The Cyclical Effects of the Basel III Capital Ratios: The Impact of the LCR Regulation

Abstract

New liquidity rules and capital buffers requirements are introduced by the Basel committee in its Basel III framework. As capital requirements play a key role in the supervision and regulation of banks, this paper investigates how the risk-sensitive LCR rule impacts the cyclical behavior of the capital ratios. The LCR rule introduces a regulatory trade-off between banks’ asset risk and liquidity, which were absent under Basel II. In addition to the existing risk-based capital ratio, this paper studies the cyclical behavior of the newly introduced leverage ratio under Basel III. It finds that both the LCR and the new buffers requirements increase the bank risk-based capital and leverage ratio during upturns and then contribute to reduce bank capital procyclicality suspected under Basel II. In the opposite, the cushion of capital that banks hold above the minimum required is more likely to decrease during upturns. This will increase the probability that banks becomes bound with the capital ratio, something which could contribute to slow down any excessive asset growth in the banking sector during upturns.