Procyclicality Management: Developing a Coherent Risk Rating Framework for Risk Management, Capital Management, Stress Testing and IFRS 9 Purposes

Bogie Ozdemir

Risk is procyclical: it follows business cycles and increases significantly during downturns and under stress conditions. Credit downturns result in significant increases in default rates, delinquency rates and downgrades. In recessions, equity returns are low or even negative, while interest rate is also low. Risk needs to be measured in a forward-looking, conditional and PIT manner utilising all available information, so that the best possible forward-looking predictions can be made. Only then can risk be managed effectively. Under Basel II, capital requirement is risk-sensitive – so it will be procyclical, similar to risk. Excessive procyclicality of capital is not desirable as it makes capital management difficult. This presents an important dilemma: risk measures and capital requirement conditional on the business cycle preserves the time dimension of risk and provides valuable directional information for decision-making; however, stability of capital is desired for day-to-day capital management and long-term capital planning purposes. To complicate matters, the Basel framework explicitly requires a TTC rating philosophy, while the IFRS 9 explicitly requires a PIT rating