Widespread problems in the banking system are often associated with sharp declines in asset prices, or the economy more broadly. When these declines result in loan defaults, bank capital can erode, leading to more stringent underwriting standards, tighter credit and further declines in economic activity. In theory, a capital cushion that can be reduced in times of stress while still maintaining adequate capital levels in banking institutions might be used to mitigate this cycle. Capital could be increased during times of irrational exuberance and then reduced as the bubble bursts and losses accrue. This theory was incorporated into section 616 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which provides that
[i]n establishing capital regulations pursuant to [the Bank Holding Company Act of 1956], the [Federal Reserve Board] shall seek to make such requirements countercyclical, so that the amount of capital required to be maintained by a company increases in times of economic expansion and decreases in times of economic contraction, consistent with the safety and soundness of the company.
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