There is a conflict between the objectives of risk sensitivity and procyclicality. In recent years, the greater market orientation of the valuation of assets and liabilities has made the risk situation of financial actors and markets more transparent.
In banking regulation, this has happened gradually with the transitions from Basel I to Basel III, while in the insurance sector the launch of Solvency II was a milestone.
The market-value orientation is intended to reduce companies’ assumption of risks and strengthen their solvency, among other things. In addition, the loss-absorbing capacity is supposed to be increased.
Risk sensitivity, if not appropriately limited, can turn long-term movements into excessive short-term volatility. It can promote the tendency towards too much credit expansion in boom phases and more restricted lending in recession phases – with potential repercussions for the real economy.
Much has been done to mitigate procyclical effects. In banking regulation, the countercyclical capital buffer was designed so that institutions should accumulate an additional capital cushion during periods of excessive credit growth.
However, ultimately it will not be possible to avoid the regulatory linking of capital and risk with market valuation to go along with some degree of procyclicality. A balance must be struck between market-value orientation and prudence which enables a risk-based regulation with the least possible procyclical effect.
The dynamic nature of the markets can only be kept on track when regulation does not spell out everything to the last detail. Regulation ought to restrict itself to forming a framework of principles within which some leeway and freedom from day-to-day supervision is granted.