Episode 3 : When Regulation Rides the Cycle: The Procyclicality Trap in Credit

Vivek Krishnan
Aug 11, 2025
4 min read

Policy Vs Practice Series

Policy Intent: Regulatory frameworks — from RBI’s capital adequacy norms to provisioning requirements — are designed to safeguard the banking system and ensure credit discipline.

Practice Reality: In real-world cycles, these very rules often push banks to lend more in booms and less in downturns — exactly the opposite of what the economy needs. This self-reinforcing pattern is called procyclicality.

When the tide is high, credit flows like a river…

When it’s low, it’s a desert.

That’s procyclicality — and it’s silently shaping your loan book.

Imagine a neighbourhood tailor shop. When the economy is doing well, customers flock in, and the tailor hires extra hands, stocks expensive fabrics, and even takes a loan to expand. The bank is happy to lend because everyone’s paying on time…

…Then a slowdown hits. Customers disappear. The tailor cuts staff, sells leftover fabric at a discount, and struggles to repay the loan. Seeing the trouble, the bank tightens lending norms and offers no fresh credit — not just to this tailor, but to other shopkeepers too.

Result?

In good times, credit flows freely, fueling expansion.
In bad times, credit dries up, making recovery harder.

That cycle — where lending rises in booms and falls in busts — is procyclicality. And policy decisions (like RBI’s capital adequacy rules) can unintentionally amplify it.

The GENESIS of PROCYCLICALITY

Procyclicality means credit growth and contraction tend to move in sync with the economic cycle — rising in booms, shrinking in downturns.

Banks, NBFCs, and even fintechs get caught in this rhythm.

The problem? It amplifies risks when the economy slows and starves good borrowers just when they need liquidity the most.

In good times…

Risk appetite increases
Underwriting relaxes
Asset prices swell

In bad times…

Lending tightens
Collateral values fall
Defaults rise

And the cycle feeds on itself.

How Policy Fuels Procyclicality

Capital Adequacy Norms (Basel & RBI)
- In good times: NPAs are low, risk weights shrink, capital appears abundant → banks lend aggressively.
- In downturns: NPAs spike, risk weights jump, capital looks inadequate → lending contracts.
Loan Loss Provisioning (ECL models)
- Risk parameters worsen in slowdowns → provisions rise → profits fall → fresh lending is curtailed.
Monetary Policy
- Rate hikes to tame inflation raise lending costs → credit demand and supply drop during slowdowns.
- Rate cuts in booms make credit too cheap, sometimes inflating bubbles.
Sector-Specific Risk Weight Changes
- RBI’s hikes in risk weights for overheated sectors (e.g., unsecured retail) curb lending during expansion, but can also choke funding to otherwise viable borrowers in downturns.
Countercyclical Buffers — The Missed Opportunity
- RBI has the tool (CCyB) but rarely deploys it, leaving the system exposed to the natural swing of the cycle.

Why This Matters

Borrowers: Viable projects in downturns face funding denial.
Banks: Risk aversion peaks when opportunities for prudent long-term lending are greatest.
Economy: Credit withdrawal deepens recessions.

Policy vs Practice Takeaway

Policy: Protect the system via prudence and capital discipline.
Practice: Rules align with, rather than counter, economic swings — amplifying both booms and busts.

COUNTER CYCLICAL REGULATION

A shift to truly countercyclical regulation — provisioning in good times, easing in bad — could break this pattern.

RBI’s Financial Stability Report (June 2024) notes that during FY21–FY23, credit growth surged to over 15% as GDP rebounded, but slowed sharply in stress pockets like MSME post-2023 tightening.

The counter-cyclical provisioning buffer (CCPB) is basically the antidote to procyclicality.

What it is

It’s an extra reserve banks build up during good times when NPAs are low and profits are strong.
Then, in a downturn, banks can dip into this buffer to absorb higher NPAs without choking credit flow.

Why RBI introduced it (conceptually)

To smoothen the credit cycle — i.e., prevent credit from swinging wildly between boom and bust.
Global best practice from Basel III norms: Build cushions when the sun is shining, use them when it rains.

Why RBI isn’t really exercising it in India right now

Bank profitability pressures
- Indian banks argue that maintaining high provisions in good years eats into lending capacity and profitability.
- Politically and competitively, banks prefer showing stronger earnings and paying dividends.
Regulatory approach in India
- RBI has talked about CCPB since 2010, but its actual activation trigger has been vague and rarely enforced.
- In practice, RBI still relies on point-in-time asset classification and provisioning norms, which are inherently procyclical.
Data & calibration challenges
- Calibrating the buffer size requires deep, reliable, sector-level credit cycle data — still patchy in India.
- Without this, setting the “right” extra provision risks overburdening banks or being too light to matter.
Short-term focus during crises
- In downturns (e.g., COVID-19), RBI has preferred moratoriums, restructuring, and liquidity windows rather than letting banks dip into a pre-built buffer (which, in truth, was never meaningfully filled).

💡 In short:

The counter-cyclical buffer is meant to soften procyclicality, but India has kept it mostly on paper. That’s why, in bad times, banks still slam the brakes on lending instead of tapping stored provisions.

Purpose

If credit policy doesn’t account for procyclicality, the system swings too far in either direction — hurting stability and inclusion. This is where counter-cyclical provisioning, dynamic risk weights, and cash-flow-based lending become more than buzzwords… they’re survival tools.

Have you seen procyclicality play out in your sector? Did it hurt good borrowers — or protect the system? Let’s discuss. Your front-line view matters.