Procyclicality of banking regulation:Analysis and reforms

• Author: Ornela Dhamo
• Position: Mediterranean University of Albania
• Pages: 213-230

213

Vol. 2 No. 3

January, 2017

Balkan Journal of Interdisciplinary Research

IIPCCL Publishing, Tirana-Albania

ISSN 2410-759X

Acces online at www.iipccl.org

Procyclicality of banking regulation:Analysis and reforms

Ornela Dhamo

Mediterranean University of Albania

Introduction

The recent f‌i 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 f‌i nancial markets are also generally considered to be themselves

cyclical (Turner, 2000). The interaction between the f‌i nancial markets and the

economic growth might result in an amplif‌i cation of the shocks. Even though it is

expected that f‌i 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 f‌i 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 f‌i 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

f‌i 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 f‌i 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

214

Vol. 2 No. 3

January, 2017

Balkan Journal of Interdisciplinary Research

IIPCCL Publishing, Tirana-Albania

ISSN 2410-759X

Acces online at www.iipccl.org

the relationship between provision, prof‌i 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

below:

• The f‌i rst possible implication on procyclicality of the capital rule is related

to the timing of the regulatory changes. During the onset of a f‌i 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 f‌i 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

,1999)

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 f‌i 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