Basel III

• Prepared by Markus Behn, Elena Rancoita, and Costanza Rodriguez dAcri [1] This article discusses the capital buffer framework under BaselIII, with particular focus on the issue of buffer usability.
• Capital buffers are a key element of the regulatory framework, inter alia aimed at enabling banks to absorb losses while maintaining the provision of key services to the economy.
• It also calls for a medium-term rebalancing between structural and cyclical capital requirements, as a greater share of capital buffers that can be released in a crisis would enhance macroprudential authorities ability to act countercyclically.

1 Objectives of the capital buffer framework

• The capital buffer framework for banks is one of the main new elements of the Basel III regulatory framework.
• Capital buffers play an important role in this respect, as they are inter alia meant to mitigate procyclicality by acting as shock absorbers in times of stress.
• In the European framework, these buffers include the capital conservation buffer (CCoB), the countercyclical capital buffer (CCyB), buffers for global and other systemically important institutions (G-SIIs and O-SIIs) and the systemic risk buffer (SyRB).
• [2] In recent years, banks in the euro area have increased their capital ratios considerably and built up capital buffers, in line with the timelines provided for in the framework.
• Starting in 2016, capital buffer requirements, such as the CCoB (in light green) and the buffers for G-SIIs and O-SIIs and the SyRB (in dark green), were phased in, increasing the total amount of required capital.
• Chart1 Evolution of bank capital ratios and their components in the euro area (percentages of risk-weighted assets)

2 Possible trade-offs between the objectives of the buffer framework

• While the various elements of the capital buffer framework are generally complementary, trade-offs and conflicts between them may exist in times of systemic stress.
• Over the medium term, the buffer framework aims to ensure a sound and stable banking system that is able to continuously provide key services to the economy.
• Following the materialisation of a systemic shock, however, when a number of banks may have to use the buffers as envisaged by the framework, conflicts between the objectives of the framework could arise.
• Maintaining lending at the onset of a crisis may help to reduce the amount of capital that will be needed to absorb losses further down the road.
• Thus, fewer losses would have to be absorbed in total, which mitigates the possible trade-off between the two objectives (see the article entitled Buffer use and lending impact in this issue of the Macroprudential Bulletin for a quantitative simulation of this effect).
• Importantly, for this benefit to materialise, it is necessary that the banking system collectively takes this positive externality into account in its lending behaviour.

3 The concept of buffer usability

• As evidenced by the crisis of 2007-09, a shortfall in credit supply (a credit crunch) can have material negative effects on GDP growth.
• Similarly, the economy may be negatively affected if banks withdraw from other activities that are economically relevant (e.g.market making, ownership of central counterparties, lending to other banks).
• Excessive deleveraging may occur in situations where banks want to avoid or mitigate deteriorations in their capital ratios, and usable capital buffers can help to prevent such undesirable behaviour.
• As noted above, such deleveraging can be harmful for the economy if it becomes excessive, which is why the buffer framework aims to ease the pressure to adjust.
• In addition, banks are explicitly allowed to operate below the remaining capital buffer requirements when needed, subject to automatic restrictions on distributions.
• Buffers are considered usable if banks are willing to operate within the CBR, while avoiding undesirable adjustment actions such as excessive deleveraging.
• First, the materialisation of losses reduces the amount of capital that is available to the bank, i.e.the numerator of the capital ratio.
• [4] In both of these cases, buffers are considered usable if banks do not take undesirable adjustment actions (such as excessive deleveraging) to avoid a breach of the buffer requirements or to shorten its duration.

4 Possible impediments to buffer usability

• Market-based factors that may undermine the usability of capital buffers include the following:
  • Higher funding costs: Banks’ funding costs could increase or the availability of funding could become restricted once capital ratios start to decline (owing to the increase in perceived default risk). This effect may be exacerbated by the potential stigma when a breach of the CBR becomes public knowledge. It could also be further aggravated if the decline in capital ratios is associated with an expansion in lending, as, in times of crisis, the latter may be associated with excessive risk-taking.
  • Possible rating downgrades: Banks’ capital positions are an important factor in their credit rating, which affects banks’ access to and cost of funding as well as their reputation more broadly.[5] As for the funding cost factor, rating downgrades may occur either because of the negative signal associated with a breach of the CBR or because of the decline in capital ratios (and the increase in default risk) more generally.
• Regulatory and prudential factors include the following:
  • Distribution restrictions: Banks would face automatic restrictions on distributions when operating below the CBR. These restrictions on dividend, bonus and AT1 coupon payments would have negative effects on investors and bank executives. To maintain a strong relationship with investors, and also to avoid triggering the market factors outlined above, banks may prefer to deleverage rather than face automatic restrictions. Concerns about distribution restrictions may be particularly relevant for certain instruments, such as AT1 bonds, since market intelligence suggests that a cancellation of a coupon payment could be seen as a particularly adverse signal – even if coupon payments are contractually set to be discretionary.
  • Existence of other regulatory/prudential requirements: Other regulatory and prudential requirements – such as the leverage ratio or the minimum requirement for own funds and eligible liabilities – may reduce the usability of the CBR if they become more binding than the risk-based requirement. The use of buffers may also be curtailed if banks wish to maintain a sufficient margin above the regulatory minimum requirement within the risk-based framework (i.e. the sum of Pillar 1 and Pillar 2 minimum requirements).
  • Concern and uncertainty about prudential authorities’ follow-up and their willingness to tolerate buffer use: Banks might want to avoid the increased supervisory scrutiny associated with a breach of the CBR, and such scrutiny is likely to increase the closer the bank comes to the minimum requirement, raising concerns regarding its viability. In addition, banks may face uncertainty with respect to the time they would have to restore their capital buffers after the initial breach of the CBR, unless this is clearly communicated by the supervisor. Finally, banks may be concerned about the speed of capital buffer increases once the crisis is over and conditions normalise. Such concerns may be more relevant at times when profitability is low or access to capital markets is constrained.
  • Many of these factors relate to some form of stigma, attached either to a breach of the CBR (potentially further strengthened by the associated restrictions on distributions) or to operating with capital ratios below market expectations.
  • Collective action problems may arise if individual banks fail to properly consider the social benefit of stabilising the economy and the banking sector through the use of the buffers.
  • Uncertainty over the future path of the crisis or existing vulnerabilities in the sector could also play a role.
  • In addition to the issue of stigma, which is about perception, there could also be difficulties relating to constraints stemming from other regulatory requirements and supervisory tolerance of buffer use.
  • Prudential and regulatory factors are one determinant of these target ratios, as banks may want to allow for sufficient (varying or constant) management buffers above the threshold of regulatory intervention.

5 Policy implications of the COVID-19 crisis

Initial policy reaction in response to the crisis

• European and national authorities took swift measures to address the impact on the financial sector of the coronavirus pandemic.
• Several euro area macroprudential authorities (including central banks and banking supervisors) reduced macroprudential buffer requirements, releasing more than 20billion of CET1 capital held by euro area banks.
• [6] Specifically, in several of the countries where the CCyB was positive or was in the course of being activated, authorities reduced the requirement or halted its activation.
• In some countries, the SyRB was also fully released or lowered, while buffers on selected O-SIIs were reduced.
• Starting on 12March 2020, ECB Banking Supervision announced a number of temporary capital and operational relief measures in response to the COVID-19 shock.
• In addition, banks were encouraged to avoid excessive procyclical effects when applying International Financial Reporting Standard (IFRS)9.

Reflections on the way forward

• Clear and convincing communication can help overcome supervisory impediments to buffer usability and, possibly, also market-based impediments.
• In their communications, prudential authorities have repeatedly stated that using buffers today would be in line with the expectations set out in the regulatory framework.
• This message clarifies authorities expectations and can help overcome impediments to buffer usability stemming from uncertainty about supervisory follow-up action.
• Moreover, clear and credible communication on the use of buffers also helps inform the expectations of financial market participants, thereby limiting the possible stigma associated with banks use of buffers.
• Shaping agents expectations on the path towards replenishing used buffers will also help to enhance their usability.

Implications for future policy design

• A possible way to address this issue would be to enhance the role of releasable capital buffers within the capital framework.
• Following the release of a specific buffer requirement, banks can operate with lower capital ratios without breaching the CBR and without being subject to automatic restrictions on distributions.
• The limited availability of releasable capital buffers in the COVID-19 crisis constrained macroprudential authorities ability to act countercyclically.
• Moreover, unless accompanied by clear communication, the release of structural buffers could impair the credibility of the macroprudential framework and generate uncertainty over the future application of the buffers.
• Any adjustments to the framework would have to ensure that all of the buffer frameworks current objectives continue to be met.
• For this reason, a clear framework for the timely restoration of releasable elements in the capital stack would be needed.

6 Conclusion

• It explains the concept of buffer usability and examines a number of impediments that may limit the use of buffers.
• Buffers are considered usable if banks are willing to operate with capital ratios below the CBR while avoiding undesirable adjustment actions such as excessive deleveraging.
• Regulatory, prudential and market-based impediments may, however, limit banks willingness to use available buffers and allow capital ratios to decline.
• To ensure that the prudential policy measures already implemented remain appropriate, the issue of buffer usability needs continuous monitoring.
• Moreover, a better balance between structural and cyclical elements of the capital stack would increase the macroprudential policy space in a stress situation.

References