While banking is procyclical, the capital framework is largely static. The countercyclical capital buffer is discretionary, with potential danger of inaction, and is also limited in scale. This column proposes an expanded capital conservation buffer, which would act as an automatic stabiliser. This could incorporated in the next Basel review and the upcoming Solvency II review.
The banking system is procyclical (Borio 2014). There is strong support for anticyclical macroprudential capital requirements. However, the political economy of activating such anticyclical measures is fraught with difficulties. We, therefore, suggest working more with rule-based capital measures, such as a significantly larger capital conversation buffer than currently required. Banks could only distribute profits to shareholders or raise bonuses to senior managers when this larger capital conservation buffer was met. It thus works as an automatic stabiliser: in good times capital is accumulated in the conservation buffer, which can be drawn down in bad times. Fiscal policy has good experience with such automatic stabilisers.
Procyclical banking system
The banking system is inherently procyclical. In good times, perceived risk is low leading to lower risk-based capital requirements, and vice versa (Brunnermeier et al. 2009). Moreover, profits are added to capital in good times and losses deducted in crisis times. In a recent contribution, Huizinga and Laeven (2019) indicate that banks’ loan loss provisioning is also procyclical. These cumulative effects lead to a very procyclical banking sytem. Borio (2014) shows clearly that the amplifications in the financial system are larger than in the economy (measured by GDP). The financial cycle is stronger than the business cycle.
Anticyclical capital requirements
Brunnermeier et al (2009) argue therefore for anticyclical capital requirements as a macroprudential tool. The Basel III capital adequacy framework contains a countercyclical capital buffer of up to 2.5% of risk-based capital requirements and a capital conservation capital buffer of 2.5%. Both buffers are part of core equity tier 1 capital (CET1). So far, good news.
First, it appears very difficult to activate the countercyclical capital buffer. When the credit-to-GDP gap passes a certain threshold, the macroprudential authority should activate this buffer. The discretionary approach leaves scope for delaying or not at all activating the buffer. Until now, only the Scandinavians, the UK, France, Ireland, Luxembourg, the Czech Republic, Bulgaria, Slovakia, and Lithuania have activated the countercyclical buffer in Europe (see the European Systemic Risk Board for an overview as of 7 June 2019). It is strange that countries which have recently shown solid economic growth (such as Germany and the Netherlands) have not (yet) activated the countercyclical buffer. Some of the stronger banks in these countries have started to buy back shares, just as happened in the run up to the global financial crisis. This leaves banks capitalised at the bare minimum when the cycle turns.
It is easily possible to show that the technical threshold is not (yet) met, so the buffer does not need to be activated. For Germany, weaknesses at some of their large banks could be a reason for delayed action (end-May. Bafin announced the activation). For the Netherlands, the higher capital floors for mortgages in the revised Basel III rules of December 2017 might be a reason for inaction. These examples show that the political economy of capital requirements may lead to biased application of the capital requirements.
Second, the countercyclical capital buffer is only part of the risk-based capital requirements. The leverage ratio is flat. The lower the leverage ratio, the stronger the financial cycle. Profits are added to a small capital base, allowing further expansion of the balance sheet in the next period. Schoenmaker and Wierts (2015) show that lower leverage ratios lead to larger swings in the financial cycle.
A proposal for a stronger conservation buffer
The solution is to make the capital framework more rule-based (Hanson et al. 2011). We therefore propose to expand the capital conservation buffer from 2.5% to 5% of risk-based capital requirements and to incorporate the conservation buffer also in the leverage ratio. This would roughly translate into an extra leverage ratio of 2.5%, since risk-weighted assets are about half total assets. The capital surcharge for global systemically important banks (the so-called G-SIB surcharge) is also for 50% translated into the leverage ratio in the Basel III update of December 2017. The G-SIBs would then have a leverage ratio of about 6% in good times (3% basic requirement, 2.5% conservation buffer and 0.5% systemic surcharge).
Such a larger and expanded conservation buffer would work as an automatic stabiliser in a financial system that is procyclical. It may not only be useful for banks, but also for insurance companies which experience procyclical investment behaviour (Duijm and Steins Bisschop 2018).
As the current macroeconomic cycle is weakening, we suggest introducing the expanded capital conservation buffer in time for the next cyclical upturn. It could thus be incorporated in the next Basel review and the upcoming Solvency II review.
Brunnermeier, M, A Crockett, C Goodhart, A Persaud and H.Shin (2009), The Fundamental Principles of Financial Regulation, Geneva Reports on the World Economy 11, ICMB and CEPR.
Borio, C (2014), ‘The financial cycle and macroeconomics: what have we learnt?’, Journal of Banking and Finance 45: 182–198.
Duijm, P and S Steins Bisschop (2018), “Short-termism of long-term investors? The investment behaviour of Dutch insurance companies and pension funds”, Applied Economics 50(31): 3376-3387
Hanson, S, A Kashyap, and J Stein (2011), “A macroprudential approach to financial regulation”, Journal of Economic Perspectives 25: 3–28.
Huizinga, H and L Laeven (2019), “The procyclicality of banking in the euro area”, VoxEU.org, 29 May.
Schoenmaker, D and P Wierts (2015), “Regulating the Financial Cycle: An Integrated Approach with a Leverage Ratio”, Economics Letters 136: 70-72.