Banking regulation, procyclicality, and asset correlations in the real economic environment

Banking regulations have often been viewed as possible sources of procyclicality. We aim to provide a critical assessment of the risk-weighted asset estimates through the relationship between asset correlation and the probability of default as stated by international regulators. Our findings show that the relationship between asset correlation and size is not linear and also changes with the economic cycle. A risk- weighted asset computed according to regulatory assumptions would not generate the required capital relief during the downturn phase, when banks should release credit resources to support firms’ resilience. Therefore, we propose to transform the regu- latory approach to empower the procyclical issues that still remain in upturns and slowdowns in economic cycles.