Bank regulators are being urged to look again at the use of “buffers” as part of the global capital framework, as evidence mounts that banks did not use their cushions during the Covid-19 crisis and there is a stigma attached to doing so.
“Rather than seeing the buffers as a cushion to be drawn upon during a downturn, as originally intended by Basel III, banks seem to be treating the regulatory buffers as additional minimum requirements,” a study released by the US Federal Reserve said last week, in probably the most critical analysis of buffers to-date.
It warned that credit supply to smaller companies had been hurt, and there are concerns that could be more severe in the next recession. As a result, regulators are looking at whether tweaks to the rules are needed.
The most likely option could be to adjust the type of buffer used, bank regulation experts said. Banks could be required to have a bigger so-called counter-cyclical buffer, which can more easily and quickly be drawn down if stress emerges. But any change is unlikely soon – it take years for rules to be adjusted, and regulators are not even sure any change is needed.
Stigma
Buffers consist of “rainy day” equity capital that sits on top of minimum capital requirements. Many bankers and regulators say the Covid-19 crisis has shown the higher capital requirements put in place in the last decade have worked well, but some adjustment to the buffers is needed.
Last week's working paper from the US Fed said “buffer-constrained” US banks – those with capital ratios closer to regulatory minimums – had reduced credit during the pandemic to private, small firms that were dependent on bank lending. Supply was also cut to firms that had shorter relationships with banks or those where credit lines had less time to run.
The Fed’s assessment is significant as the coronavirus crisis has been the first real test of how buffers are used, and the analysis was the most detailed to-date on whether banks have curtailed lending. The findings came despite the Fed encouraging banks to eat into their buffers if necessary to support the economy, and there is evidence that capital-constrained banks in Europe reduced lending despite the European Central Bank telling them to use buffers.
Several reasons have been cited for that, including banks conserving capital because they were uncertain about economic prospects and the threat of worse times ahead; a risk of credit downgrades; a desire to keep capital so they could pay dividends in the future; and a stigma, and potential backlash from investors.
"There may be stigma associated with use of a regulatory buffer," Victoria Saporta, executive director of prudential policy at the Bank of England, said in a speech last week.
But some view the criticism as overdone. They say the fact that no major bank has breached buffers during the crisis is thanks to the capital built up since the 2008 financial crisis, and there has simply been no need for buffers to be used. Massive government and central bank support rode to the rescue and kept taps flowing for financing the economy, and banks worked alongside that to keep lending to the economy, in stark contrast to 2008.
It means the jury is still out on whether buffers have been truly tested.
“There is probably a stigma attached to [use of buffers],“ said Nicolas Hardy, a banking analyst at Scope Ratings. “But we also haven’t reached the situation where banks were in dire need to deplete core capital to cover unexpected events.”
Refinement and calibration?
IFR reported in October that regulators were watching how buffers were being used as the crisis unfolded, and that remains the case. Randal Quarles, head of supervision at the US Fed and chair of the Financial Stability Board, said at that time buffers required further work, and at least some refinement and calibration.
The Basel Committee, the group of global supervisors who set rules, said buffers may not have been used as planned, but it was hard to disentangle a lot of moving parts.
"The Basel III buffer framework has not yet been clearly tested," the Committee said in a report this month on early lessons on Basel reforms from the Covid crisis.
But the report said there was evidence banks may have been hesitant to use their regulatory capital buffers "had it been necessary", and said one-third of respondents in a survey of 60 banks in early 2021 cited the stigma risk. "Buffer use could be seen by markets as a sign of weakness, negatively affecting a bank’s share price, credit rating and access to low-cost funding," the report said, adding there could be a first-mover disadvantage.
Refining rules so counter-cyclical capital buffers, or CCyB, play a bigger role could have a twofold benefit, regulatory experts said.
CCyB is a varying capital requirement determined by domestic regulators. It is built up during good times or when risk-taking is elevated, and can then be quickly reduced at times of stress. The UK and other regulators reduced the CCyB to zero when strains started to emerge last year.
In addition to being more flexible and quick to release, it is also implemented for all banks, so banks are not singled out for special treatment for dipping into buffers.
The CCyB could be raised alongside a reduction in the capital conservation buffer (CCoB), which is a fixed and common layer of usable capital above the minimum capital requirement. When a firm dips into its CCoB restrictions are imposed on distributions, such as dividends and share buybacks – but almost all global regulators imposed those restrictions anyway at the start of the Covid crisis.