requirements directive : preliminary concepts for developing a framework

This paper provides an overview of the questions that will need to be addressed in order to determine whether increased cyclicality in capital requirements will exacerbate the pro-cyclicality in the financial system. Many central banks have raised concerns about the potential cost of procyclicality that could come with the Basel II framework, which will be implemented in the EU via the Capital Requirements Directive (CRD). Previous capital adequacy rules required banks to hold a minimum amount of capital for each loan, regardless of the different risks involved. The main objective of the Basel II framework/CRD is to make capital requirements more risk-sensitive. Therefore, by construction, the capital requirements under the CRD will be more cyclical than under the previous rules. This raises two questions. First, does it matter whether regulatory capital requirements fluctuate more than before if banks’ (lending) behaviour is driven by other capital considerations (for example economic capital) ? Second, if it does matter, what impact will this have on the economic cycle?Basel II/CRD, pro-cyclicality

Job Reallocation and Productivity Growth under Alternative Economic Systems and Policies: Evidence from the Soviet Transition

How do economic policies and institutions affect job reallocation processes and their consequences for productivity growth? This paper studies the extreme case of economic system change and alternative transitional policies in the former Soviet Republics of Russia and Ukraine. Exploiting annual manufacturing census data from 1985 to 2000, we find that Soviet Russia displayed job flow behavior quite different from market economies, with very low rates of job reallocation that bore little relationship to relative productivity across firms and sectors. Since liberalization began, the pace, heterogeneity, and productivity effects of job flows have increased substantially. The increases occurred more quickly in rapidly reforming Russia than in “gradualist” Ukraine, as did the estimated effects of privatization and competitive pressures from product and labor markets on excess job reallocation and on the productivity-enhancing effects of job flows.http://deepblue.lib.umich.edu/bitstream/2027.42/39899/3/wp514.pd

Time deposits in monetary analysis

Certificates of deposit ; Savings accounts

Asset correlations and credit portfolio risk: an empirical analysis

In credit risk modelling, the correlation of unobservable asset returns is a crucial component for the measurement of portfolio risk. In this paper, we estimate asset correlations from monthly time series of Moody's KMV asset values for around 2,000 European firms from 1996 to 2004. We compare correlation and value-atrisk (VaR) estimates in a one-factor or market model and a multi-factor or sector model. Our main finding is a complex interaction of credit risk correlations and default probabilities affecting total credit portfolio risk. Differentiation between industry sectors when using the sector model instead of the market model has only a secondary effect on credit portfolio risk, at least for the underlying credit portfolio. Averaging firm-dependent asset correlations on a sector level can, however, cause a substantial underestimation of the VaR in a portfolio with heterogeneous borrower size. This result holds for the market as well as the sector model. Furthermore, the VaR of the IRB model is more stable over time than the VaR of the market model and the sector model, while its distance from the other two models fluctuates over time. --Asset correlations,sector concentration,credit portfolio risk