Good Times Absolutely Call for a Countercyclical Capital Buffer

Good Times Absolutely Call for a Countercyclical Capital Buffer

The staff of the Bank Policy Institute (BPI) recently penned a piece arguing that, despite it being a good time to work in finance, the Fed shouldn’t increase the countercyclical capital buffer (CCyB), a supplementary capital requirement (currently at 0%) that increases during good times and decreases during downturns:

So, what is the purpose of the CCyB? Because times are normally “good,” an analysis of where capital requirements should generally be set “in good times” is the same as an analysis of where capital should be set in normal times. Roughly all efforts to estimate the best level of capital requirements in normal times do so by weighing the impact of the level of capital on the odds of a crisis against the impact of capital on economic activity. The logic of the CCyB is that when the likelihood of a crisis is higher than normal, the appropriate level of capital is higher than the normal level. But the Federal Reserve currently judges that the likelihood of a crisis is moderate, not elevated, in large part because bank capital levels are so high. Federal Reserve Vice Chair for Supervision Randal Quarles recently affirmed this view, stating that “Taken as a whole, financial system vulnerabilities strike me as being not outside their normal range, which is consistent with a zero CCyB under the Board’s framework.”

BPI points out two already existing forms of “rainy day” capital requirements–the 2.5% capital conservation buffer (CCB) and the Fed’s annual stress tests. The CCB (which the post mistakenly calls the “capital conservation capital buffer”) is, unlike the CCyB, not really a countercyclical tool since it is constant across the business cycle, whereas the CCyB can be raised and lowered. As this blog post from the Federal Reserve Bank of Cleveland explains:

In principle, the CCB could help reduce the procyclicality of the banking system and have a countercyclical effect. If the CCB works as intended, banks will build up their buffers during expansions. During recessions, banks that sustain capital losses and fail to satisfy the CCB requirement face less severe penalties than if they were failing to satisfy the [minimum capital requirements, MCRs]. They may choose to incur the penalty rather than contract their lending and restore their capital-to-asset ratios.

In practice, however, the CCB’s countercyclical impact may be small. The constraints for failing to maintain the CCB—on dividends, share buybacks, and bonuses—are still rather restrictive. To avoid these constraints, banks may aim to satisfy the CCB requirement at all times, effectively treating the introduction of the CCB as equivalent to an increase in the MCRs. During recessions, in particular, banks that sustain capital losses may still contract their lending in order to rebuild their CCB as soon as possible.

This isn’t to say the CCB is bad. Capital requirements in general are too low. Most research shows the optimal capital requirement is somewhere around 20%, while the financial sector is currently around 11% equity financed, and current policy requires a total of 10.5% equity financing. But as a countercyclical tool, it is somewhat lacking, making BPI’s argument misleading.

The stress tests, the other countercyclical tool identified by BPI, while designed to determine how well a bank could perform in a hypothetical recession, are also not countercyclical in that they do not impose any additional requirements, only verify that a bank is sufficiently capitalized as it exists today. It’s the difference between a check-up and a seasonal flu shot.

While it is true that there’s no immediate risk of a banking crisis, there is an inherent tension in BPI’s argument. On the one hand, they argue that it’s inherently difficult to predict a downturn (true). On the other, they argue that because there’s little risk of a catastrophic banking failure, there’s no need to prepare for the coming storm. “We can never know when the next downturn is going to come, only that it isn’t coming right now” is a rather strange argument to make.

It is exactly because we can’t be sure when the next downturn will come about that we need to keep the CCyB high while things are going well. Raising the CCyB, under BPI’s logic, signals an increase in systemic risk, which could in turn spook the market and make a downturn a self-fulfilling prophecy.

I didn't find this helpful.This was helpful. Please let us know if you found this article helpful.
By |2019-04-25T08:31:33-07:00April 25th, 2019|Blog, Financial Regulation|