The second source is distortions in incentives. Collateral-based lending or margin requirements can protect lenders and traders from actions taken by counterparties that could erode the value of their claims. But by establishing a direct link between asset valuations and funding, fluctuations in margin requirements can exacerbate procyclicality. Alongside limitations in risk measurement and distortions in incentives, change in accounting norms like moving away from historical-cost based accounting to fair value accounting may add to procyclicality by making valuations more sensitive to the economic cycle, which may in turn have a procyclical impact on risk-taking decisions based on these valuations.
To the extent that financial regulation contributes to procyclicality and excessive risk-taking, supervisors could design their policies in a counter-cyclical fashion to reduce procyclical behavior of financial institutions. A report form Financial Stability Board FSB made recommendations in three key areas: capital regulation, loan loss provisioning, and leverage especially the financial sector, and valuations.
The policy recommendations are mostly counter-cyclical fashion to reduce procyclical behavior of financial intermediaries and risk-taking abilities. Some of the key policy parameters considered in the literature, which can be considered by Central Banks are: 1 Reducing procyclical effects of minimum capital requirement by adopting through-the-cycle risk parameters such as default correlations, probabilities of default and loss given default etc. This will help to achieve less pro-cyclical capital ratios.
Leverage ratios should take due account of off-balance sheet exposures. The author is associate director with financial risk management advisory practice. The view are personal. Follow us on. Download et app.
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