In the scorched-earth aftermath of the financial crisis, regulators were looking for novel ways to avoid a repeat of the carnage they had just lived through. Capital buffers — war chests of reserves specifically designed to help banks navigate the highs and lows of their businesses — seemed to offer just that.
A decade on, buffers are largely seen to have just failed their first test in the aftermath of the Covid-19 pandemic. They did provide some assurance to investors but did not unleash extra credit to the economy in a period of stress, leaving regulators scrambling to come up with a fix in an area fraught with market and political sensitivities.
It’s easy to see why the buffers were attractive to regulators back in the day.
One type, the countercyclical buffer, is specifically tied to crises. The idea is that banks build up a war chest during good times. Then, in bad times, their national regulator lets them dip into the vault by reducing or eliminating the buffer requirement, freeing up resources when they are most needed to absorb losses or support lending.
Another one, the capital conservation buffer, is a different kind of safety net. It’s set at an industry-wide level and banks can use it whenever they need to. Dipping into this buffer does restrict banks’ ability to pay dividends and some bond coupons, but that penalty is a lot less severe than the forced-capital raises triggered by breaching core capital requirements.
The buffers’ time to shine came last year, as the pandemic threatened the most dramatic cycle the world’s economies and banks had ever faced. The European Central Banks, the US Federal Reserve and the Bank of England all played their parts, allowing banks to use their countercyclical buffers and encouraging them to dip into their capital conservation ones.
And then, almost nothing happened. Research by the Bank for International Settlements showed the buffers — totalling more than $2.5tn heading into 2020 — had been mostly untouched right across the world.
Some say banks did not use their buffers to lend money because credit demand from their customers was sated by the trillions spent by governments on both sides of the Atlantic in support of companies.
Still, officials including Fed supervision head Randy Quarles and the BoE’s head of prudential regulation, Vicky Saporta, publicly lamented the buffers’ performance.
Regulators have spent the best part of a year trying to work out how they might put things right.
Last week, lobby group the Association of Financial Markets in Europe offered its two cents in a paper published ahead of the EU’s next deliberation on capital rules. The meat of AFME’s proposal is that the countercyclical buffer should be larger and the capital conservation buffer smaller.
AFME argues that banks were reluctant to use their capital conservation buffers because of the stigma attached, the perception that markets and investors wouldn’t like it. The countercyclical buffers are easier to use, AFME says, because when regulators reduce them that actually increases banks’ capacity to pay dividends or coupons, so stigma of reducing capital doesn’t apply in the same way.
In her July speech, Saporta noted that to avoid “investor and rating agency opprobrium” banks would consider cutting lending before dipping into buffers. “If a regulatory buffer is not practically usable in the sense that banks do not want to dip into it, then it has little value in helping firms to absorb shocks in ways that keep lending going in bad times,” she added.
In a speech last week, Quarles spoke of the importance of research into banks’ reluctance to draw down buffers so the Fed could “improve” its tools for the next crisis.
Corinne Cunningham, head of credit research at Autonomous, said European banks were sensitive about depleting capital conservation buffers since to do so would restrict their ability make coupon payments for additional tier one bonds, a non-issue for US banks, which do not use that type of debt.
Rebalancing buffers in favour of the countercyclical type would solve some problems but risks creating new ones. Nicolas Véron, of think-tank Bruegel, points out that a bigger countercyclical buffer could mean that capital was lower through the cycle as reserves rise and fall. Michael Lever, prudential regulation head at AFME, says that would be a positive thing since “the whole purpose is to enable a greater drawdown of capital buffers” in challenging times. Investors might not agree.
Another complexity is that national authorities set the countercyclical buffers. The gaps between different countries’ regimes could get bigger, since local regulators would be setting a bigger portion of the overall buffer.
Such divergence might be unwelcome for investors. Having the ECB oversee buffers across the eurozone would help consistency, but would open an even bigger can of worms.
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