Banking Regulation: New Evidence On How ''Basel Iii'' Should Be Designed

01 Dec 2010

Basel II regulation fails to protect the banking sector from the consequences of periods of excessive credit growth, according to research by Gregory de Walque, Olivier Pierrard and Abdelaziz Rouabah, published in the December 2010 issue of the Economic Journal.

Instead, they argue, banking supervision should aim at promoting capital buffers in good times, which could be used in periods of stress. They conclude that the Basel III regulation, which is currently under development, is a step in this direction.

The study examines the impact of the different Basel Accords on banking regulation. First, the researchers consider Basel I, also known as the 1988 Basel Accord, which is based on asset type, and where banks are required to hold capital equal to at least 8% of their risk-weighted assets. They show that imposing a minimum capital ratio reduces the long-run level of output but improves the resilience of the economy to shocks.

Next, the researchers consider the second of the Basel Accords (Basel II), from June 2004. Here, the requirements are based on asset type and asset quality, and are therefore dependent on the business cycle. But introducing the quality-sensitive Basel II capital requirements increases business cycle fluctuations. Indeed, a positive shock usually improves asset quality and therefore softens the requirements. This stimulates loan supply and amplifies the initial shock.

The researchers argue that fair regulation should instead be countercyclical – that is, it should promote financial soundness during good times and hence attenuate business cycle fluctuations.

They note that Basel III foresees a regulatory framework with a countercyclical capital surcharge – within a range of 0 to 2.5% of common equity – in addition to a capital buffer. These regulations should help to ensure a sufficient degree of protection against losses during the downturn of the economic cycle.

Credit market imperfections and the behaviour of financial market participants are often considered a key contributing factor to the severity of crises, as was evident in the Great Depression and more recently during the subprime crisis and associated financial turmoil. This central role of the credit market may in turn explain why banking remains regulated despite significant deregulation in many other industries in recent decades.

This study looks at banking regulation through the lens of a ''dynamic general equilibrium model'' with imperfections in the credit market. The authors believe that a general equilibrium model is the only framework that can properly assess the dynamic interactions between the financial system, the broader economy and the financial regulatory environment.

''Financial (In)Stability, Supervision and Liquidity Injections: A Dynamic General Equilibrium Approach'' by Gregory de Walque, Olivier Pierrard and Abdelaziz Rouabah is published in the December 2010 issue of the Economic Journal.


Gregory de Walque

National Bank of Belgium

Olivier Pierrard

the Central Bank of Luxembourg | +352 4774 4449 |

Abdelaziz Rouabah

Central Bank of Luxembourg