Is bank portfolio riskiness procyclical?

This study analyzes the procyclical behavior of the default rates of Italian bank borrowers over the last two decades. A vector autoregression (VAR) is employed to assess the extent to which macroeconomic shocks affect the banking sector (first round effect). The VAR also helps to disentangle the feedback effects from the financial system to the real side of the economy. We find evidence of the first round effect and some support for the feedback effect, which tends to operate when banks have thin capital buffers. From a policy perspective, our results confirm the importance for banks to keep capital well above the regulatory minimum in order to maintain an adequate credit supply also during contractions thus reducing second round impacts.