Banking regulators should actively adjust capital requirements as economic conditions change to avoid the effects of procyclicality, says Tax advisory firm Grant Thornton LLP.

In a letter to U.S. Treasury secretary Tim Geithner, Ben Bernanke, chairman of the U.S. Federal Reserve Board, and Sheila Bair, chairman of the Federal Deposit Insurance Corp., the firm issued a proposal that calls for bank regulators to exercise their authority to adjust capital requirements to account for different economic environments, thus providing what it calls “dynamic regulatory capital provisioning”.

“Taking this approach would increase capital requirements in booming economies and decrease those requirements in strained ones,” it notes.

It sees a number of advantages to such a move. “In prosperous economies, financial institutions often invest in increasingly risky assets in order to drive income and compete in the marketplace. An increase in the overall capital requirements in such economies would serve as an effective braking mechanism by reducing the capital available for potentially excessive risk-taking. Further, the reduction in excessive risk-taking would redirect public investment in these institutions toward investors who look for long-term value creation rather than short-term earnings,” it suggests.

Conversely, in weak economies, it notes that the additional capital “would provide the necessary cushion and time frame for institutions to absorb losses and hold or seek more orderly liquidation of assets. This process would, in turn, prevent dramatic declines in sales prices (and, thus, fair value) across other institutions.”

“The counter-cyclical declining capital requirements in weak economies would enable financial institutions to operate their core lending businesses rationally, without limiting them to capital requirements better suited to stable economic environments,” it adds.

Also, such a practice would also more effectively separate accounting rules from the regulatory capital requirements, “thereby enabling investors to have the information they need while, at the same time, providing regulators with the tools they need for properly monitoring financial institution safety and soundness.”

IE