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We use a macroeconomic euro area model with a bank sector to study the pro-cyclical effect of the capital regulation, focusing on the extra pro-cyclicality induced by Basel II over Basel I. Our results suggest that this incremental effect is modest. We also find that regulators could offset the extra pro-cyclicality by a countercyclical capital-requirements policy. Our results also suggest that banks may have incentives to accumulate countercyclical capital buffers, making this policy less relevant, but this finding is depends on the type of economic shock posited. We also survey different policy options for dealing with procyclicality and discuss the pros and cons of the measures available.

Pro-Cyclicality of Capital Regulation: Is it a Problem? How to Fix it?