Banking procyclicality: cross country evidence

Abstract

The stylized fact of co-movement of lending and economic activity

has been widely interpreted as evidence of a destabilizing feedback mechanism

between the banking and real sectors, suggesting the special role of credit supply

in amplifying financial and macroeconomic instability. Indeed, this

“procyclicality” view significantly influences bank regulations internationally.

Under the Basel III, the countercyclical capital buffer is exclusively designed to

dampen the volatility of credit supply over the business cycle.

The strong co-movement of lending and economic activity,

however, is insufficient to confirm the existence of the procyclicality, given that

both demand and supply of loans decline during economic downturns. If loan

supply does not play a causal role, then any measure to strengthen lending

capacity of banks would be ineffective in addressing this procyclicality issue.

The literature, however, provides limited, otherwise inexistent,

cross-country evidence to answer these fundamental questions. This research gap

calls into question the sufficiency of international evidence to assess the

effectiveness of the new capital measure, and more broadly, the regulatory reform.

This cross-country econometric study covering 39 economies for the period 1990–

2009 examines these fundamental issues in detail. There are three main findings

and policy implications.

For banking stability, a significant procyclical pattern of loan

supply exists, and such pattern is negatively associated with bank capital. These

findings together support the view that the countercyclical capital buffers of Basel

III could be effective tools for dampening loan volatility over the business cycle.

For the regulatory reform, there is prevalent evidence that capital and liquidity are

determinants of loan supply. This finding bears out the main Basel III argument

that stronger capital and liquidity could strengthen the resilience of the global

banking sector to macroeconomic shocks.

For macroeconomic stability, empirical findings suggest a

moderate macroeconomic effect of loan supply, particularly for developed

economies. However, the finding does not imply a small impact of banking

instability on the real sector. In fact, banking crises are estimated to have a larger

independent negative effect on economic growth after controlling for the

macroeconomic effect through impacts of banking crises on loan supply. There

are two main policy implications of these findings. First, the main channel

through which stronger capital and liquidity of banks help reduce macroeconomic

instability would have an impact on reducing the likelihood of the occurrence of a

banking crisis. Second, during non-crisis periods, bank regulations aiming at

smoothing loan supply may have a relatively moderate impact on reducing

macroeconomic instability.

For policy to address banking procyclicality, the results show that

aside from higher quantitative capital and liquidity requirements, more stringent

definitions of capital could dampen loan supply procyclicality, which speaks in

favor of recent policy initiatives to strengthen the quality of regulatory capital.

More stringent bank regulations are also found to reduce loan supply

procyclicality in countries with deposit insurance schemes. To reduce the

propagations of loan supply shocks to the real sector, policy to improve the

breadth of the stock market and the size of the domestic bond market would be

useful.