Procyclicality of banking regulation:Analysis and reforms

AuthorOrnela Dhamo
PositionMediterranean University of Albania
Vol. 2 No. 3
January, 2017
Balkan Journal of Interdisciplinary Research
IIPCCL Publishing, Tirana-Albania
ISSN 2410-759X
Acces online at
Procyclicality of banking regulation:Analysis and reforms
Ornela Dhamo
Mediterranean University of Albania
The recent nancial crisis highlighted the need to evaluate the full impact of the
regulatory on the evolution of the economic activity. Generally speaking, the
economic activity is known to be subject to cyclical behavior. AsOrdonez (2009)
argues, cyclicality can be considered to be an inherent part of the economic activity.
In this aspect, the nancial markets are also generally considered to be themselves
cyclical (Turner, 2000). The interaction between the nancial markets and the
economic growth might result in an ampli cation of the shocks. Even though it is
expected that nancial system might amplify shocks in cas es of economic turmoil, the
question we want to arise is whether the regulatory framework which is part of the
supervisory process of the nancial system (banking sector) might itself be a source
for this procyclicality process.
The policymakers might have less impact on avoiding economic cycles, yet they
still should consider reducing the impact of these cycles on the banking sector, by
constructing anticyclical measures and regulations. Banking sector procyclicality
has proven to have a severe impact on economic growth. When economic activity
is increasing above the potential level, banking sector tends to take excessive risk by
providing a strong credit growth to the economy but possibly with poor standards.
However, once there is an economic downturn, banks shrink dramatically their credit
to the economy and exacerbate the GDP decline. As argued above, a possible key
source of the process ofprocyclicalitybetween banking sector and business cycles is
directly related to banking regulation.
The recent research on this issue relates strongly to the concept of procyclical
movements between the regulatory frameworks of the banking sector and real
economy growth. Before the onset of the crisis, the banking sector especially in the
emerging market was characterized by high credit growth and fast acceleration of
economic activity during this period. However, once the economic growth was hit by
the nancial crisis resulting in recession, the process of credit growth reversed to the
opposite. Currently, the sharp contraction of bank lending is considered to actually
cause a further deterioration in terms of economic growth. A large body of literature
suggests the procyclicality has played a crucial role in the development of the latest
nancial crisis. Here we can mention the work of Rochet(2008) who states that “The
subprime crisis is a perfect illustration of the “procyclicality” oU nancial systems....Financial
history abounds with examples of such nancial cycles, withan alternation of credit booms
fuelled by “exuberant” optimism during growth phases,followed by dramatic episodes of credit
“crunches” triggered by relatively moderatenegative shocks but ultimately generating major
downturns in economic activity”. The aim of this paper is to discuss procyclicalilty of
the main banking activity ratios which are a derivation of bank regulatory system in
Albania. Our analysis will focus not only on credit growth procyclicality but also on
Vol. 2 No. 3
January, 2017
Balkan Journal of Interdisciplinary Research
IIPCCL Publishing, Tirana-Albania
ISSN 2410-759X
Acces online at
the relationship between provision, pro tability, equity capital and economic growth.
When we discuss the concept of procyclicality, we base our work on the several
aspects of this processes as presented by an early work of Turner (2000) as discussed
The rst possible implication on procyclicality of the capital rule is related
to the timing of the regulatory changes. During the onset of a nancial crisis, even
though bank credit growth usually contracts, the supervisory authorities also tighten
the capital rules, with an increase of the capital requirement for the banks. However,
this process might cause a further deterioration of the credit growth as banks are
obliged to increase their capital adequacy ratio which in turn, will also have a negative
impact economic growth.
The second possible implication is related to the structure of lending maturity
of short term versus long term credit. This structure may also be a result of regulatory
bias in favor of short term lending which causes vulnerability of the emerging markets
during a downturn of economic cycle.The example in this case is related to the low
risk weight applied to the short term lending which even though provides protection
to the lending process of a single bank, if applied to the whole banking sector, might
cause a sudden loss in clients availability to lending in case of economic turmoil.
The third implication is related to the lack of a variant minimum capital
adequacy ratio. As in the case of Albania, the regulatory framework of capital
adequacy ratio is invariant to the concept of economic cycle. During an economic
recession there is an increase of loan losses which are not always fully covered by
loan provisions. As a result, these losses will lead to capital write-oT s and overall, to
lower capital ratios. If the capital ratios will fall close to or even below the minimum
required, banks have only to possibilities. The rst one is to raise new capital which
in case of a recession is diU cult. The second option is to decrease risk weighted assets,
mainly by cum ing lending to the economic. Generally the empirical literature suggest
that banks tend to use the second option to keep up their capital ratios (Jackson et al
The structure of the paper is organized as follows. The second section presents the
concepts of the regulatory framework which are directly related to the process of
procyclicality. We then proceed to provide some stylized facts for the development of
the nancials system in Albania and the interaction with economic activity in the third
section. The fourth section measures procyclicality of some of the major indicators of
banking activity in Albania. The results indicate the procyclicaty is present over the
whole period taken into consideration (2002-2013) and it has increased during the post
crisis period, especially in terms of credit growth and provisioning. Wethen proceed
to discuss the recent measures taken by Bank of Albania which are considered to be
anticyclical and present their implication in terms of the banking sector.
I. Procyclicality and regulatory framework
The basic approach of many countries around the world is to set a minimum level of
capital ratio for the banks in relative terms to their risk weighted assets. This process
is intended to provide a way of absorbing unexpected losses and also mitigate the
risk of insolvency (Arjani, 2009). The Basel accord, introduced in 1988 by the Basel

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