Regulatory solutions to the pro-cyclicality of bank credit, is the cure worse than the disease?

Working papers | 2011 | N 54

Abstract

The impact of the economic cycle on the flow of funds generated internally by banks is an important factor in the pro-cyclical dynamics of the traditional banking business. This aspect has tended to be underestimated in the discussion on counter-cyclical regulations. The debate has focused on the need to reduce capital shortages during recessions and the discrepancies that arise between accounting and prudential standards. In contrast, the importance of the incentives that arise from these regulations has received little attention. With a representative bank exercise we attempt to illustrate the dynamic effects of certain counter-cyclical regulation schemes, placing emphasis on the impact on fund flows. We show that a counter-cyclical forecasting scheme modifies the temporary impact of the economic cycle on accounting results, but can exacerbate the deterioration of the flow of internal funds in the negative phase. Counter-cyclical regulatory schemes that modify capital and liquidity requirements are also studied. In addition to the aforementioned impact on the flow of funds, there are problems that may arise from these proposals, related to the interrelation between accounting, signals (since the banking business itself is subject to agency problems and asymmetric information). and incentives to “manage the balance sheet” (to take advantage of the valuation differences between the regulated and non-regulated segment).