Abstract
This paper provides an overview of the questions that will need to be addressed in order to determine whether increased cyclicality in capital requirements will exacerbate the pro-cyclicality in the financial system. Many central banks raised concerns about the potential cost of pro-cyclicality that could come with the Basel II framework, which will be implemented in the EU via the Capital Requirements Directive (CRD). Previous capital rules require banks to hold a minimum amount of capital of each loan independent of the risks of the loans. The Basel II framework/CRD has the objective of making capital requirements more risk-sensitive. Therefore, by construction, the capital requirements under the CRD will be more cyclical than under the previous rules. This raises 2 questions. First, does it matter that regulatory capital requirements fluctuate more than before if banks' (lending) behaviour is driven by other capital considerations? Second, if it does matter, what will be the consequences on the economic cycle?
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