Procyclicality in Indian Financial System

An economic variable that moves in the same direction as real GDP is called procyclical.

An economic variable that moves in the opposite direction to real GDP is called countercyclical.

Consumption, procyclical

Investment Economic

and

Employment (GDP)

are and

with

Growth

Unemployment is counter cyclical, as it moves in the

opposite direction with the Economic growth

Pro cyclicality :

Dynamic interactions between the financial

and the real sectors of the economy that tend

to amplify business cycle fluctuations and

cause or exacerbate financial (Financial Stability Forum, 2009). instability

Why Does Procyclicality Become an Important Issue

Procyclical Behaviour
Banks decrease capital during upturn side of economy and increase it at the downturns.

Counter cyclical behavior

Banks increase capital during economy boom and decrease it as economy swings down more buffer will be available to reduce loan supply fluctuation when economy enters the downturn phase

Bank lending is expected to exhibit pro-cyclical behavior through two channels:

01.Demand for bank lending 02.The cost of bank lending Both of them fluctuate over the business cycle. The demand for bank lending is based on the production and investment activities of firms or household consumption and thus inherently procyclical.. The costs that banks need to pay when they raise funds for lending is fluctuating counter-cyclically and, hence, make supply of bank lending procyclical.

Consumption Demand
Investment Demand Demand For Bank Credit

GDP Procyclical Counter Cyclical GDP

Procyclical

Production Demand

For Supply of Bank Credit

Cost of Capital

Counter Cyclical

For example, when economic conditions are depressed, collateral values decrease and the cost of bank lending increases so that even borrowers with profitable project find it difficult to obtain funding. When economic conditions are improved, the reverse tends to be the case. Prudential regulation on financial institutions also can be pointed out as another factor of the procyclicality of bank lending. In particular, regulations of minimum capital requirements for banks has been a long-standing concern for supervisory authorities in that pressures on bank capital in a recession could lead to cutbacks in bank lending further and exacerbate the recession into credit crunch.

In addition, if bank lending is highly dependent upon collateral

values as in most of developing countries including Korea, and

if the risks associated with collateral are misassessed, the procyclicality of bank lending will increase.

In other words, rating methodologies that deliver collateral values moving closely with the business cycle are likely to generate greater procyclicality.

The same is true when the average loan-to value(LTV) ratio is higher, since the higher the LTV ratio means higher marginal amount of new lending that can be granted for a given change in the value of the collateral

Procyclicality of bank lending could also increase when financial regulations are more sensitive to the estimated risk. In general, banks are required to make provisions to cover the expected loss (EL) of their loan portfolio, and this leads to increasing provisions in downturns.

Thus, the marginal cost of bank lending will increase when

economic conditions are depressed and, when accounting

standard is more sensitive to the risk, the procyclicality will

be extended.

The New Basel Accord (Basel II) reinforces the capital regulations by applying diversified risk weights according to the creditworthiness of the borrowers, thus one of the main objectives underlying the Basel II is to substantially increase the risk sensitivity of the regulatory capital.

During Recession
a) Credit Risk Increases b) Capital requirements increases c) Profitability decreases d) Cost of capital increases.

e) Increased Capital requirements decreases supply of Bank Credit

f) Deepening of Downturn or recession. g) Financial Instability occurs.

The financial system already is considered to be of procyclical nature due to a mechanism referred to as the financial

accelerator, which focuses on information asymmetries

between borrowers and lenders. The idea namely is that as the economy goes into a downturn and prospects of credit risk increase, these information asymmetries become much larger with the result of inhibiting

the lending process.

Hereby this tendency is reinforced by the procyclical behaviour of asset prices,

which provides good collateral in booms but makes sure that in downturns collateral loses its value.

The procyclical result then of the financial accelerator effect is that economic activity is stimulated in a boom by easier lending and discouraged in a downturn as lending becomes relatively difficult.

In addition, during recession the capability of banks to lend usually declines due to a lower interest income and an increased rate of loan defaults. Moreover, severe losses from defaulted loans can affect the banks profitability, potentially even to the point that solvability is endangered with the result that capital reserves first have to be replenished before taking on new loans.

During booms, banks will find it easy to raise equity capital and potential earnings retentions will be high. During downturns, with the declines in loan demand and increased default risks, banks may prefer to cut back their loan base
So in a boom period banks will find less difficulty expanding their credit supply due to that extra capital can be easily raised and decreasing capital requirements release a part of the capital stock. On the other hand in a downturn poorly-capitalized banks are somewhat likely to have to contract their credit supply in order to meet the increasing capital requirements. These procyclical changes in the credit supply caused by the capital regulation will then bring extra reinforcement to the business cycle. Stimulating consumption and investment in the boom and discouraging it in the downturn

Basel II may potentially lead to banks behaving in an extra procyclical manner.

This may be the case when estimated risk in a boom turns out
to be relatively low and in a downturn relatively high, so that the risk-sensitive Basel II regulation pushes down capital

requirements in a boom and upwards in a recession.

The procyclical effect will then come from the fact that low capital requirements helps to expand the credit supply, and high capital requirements may decrease the credit supply.

The current global financial crisis has brought to fore serious lacunae in the approach to regulation and

supervision and put the issue of systemic risk on to the

regulatory agenda. A comprehensive definition of systemic risk is, The risk of disruptions to financial services that is caused by an impairment of all or parts of the financial system, and can have serious negative

consequences for the real economy.

There are two facets to systemic risk.

Systemic risks can be grouped into two dimensions a time dimension

and a cross sectional dimension.

The time dimension of systemic risks, or what is more commonly

known as procyclicality, relates to the progressive build-up of aggregate risk over time.

The second dimension of systemic risk - common exposures / inter linkages in the cross section focuses on how risk is distributed within

the financial system at any given point in time.

.

Systemic risk in this dimension arises due to the interconnectedness of institutions, balance sheet entanglements, common exposures and,

sometimes, even common business models of

financial institutions

The time dimension on the other hand deals with how aggregate risks in the financial system evolve over

time the procyclicality issues in the financial system.

The dynamics of the financial system and the macro economy interact with each other increasing the amplitude of booms and busts. The larger is the

boom, the larger is the bust and larger is the damage

to the economy.

The set of policies which deal with managing the downside of systemic risk is known as macro prudential policy. Macro prudential policies primarily use prudential tools to limit systemic risk and thereby minimize disruptions in the provision of key financial services that can have serious consequences for the economy

Three purposes of macro prudential regulation:

i) To address procyclical elements in the financial system:

ii) To provide a mechanism to correct the inherently skewed

pricing of credit risk by financial institutions through the cycle.

iii) To attempt pre-empting asset price bubbles in the economy and limit the build-up of financial risks in the system

During the expansionary phase since 2004, the Reserve

Bank had taken various measures to counter pro-cyclical

trends.

The potential adverse impact of high credit growth in some

sectors and asset price fluctuations on banks balance sheets at various points in time were contained through pre-emptive countercyclical provisioning and differentiated risk weights for certain sensitive sectors.

It was for the first time in October 2004 that the rapid growth in housing and consumer credit was flagged as a concern and as a temporary counter cyclical measure, the risk weight

applicable to these loans was increased by 25 basis points.

In the context of continuing high credit growth, the limitations

of the prudential framework in capturing the ex-ante risks of

pro-cyclical nature of bank credit were explicitly recognized in October 2005 which triggered an across the board increase in provisioning requirement for standard assets.

Loan to Value Ratio in Housing Loans

At present, there is no regulatory ceiling on the loan to

value (LTV) ratio in respect of banks housing loan exposures. In order to prevent excessive leveraging, it is

proposed that the LTV ratio in respect of housing loans

hereafter should not exceed 80 per cent. Risk Weights on Residential Housing Loans

At present, the risk weights on residential housing loans with LTV ratio up to 75 per cent are 50 per cent for loans up

to `30 lakh and 75 per cent for loans above that amount. In
case the LTV ratio is more than 75 per cent, the risk weight of all housing loans, irrespective of the amount of loan, is

100 per cent. Accordingly, it is proposed to increase the risk

weight for residential housing loans of 75 lakh and above, irrespective of the LTV ratio, to 125 per cent.

Teaser Rates for Housing Loans To increase the standard asset provisioning by commercial banks for all such loans to 2 per cent.

One of the major causes of the recent crisis was the general euphoria in
the pre-crisis boom period which led to the financial sector's severe under-pricing of the risks. In a risk-based capital regime, this directly implied less capital for high-risk activities during booms, hence increased lending to high-risk sectors and increased trading volumes in riskier instruments.

The extent of risk under-pricing only became evident after the crisis had set in. The situation swung to the other extreme after the crisis.

Macro prudential tools, including the leverage ratio, are meant to address situations like this by effectively influencing the costs of credit exposures dynamically.

To counter the possibility of an asset bubble, in addition to

concerns about credit quality, the risk weight on banks exposure

to commercial real estate and the capital market was increased from 100% to 125% in July 2005. Given the continued rapid

expansion in credit to the commercial real estate sector, the risk

weight on exposure to this sector was increased to 150% in May 2006. Further, the general provisioning requirement on standard advances in specific sectorspersonal loans, loans and advances qualifying as capital market exposures, residential housing loans above Rs2,000,000 and commercial real estate loanswas increased from 0.4% to 1.0% in May 2006 and further to 2.0% in January 2007