How Important Is the Adverse Feedback Loop for the Banking Sector?
How Important Is the Adverse Feedback Loop for the Banking Sector?

Summary/Abstract: Current regulatory framework for EU banks can have potential procyclical effects. Under certain conditions, procyclical behaviour of the banking sector can lead to an adverse feedback loop whereby banks, in response to an economic downswing, engage in deleveraging and reduce their lending to the economy in order to maintain the required capital adequacy ratio. This then further negatively affects economic output and impacts back on banks in the form of, for example, increased loan losses. This effect was simulated on the example of the banking sector of a selected EU country, namely the Czech Republic. The simulation results point out that under certain assumptions the feedback loop may play an important role.

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