The Cyclical Effects of the Basel III Capital Ratios : The Impact of the LCR Regulation

New liquidity rules and capital buffers requirements are introduced by the Basel committee in its Basel III framework. As capital requirements play a key role in the supervision and regulation of banks, this paper investigates how the risk-sensitive LCR rule impacts the cyclical behavior of the capital ratios. The LCR rule introduces a regulatory tradeoff between banks' asset risk and liquidity, which was absent under Basel II. Based on the model by Heid (2007) , we derive three results on the capital ratios cyclical behavior under Basel III. First, we find that the short term liquidity rule adds to the risk-based capital procyclicality and then reduces the effectiveness of the buffers requirements. Second, the cyclical behavior of the newly introduced Basel III leverage ratio becomes risk sensitive when we introduce the LCR requirement. Third, the cushion of capital that banks hold above the minimum required is more likely to decrease during upturns. This will increase the probability that banks become bound with the capital ratio, something which could contribute to slow down any excessive asset growth in the banking sector during upturns