What did Bernanke mean by "procyclicality?" His January speech included the following observation:
We should revisit capital regulations, accounting rules, and other aspects of the regulatory regime to ensure that they do not induce excessive procyclicality in the financial system and the economy.
"Procyclicality" is not quite in the same league with "conundrum" but it is not used in daily conversation and merits discussion and analysis.
Procyclicality is a noun referring to the property of exaggerating or exacerbating cyclical tendencies. Clearly the current economic downturn and financial implosion cycle is severe enough without being exaggerated or exacerbated. How can a regulatory regime of capital requirements do that?
Actually there was some academic discussion (which as it turns out was not really academic in the sense of having no relevance to present or future events) before we got into the current mess. Here is a link to a paper on the subject. This paper is about the Basel-II regulatory framework and RBC (risk based capital.)
What the author raises as a possibility, and what has actually occurred, is that the present RBC regulatory regime intensifies the cycle by continuously demanding more and more capital for banks to be adequately capitalized as the downturn persists. In turn, banks provide less and less credit and are perceived as less and less credit-worthy themselves, thereby amplifying the financial deterioration as they are unable to attract capital and make profitable loans which are necessary to keep the economy moving.
The solution is simple enough, although counterintuitive. Bank capital requirements need to be eased in times of economic stress. In statistical terms, a requirement that a bank's capital provide for example a 99.9% safety level should be decreased to 99.5%. These tiny fractions on the tails of normal distributions can have disproportionate effects on capital requirements. Tier 1 capital requirements could be eased during times of financial stress and made more demanding when times are good. Such an approach would get around the paradox that banks throw money at bad risks during good times and then withhold credit from good risks during bad times.
With the wisdom of hindsight, we now know that banks must not be "too big to fail." This is particularly true when we become aware that we need to accept increased risks of bank failure during times of financial stress. Going forward, banks that become large enough to create systemic risk due to size will be required to split up.
How about the procyclicality of accounting rules? That would be mark to market, which has functioned similar to putting out a fire by squirting it with gasoline. So the panic of the markets is fed back into the financial system through the accounting rules, making the hysterical fears into a self-fulfilling prophecy. A recipe for disaster. Steve Forbes has been articulate on the topic.
As Ben suggests, we should revisit these issues – promptly and decisively. This procyclicality thing has got to go.
Disclosure: no positions
