Since the credit crisis many commentators have accused the global banking system of storing up too little risk capital through the good times and then deepening any recession by reining in lending when the crunch comes.

The banking industry and its regulators are trying to hammer out some potentially contentious industry-level solutions to this "procyclical" behavior, such as leverage ratios and cycle-dependent capital multipliers.

But individual institutions also must explore the problem, because it has implications for strategy, e.g., which businesses can the bank invest in without making itself hostage to the next downturn in terms of its capital adequacy?

Unfortunately a bank can't answer this kind of question without understanding what the economic cycle means for its existing system of risk and capital adequacy metrics — and this is complicated.

In the past, banks have not always been clear about the degree to which their conceptions of capital — economic, regulatory, available capital — capture cyclical risk. A key reason for this is that the risk systems underpinning bank capital calculations, such as internal rating systems, are themselves far from transparent. For example, is the probability of default of an obligor assessed with reference to the next year and the current economic climate, or the next five years and not conditioned on the current climate?

Part of the answer is to build an understanding of where each bank's fundamental risk systems are on a spectrum of possibilities from pure "point in time" to pure "through the cycle." This means looking at how the bank structures its rating system, and applying quantitative benchmarking and back-testing procedures.

The bank can then take testing results into account when developing more rational and transparent views of capital adequacy.

Creating clarity on this issue does not, however, mean the bank must apply a purist through-the-cycle or point-in-time stance across its risk and capital metrics.

Instead, the best approach is first to build a point-in-time view of risk using the bank's economic capital model and then make explicit adjustments when calculating available capital so as to capture cyclical risks and other uncertainties. The bank will then have a best estimate of the risks it is running at any one point in time and understand the size of its capital buffer.

This leads us to the billion-dollar question: how big should the safety buffer be to safeguard the bank against cyclical shocks? The answer will have to be found through creating a more comprehensive, bankwide approach to stress testing.

Traditionally, banks have set up stress tests to look at a narrow range of risk interactions within specific portfolios and business lines.

This left firms unable to make any rigorous connection between individual stress-test results and enterprisewide capital adequacy.

To calculate a cyclical capital buffer, banks will have to look more broadly at what a stress scenario — potentially expressed via a shock to several macroeconomic indicators — might do to portfolios across the bank through an extended period and its impact on capital adequacy.

This is challenging because it means estimating how risk factors such as probability of default, loss given default and exposure at default interact, as well as how liquidity constraints might exacerbate credit and market risks.

It will often mean building in complex judgments about the effects of a downturn on different businesses and about the relationship between risk portfolios and risk types.

It's critical that banks confront these issues, because the answers will have implications not only for capital adequacy, but for other major decisions on business growth, mergers and acquisitions, earnings retention and dividend policies.

Each bank has to develop its own approach to the problem of risk capital cyclicality, based on transparent risk metrics and carefully defined conceptions of capital, rather than rely solely on the industry to make adjustments to regulatory capital formulas.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.