EBA recommends retaining risk-sensitive framework for banks regulatory capital

The European Banking Authority (EBA) published today its Report on cyclicality of banks’ capital requirements aiming at clarifying whether risk-sensitive bank capital requirements as laid down in the Capital Requirements Regulation (CRR) and Capital Requirements Directive (CRD) create unintended pro-cyclical effects by reinforcing the endogenous relationships between the financial system and the real economy.

This report, which has been drafted in close cooperation with the European Systemic Risk Board (ESRB) and the European Central Bank (ECB) is in response to a request by the European Commission to understand whether CRDIV/CRR requirements exert significant effects on the economic cycle and, if so, whether any remedial measures are justified.

In addition, this Report may inform the European Commission’s currently ongoing reviews of the EU micro- and macro-prudential frameworks and could serve as a valuable complementary contribution to the global discussions about the bank capital regulatory framework.

Increased risk-sensitivity of the bank capital regulatory framework raises the concern whether resulting regulatory capital requirements tend to be pro-cyclical, e.g. contribute to mutually reinforcing feedback loops between the financial system and real economic developments.

Findings

Against the background of considerable challenges to empirically identify with sufficient certainty the relationship between risk-sensitive regulatory capital and the amplitude of the economic cycle, the key conclusions of the Report are the following:

Banks’ capital requirements, since 2008, appear to have developed relatively stable and series on banks’ IRB risk parameters (Probability of Default, Loss Given Default, default ratio) do not show a particularly cyclical pattern.
The surprising lack of a strong correlation between the economic cycle and banks’ risk-weighted assets (RWAs) and underlying parameters is evident in various regression specifications at bank and portfolio level.

Higher capital requirements due to CRD/CRR could have exerted some restricting impact on banks’ loan supply, but in the period observed (after 2008), results indicate that it is likely that broader macroeconomic and financial factors had a predominant impact on banks’ lending decisions.
Further econometric analysis provided only limited evidence of any significant pro-cyclical effect induced by the regulatory framework on the real economy.

Recommendations

Against the background of the weak evidence on the existence of pro-cyclical effects due to the CRDIV/CRR framework, this Report recommends that the EU retains its current risk-sensitive framework for bank regulatory capital. If pro-cyclicality risks were to become more material, the EU financial regulatory framework has various tools at its disposal, which could in principle be used.

For that purpose, the impact of the EU bank regulatory framework on the economic cycle should be monitored regularly and the potential impact, effectiveness and efficiency of counter-cyclical instruments be further analysed.

Source: EBA statement