Abstract
After many years of discussion, the implementation of two major reforms to international bank regulation and accounting practices is imminent. The Basel II Capital Accord and the accounting guidelines IAS 39, which are to be adopted from the end of 2006 and January 2005 respectively, are designed to provide improved accuracy in assessments of the relative riskiness of banks and their asset values.1 However, the informational and allocative efficiency benefits of such improvements may come at the potential cost of greater real procyclicality and volatility.2 For example, if risk-sensitive regulation requires banks to hold a higher capital ratio during economic downswings, reflecting the increased potential credit losses in their portfolios, then they may respond by reducing their loan book, or by passing on the funding costs of raising capital. The resulting rationing of credit, or its higher cost, may lead to real effects through reduced investment and consumption. Similarly, under IAS 39, losses during a market downturn on tradable assets, which are booked at fair value, could lead to greater volatility of income and profits which, due to market imperfections, may not reflect underlying fundamentals. These losses could eat into capital positions and again this could lead to a contraction in credit.
In preparing this paper we benefited greatly from discussions with Patricia Jackson, Ian Michael and Chris Orton. All errors remain our own.
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Taylor, A., Goodhart, C. (2006). Procyclicality and Volatility in the Financial System: the Implementation of Basel II and IAS 39. In: Gerlach, S., Gruenwald, P. (eds) Procyclicality of Financial Systems in Asia. Procyclicality of Financial Systems in Asia. Palgrave Macmillan, London. https://doi.org/10.1057/9781137001535_2
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DOI: https://doi.org/10.1057/9781137001535_2
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