COUNTERCYCLICAL MACROPRUDENTIAL TOOLS.

Risk-sensitive capital requirements, such as those established in Basel 2/3, and loan loss provisions based on incurred losses or on short-horizon expected losses, increase procyclicality in the banking system. They could, therefore, contribute to fuelling credit bubbles in good times, as rising risks are not properly covered either with capital or provisions, and credit crunches in bad times, as requirements are sharply increased to compensate for the former undercapitalisation and under-provisioning, and banks respond by cutting credit to households and firms. This paper shows that the procyclicality of current and envisaged capital requirements and loan loss provisions is a serious concern. But, at the same time, it can be dealt with using countercyclical macroprudential tools, first, by smoothing minimum capital requirements using a very simple and intuitive formula based on GDP growth and, secondly, by using forward-looking provisions such as the Spanish dynamic provisions, a working macroprudential mechanism for more than a decade and a full lending cycle. [ABSTRACT FROM AUTHOR]