What Is Procyclicality in the Context of Risk Management?

Procyclicality refers to behavior or policies that move in the same direction as the economic cycle, and can thereby amplify its fluctuations. Monetary authorities generally define it as the tendency of financial actors or institutions to follow the direction of the economic cycle. In risk management, this is seen when financial institutions adjust their actions in line with prevailing economic conditions.

During growth phases, financial institutions tend to loosen credit requirements and increase market liquidity. During slowdowns, they tend to tighten credit and increase loss reserves. This pattern can affect the magnitude of economic fluctuations in both phases.

Procyclicality vs. Countercyclicality

Countercyclicality is an approach that moves against the direction of the cycle. Macroprudential policy is generally designed to be countercyclical, meaning it tightens requirements when the economy is expanding and eases them when the economy is slowing, with the aim of keeping fluctuations manageable.

How Procyclicality Affects Economic Stability

Systemic risk is the potential for disruption to part or all of the financial system, influenced by institutional size, business complexity, interconnectedness among institutions, and procyclicality. For this reason, procyclicality is one of the factors considered when assessing financial system stability.

Examples of Procyclicality in the Financial System

In the banking sector, credit growth that continues throughout an expansion phase is often associated with the buildup of financial risk later on. During slowdowns, banks generally adjust their loss expectations, so credit supply also shifts along with the cycle.

Why Is Procyclicality a Serious Challenge for Indonesia?

Vulnerable Characteristics of the Indonesian Economy

Indonesia is one of the largest economies in Southeast Asia and is classified as an emerging market economy. Its economy is supported by the domestic market and government spending, and involves a considerable number of state-owned enterprises. These characteristics shape how economic and financial dynamics are interconnected.

The 1997 monetary crisis is often used as a subject of study on the links between fiscal conditions, bank credit quality, and the financial system safety net. The crisis had a wide impact on various economic sectors, including the financial industry.

Impact of Procyclicality on the National Banking Sector

Credit expansion that follows the economic cycle is one of the most widely studied topics in relation to financial stability. A number of empirical studies show that periods of high credit growth are often followed by financial stress. Small and medium enterprises play a major role in the economy, and financial institutions, including rural banks, help provide financing for this sector.

Various studies also examine the relationship between economic growth and credit growth across different types of financial institutions. Findings may vary depending on the period, methods, and data used.

Systemic Risks Posed

Systemic risk can be understood as a condition in which the failure of one bank affects other banks, or in which several banks experience difficulties at the same time. Changes in the level of systemic risk can affect financial system stability, for example through changes in loan quality, liquidity conditions, and the level of economic uncertainty.

The Risk Management Process in Addressing Procyclicality

Identifying Procyclical Risks

Risk identification is carried out across all business activities to analyze the sources, likelihood, and impact of risks. This stage covers risk events, causes, and impacts, drawing on audit reports, loss event databases, expert opinion, and benchmark data from other relevant organizations. Identification is performed periodically, and for new products it is performed before the product is introduced.

Measuring and Analyzing the Impact of Procyclicality

Risk measurement is carried out to determine the size of exposure as a reference for risk control and for calculating minimum capital requirements. Measurement can be quantitative or qualitative, using methods set by the regulator or internal methods based on prevailing practice. To account for extreme conditions, measurement is complemented by stress testing for credit, market, and liquidity risk.

Evaluating Risk Exposure

Risk analysis is performed by determining the level of likelihood and the level of impact based on risk criteria, taking into account the reliability of existing control systems. This evaluation includes an inventory of the internal control systems already in place.

Procyclical Risk Control Strategies

Risk control is carried out primarily to manage risks that could affect business continuity. The control system refers to established policies and procedures, adjusted to the exposure, the level of risk taken, and risk tolerance. Hedging and mitigation mechanisms are carried out by operational units together with risk management units.

Continuous Monitoring and Reporting

Monitoring is carried out to ensure risks are managed according to plan, among other things through monitoring of mitigation and risk limits. Its scope includes the size of exposure, risk tolerance, compliance with limits, stress testing results, and consistency in implementing policies and procedures. Results are reported periodically to internal and external parties, and ideally become part of the risk management work plan with clearly assigned owners.

Procyclicality Mitigation Measures in Indonesia’s Financial Sector

Implementing a Countercyclical Capital Buffer

The Countercyclical Capital Buffer (CCyB) is additional capital that serves as a cushion to anticipate losses when credit growth is judged to be excessive. Its size is dynamic, within a certain range of a bank’s Risk-Weighted Assets (RWA), and is adjusted by the authorities according to cyclical conditions. In general, the buffer is raised when the economy is expanding and lowered when the economy is contracting.

Adjusting Macroprudential Policy

Macroprudential policy uses various instruments to manage the accumulation of systemic risk from both the credit and liquidity sides, for example the Loan to Value ratio, the statutory reserve requirement, and the macroprudential intermediation ratio. Several studies examine the relationship between the capital adequacy ratio and reserve requirements on one hand and credit disbursement on the other, with results that can differ between studies.

Strengthening Stress Testing and Scenario Analysis

Stress testing has been widely developed as a tool for regulators since the global financial crisis. The financial services authority has also prepared stress testing guidance related to climate change risk. A multi-scenario approach makes it possible to identify which parts of the banking system, as well as which individual banks, are most sensitive to particular conditions.

Collaboration Between Regulators and Financial Institutions

Coordination among financial authorities is part of implementing macroprudential policy, particularly in managing credit risk and the credit cycle.

Improving Transparency and Risk Communication

Information transparency is one of the principles of good governance, including in communicating risks to the public and market participants.

Learning from International Practice

The international standard-setting body for banking supervision has updated its stress testing principles, which are now positioned as an element of bank risk management as well as a tool for supervisors and macroprudential authorities.

Conclusion

Procyclicality is a concept that describes the relationship between the behavior of the financial system and the economic cycle. In practice, managing it involves a structured risk management process, from identification through continuous monitoring, as well as various instruments such as countercyclical capital buffers, macroprudential policy, and stress testing. Coordination between regulators and financial institutions is part of the effort to maintain financial system stability.