Abstract
Background: Procyclicality plays a pivotal role in finance in both thriving and crisis periods. This influence stems not only from the way market participants behave but also from risk metrics used and regulatory capital amassed and released during bust and boom periods, respectively. The introduction of the regulatory Countercyclical Capital Buffer aims to thwart procyclicality by accumulating (releasing) capital in upswings (downswings), subsequently reducing the amplitude of the financial cycle and promoting macroprudential stability. The timing of the accumulation and release of buffer capital is critical so identifying accurate indicators is important. Aim: This paper applies a Kalman filter to South African data and confirms the procyclicality of the Basel Committee on Banking Supervision (BCBS) proposal. Setting: For South Africa, studies suggest alternatives such as residential property indices because research has demonstrated that the BCBS proposal is procyclical rather than countercyclical. Methods: This paper applies a Kalman filter to South African data and compares the results obtained with those filtered using the Hodrick–Prescott filter. Results: Results indicate that buffer signals are dependent upon the filter employed. Conclusion: Buffer signals are strongly dependent upon the filter employed to detect procyclicality. The South African Reserve Bank and other regulators should reconsider the use of the Hodrick–Prescott filter and entertain the possibility of using the Kalman filter instead.
Highlights
The procyclical nature of financial markets is well documented as are the intrinsic procyclical characteristics of regulatory capital regulations prior to Basel III
The credit-to-GDP gap is disputed with regards its appropriateness as Countercyclical Capital Buffer (CCB) buffer indicator for South Africa, the purpose of this paper is to primarily focus on the measurement technique of a CCB and on the indicator variables
As it is recommended as a common reference guide by the BCBS, it is used as an investigation point of departure
Summary
Several studies including Heid (2003), Gordy and Howells (2004) and Goodhart and Taylor (2006) forewarn that the procyclical nature of regulatory requirements impede macroeconomic stability as these regulations force institutions to retain more capital in low-profit, liquid divisions when they may need to continue extending credit. This institutional behaviour and the inability of risk measurements to capture this phenomenon proved to be disastrous in the 2008/2009 financial crisis. The timing of the accumulation and release of buffer capital is critical so identifying accurate indicators is important
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