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Mitigating Procyclicality in Basel II: A Value at Risk Based Remedy

A side-effect of the better differentiation of credit risk in the New Basel Capital Accord is the danger of a sharp rise of capital requirements in recessions due to a large number of borrower downgrades and defaults. Thus, the Accord may worsen recessions. In the present paper these worries about Basel II are analyzed in some detail. A “historical simulation” is calculated with S&P’s transition and default rates from 1982 to 2000. In accordance with the literature it turns out that procyclicality may be substantial - at least due to an increasing number of defaults in recessions. A solution is suggested which “buffers” the cyclicality effect by considering simple Value-at-Risk calculations. Its main advantage is the transparent reflection of a bank’s actual risk and the retention of risk sensitive weights - an essential goal of Basel II.