Pro-cyclicality in the new Basel Accord

Could Basel II worsen recessions? By backtesting the proposed capital rules to the last recession, D. Wilson Ervin and Tom Wilde argue that the increased risk sensitivity of loan portfolio regulatory capital in the new Accord could have unwelcome systemic side effects.

The proposed new capital Accord (Basel, 2001) is designed to be more sensitive to risk in general and to credit risk in particular. Lower-rated assets will cost more in terms of capital in both the standardised and, especially, the internal ratings-based (IRB) approach. Greater risk sensitivity is seen as desirable because it should promote risk-adjusted business decisions and improve capital allocation within banks as well as improving capital allocation across banks. The new rules will

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