Bank procyclicality and output: Issues and policies

• This paper provides a comprehensive review of the literature on procyclicality of the banking sector.
• It explores certain aspects of procyclicality that have not been addressed in the literature.
• It analyzes the impact that procyclicality has on the banking sector and on the real economy by focusing on its driving forces.
• It discusses the procyclical behavior of capital requirements, accounting rules, leverage and of other factors like liquidity and rating agencies assessments.
• It examines a number of proposals on mitigating procyclicality and analyzes the relevant proposals of Basel III.

The recent global financial crisis has highlighted the importance of the procyclicality of the financial sector. The procyclicality has transformed banks from mitigation mechanisms to amplifiers of changes in economic activity, potentially affecting financial stability and economic growth. The causes of procyclicality can be attributed to market imperfections and deviations from the efficient market hypothesis, while other factors including the Basel-type regulations, accounting standards and leverage have exacerbated it. Several suggestions have been forwarded to attenuate procyclicality, in the form of rules and discretion. They are presented here according to the factors they aim to alleviate. Some of the suggestions have been adopted under the Basel III framework, which explicitly addresses the procyclicality issue.