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Horváth Edit - Mérő Katalin - Zsámboki Balázs

Studies on the procyclical behaviour of banks

CONTENTS, FOREWORD


Contents


BALÁZS ZSÁMBOKI: THE EFFECTS OF PRUDENTIAL REGULATION ON BANKS' PROCYCLICAL BEHAVIOUR
1 Introduction
2 Lending cycles
3 Banking regulation and cyclicality
4 Provisioning rules and cyclicality
5 Conclusions
6 References

KATALIN MÉRŐ: FINANCIAL DEPTH AND PROCYCLICALITY
1 Introduction
2 Economic growth and financial depth
3 Procyclical character of banks' behaviour
4 The depth of financial intermediation in Hungary, the Czech Republic and Poland
5 Necessity of financial deepening and procyclicality
6 Conclusions
7 References

EDIT HORVÁTH: LENDING BOOMS, CREDIT RISK AND THE DYNAMIC PROVISIONING SYSTEM. REGULATORY REACTIONS TO PORTFOLIO PROBLEMS ARISING FROM LENDING BOOMS DURING PERIODS OF ECONOMIC EXPANSION
1 Introduction
2 Cyclical development of bank lending problem loans and provisions
3 Limitations of risk measurement methods in the assessment of systemic risks
4 Possible regulatory intruments for reducing the volatility of financial cycles
5 International examples of dynamic provisioning
6 Advantages and disadvantages of alternatives for evaluating expected losses
7 Conclusions
8 References



Foreword

The three papers in this volume investigate the same subject matter, the procyclicality of banking sector behaviour, from three different perspectives.

Banks are said to behave in a procyclical way when their lending, the stringency of their credit rating policy and provisioning practices as well as their profitability move in correlation with the economy's short-term business cycles. During a cyclical upswing, banks tend to be excessively optimistic about the economy and hence their customers' position and to advance loans against poorer collateral (possibly overrated due to asset price bubbles created during the cycle), as well as to reduce the applied risk premia and to allocate less loan-loss reserves to cover expected risks. At the same time, there is usually an upsurge in banks' profitability during a boom.

However, the heady optimism of a cyclical upswing vanishes once the business cycle turns down and economic conditions become less rosy, causing formerly hidden shortcomings to become visible. At such times banks may incur disproportionately large provisioning burdens, which can undermine profitability and worsen their capital situation. Banks will typically respond by an excessive cut-back in lending, often declining loans even to enterprises which have maintained their creditworthiness despite the cyclical downturn. Thus, when times get hard, banks may start to behave in a way that further aggravates the situation. Cutting back sharply on lending may even result in a credit crunch, i.e. a major restriction of credit, while the shortage of reserves and the erosion of earnings potential and capital may, in extreme scenarios, even precipitate a system-wide banking crisis.

Thus, procyclicality in banking may contribute in its own right to the volatility of economic trends, increasing the amplitude of economic cycles. As this is a harmful trend from the point of view of financial stability, central bankers, responsible for financial stability, have the task of exploring the causes of procyclical behaviour, gaining thorough knowledge about its nature and, if necessary, mitigating it by regulatory means (or if the required means are not available within central bank regulatory instruments, promoting the creation and adoption of such).

Guided by this objective, the economists of the Banking Department and Regulatory Policy Department of the National Bank of Hungary have attempted to examine procyclicality in banking behaviour from a number of perspectives. The following three papers do not aspire to explore all facets of the problem, wishing only to make some contribution to the ongoing research on the subject. Thus, none of the studies deal with the actual progress of and experiences with historical lending cycles in great detail, and they do not (or only to a limited extent) make any specific proposals. Although all three papers focus on procyclicality, they differ significantly in terms of their approach and the issues dealt with.

Balázs Zsámboki, author of the first paper of the volume, focuses on some regulatory aspects of banks' procyclical behaviour. He begins with a look at the real economic role of bank loans and a description of the effects on monetary transmission. He then analyses the real economic implications of lending cycles, concentrating on the effects on small and medium-sized enterprises, the importance of demand and supply factors and the implications of changes in lending standards.

This is followed by an assessment of the relationship of the current and proposed Basle capital regulations, and accounting and provisioning principles to procyclical behaviour. The author points out that regulatory shortcomings, perverse incentives generated by the system and problems arising from asymmetric information significantly influence the rate of credit growth, the composition of the lending portfolio and, indirectly, the correlation between and prospective development of the banking system and the real economy.

The second paper in the volume, by Katalin Mérő, deals both with the depth of financial intermediation and banks' procyclical behaviour. It seems justified to link these two subjects as the catching-up economies (including Hungary, of course), which exhibit a very low level of financial intermediation in global comparison, may in all likelihood need to deepen financial intermediation to a significant degree in order to facilitate the sustainable economic growth necessary for the catching-up process. Thus, the strong credit expansion seen in these countries may not be merely the consequence of procyclical lending behaviour, but also that of an unavoidable financial deepening. Hence, the two effects cannot be separated. Consequently, the regulatory dilemma posed by the proposed restriction of financial institutions' procyclical behaviour in these countries is a much more complex issue. The primary conclusion of the paper is that in the catching-up countries (which have a low level of financial intermediation) effective regulation should be based on a regulatory framework that focuses on qualitative measures in promoting the development of the sector and its operation according to international standards rather than quantitative rules which (may) hamper activity growth.

The third paper, by Edit Horváth, describes some regulatory options that may encourage banks to prepare in due time for a deterioration in loan quality due to changes in the economic environment. This paper seeks to pinpoint the specific methodological and regulatory deficiencies which prevent banks from taking account of a downturn in economic conditions and which lead to risk assessment and risk classification assuming that the current economic situation is permanent. Of the regulatory options devised to prevent procyclical behaviour, such as amendments to the rules on collateral assessment, provisioning and capital adequacy, the paper takes a close look at "dynamic provisioning" for expected loss, which also considers the trend of systemic risk. It presents the conceptual model of dynamic provisioning, the main obstacles to its widespread implementation, in addition to detailed analyses of some specific international examples.

We sincerely hope that this volume will promote a better understanding of banks' procyclical behaviour and greater awareness of risk, as well as contribute to professional thinking about the questions raised in the volume.

Authors