The cyclical effects of the Basel II capital requirements

Capital requirements play a key role in the supervision and regulation of banks. The Basel Committee on Banking Supervision is in the process of changing the current framework by introducing risk sensitive capital charges. Some fear that this will unduly increase the volatility of regulatory capital. Furthermore, by limiting the banks’ ability to lend, capital requirements may exacerbate an economic downturn. The paper examines the problem of capital-induced lending cycles and their pro-cyclical effect on the macroeconomy in greater detail. It finds that the capital buffer that banks hold on top of the required minimum capital plays a crucial role in mitigating the impact of the volatility of capital requirements.