Procyclicality in the banking sector

Procyclicality generally refers to the virtue of the financial system, especially the banking sector, to amplify business cycle swings and thereby intensify financial instability. Particularly economic contractions are often exacerbated by credit market frictions and other mutually reinforcing mechanisms in the banking sector. But also economic expansions may be magnified by a rapid growth in credit supply, which may lead to an overheating of the economy and an amplification of the subsequent downswing. Credit supply and banks’ lending behaviour are major elements of procyclicality in the financial industry. Additionally, there are other causes and mechanisms that are linked to these factors and lead to procyclical behaviour of market participants. Important issues in this field are capital regulation standards set forth by the Basel Committee on Banking Supervision (Basel I, II and III), accounting standards, especially the impacts of mark-to-market valuation and fair value accounting, as well as risk perceptions of banks, rating agencies and bank supervisors.