TWN Info Service on Finance and Development (July10/03)
27 July 2010
Third World Network

Capital buffer to protect against future bank losses BCBS
Published in SUNS #6972 Friday 23 July 2010

Geneva, 22 Jul (Kanaga Raja) -- The Basel Committee on Banking Supervision (BCBS) has tabled a proposal on counter-cyclical capital buffers that would be deployed when, in the view of national authorities, excess aggregate credit growth is judged to be associated with a build-up of system-wide risk to ensure that the banking system has a buffer of capital to protect it against future potential losses.

The focus on excess aggregate credit growth means that jurisdictions are likely to only need to deploy the buffer on an infrequent basis, perhaps as infrequently as once every 10 to 20 years, although internationally-active banks will likely find themselves carrying a small buffer on a more frequent basis, since credit cycles are not always highly correlated across the jurisdictions to which they have credit exposures, says BCBS.

The proposal came following a two-day meeting (14-15 July) of the Committee that amongst others reviewed the design and overall calibration of the capital and liquidity frameworks, the results of its comprehensive quantitative impact study and its economic impact assessment analyses.

The counter-cyclical capital buffer proposal has been issued for consultation, and comments on the proposal are to be submitted by 10 September.

According to the Committee, the counter-cyclical buffer proposal is designed to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. It should be viewed as an important internationally consistent instrument in the suite of macro-prudential tools at the disposal of national authorities.

BCBS says that the key features of the proposal that distinguish it from some other macro-prudential tools and foster a consistent international implementation are: a single objective; national buffer decisions combined with jurisdictional reciprocity; and a common starting reference guide combined with principles and disclosure requirements to guide the use of judgment, promote sound decision-making and foster accountability.

BCBS further says that the primary aim of the proposal is to use a buffer of capital to achieve the broader macro- prudential goal of protecting the banking sector from periods of excess aggregate credit growth that have often been associated with the build up of system-wide risk. Protecting the banking sector in this context is not simply ensuring that individual banks remain solvent through a period of stress, as the minimum capital requirement and capital conservation buffer are together designed to fulfill this objective.

Rather, the aim is to ensure that the banking sector in aggregate has the capital on hand to help maintain the flow of credit in the economy without its solvency being questioned, when the broader financial system experiences stress after a period of excess credit growth.

"This should help to reduce the risk of the supply of credit being constrained by regulatory capital requirements that could undermine the performance of the real economy and result in additional credit losses in the banking system," stresses BCBS.

In addressing the aim of protecting the banking sector from the credit cycle, BCBS adds, the proposal may also help to lean against the build-up phase of the cycle in the first place. This would occur through the capital buffer acting to raise the cost of credit, and therefore dampen its demand, when there is evidence that the stock of credit has grown to excessive levels relative to the benchmarks of past experience. This potential moderating effect on the build-up phase of the credit cycle should be viewed as a positive side benefit, rather than the primary aim of the proposal.

According to the proposal, the counter-cyclical capital buffer will work by giving each jurisdiction the ability to use their judgement to extend the size of the minimum buffer range established by the capital conservation buffer. This will be effected by implementing a buffer add-on during periods of excess aggregate credit growth that are judged to be associated with an increase in system-wide risk.

(Annex 1 of the proposal provides an example of how the counter-cyclical capital buffer and the capital conservation buffer could be integrated in practice.)

Under the proposal, buffer add-on decisions would be pre-announced by 12 months to give banks time to meet the additional capital requirements before they take effect, while reductions in the buffer would take effect immediately to help to reduce the risk of the supply of credit being constrained by regulatory capital requirements. The consequences of not meeting the counter-cyclical capital buffer will be the same as not meeting the capital conservation buffer (i. e. constraints on distributions of earnings).

Authorities in each jurisdiction will be responsible for setting the buffer add-on applicable to credit exposures to counter-parties/borrowers in its jurisdiction. The add-on will be subject to an upper bound (to be determined in the calibration process) and will only be in effect when there is evidence of excess credit growth that is resulting in a build-up of system-wide risk. The add-on will be zero at all other times.

Banks with purely domestic credit exposures will be subject to the full amount of the prevailing add-on published by their home jurisdiction. Internationally active banks will look at the geographic location of their credit exposures and calculate their buffer add-on for each exposure on the basis of the buffer in effect in the jurisdiction in which the exposure is located. At an enterprise-wide consolidated level, this means that each bank's buffer will effectively be equal to a weighted average of the add-ons applied in jurisdictions to which they have exposures.

If a bank's capital level falls into the extended buffer range, they would be given 12 months to get their capital level above the top of this range before restrictions on the distributions of their earnings come into effect.

According to BCBS, the proposal implies that there would be jurisdictional reciprocity. The host authorities take the lead in setting buffer requirement that would apply to credit exposures held by local entities located in their jurisdiction. They would also be expected to promptly inform their foreign counterparts of buffer decisions so that authorities in other jurisdictions can require their banks to respect them. Meanwhile, the home authorities will be responsible for ensuring that the banks they supervise correctly calculate their buffer requirements based on the geographic location of their exposures.

"Such reciprocity is necessary to ensure that the application of the counter-cyclical buffer in a given jurisdiction does not distort the level playing field between domestic banks and foreign banks lending to counter-parties in that jurisdiction. This reciprocity does not entail any transfer of power between jurisdictions, in keeping with Basel Committee agreements more generally; the power to set and enforce the regime will ultimately rest with the home authority of the legal entity carrying the credit exposures."

The home authorities will always be able to require that the banks they supervise maintain higher buffers if they judge the host authorities' buffer to be insufficient. However, the home authorities should not implement a lower buffer add-on in respect of their bank's credit exposures to the host jurisdiction. This will help to ensure that concerns about a competitive equity disadvantage to domestic banks (from foreign bank competition) do not discourage the implementation of the buffer add-on.

To assist the relevant authority in each jurisdiction in its decision on the appropriate setting for the buffer, BCBS says that a methodology has been developed to calculate an internationally consistent buffer guide that can serve as a common starting reference point for taking buffer decisions.

The methodology transforms the aggregate private sector credit/GDP gap into a suggested buffer add-on. It indicates a zero guide add-on when credit/GDP is near or below its long-term trend and a positive guide add-on when credit/GDP exceeds its long term trend by an amount which, on the basis of past experience, suggests there could be excess credit growth that may be associated with a build up of system-wide risk.

(A step-by-step description of how this guide is calculated is set out in Annex 2 of the proposal.)

According to BCBS, the evidence presented in Annex 2 suggests that while the credit/GDP gap would often have been a useful guide in taking buffer decisions in the past, it does not always work well in all jurisdictions at all times. Judgment coupled with proper communications is thus an integral part of the proposal. Rather than rely mechanistically on the credit/GDP guide, authorities are expected to apply judgment in the setting of the buffer in their jurisdiction after using the best information available to gauge the build-up of system-wide risk.

It is crucial, however, that the use of judgment be firmly anchored to a clear set of principles to promote sound decision-making in the setting of the counter-cyclical capital buffer. By extension, communicating buffer decisions should help banks and other stakeholders understand the rationale underpinning the decisions and promote sound decision-making by authorities responsible for operating the buffer, adds BCBS.

The proposal outlines several principles that have been formulated by the Committee to guide authorities in the use of judgment in this framework.

Firstly, buffer decisions should be guided by the objectives to be achieved by the buffer, namely, to protect the banking system against potential future losses when excess credit growth is associated with an increase in system-wide risk. The counter-cyclical capital buffer is meant to provide the banking system with an additional buffer of capital to protect it against potential future losses, when excess credit growth in the financial system as a whole is associated with an increase in system-wide risk. The capital buffer can then be released when the credit cycle turns so that the released capital can be used to help absorb losses and reduce the risk of the supply of credit being constrained by regulatory capital requirements. A side benefit of operating the buffer in this fashion is that it may lean against the build-up of excess credit in the first place.

As such, BCBS underscores, the buffer is not meant to be used as an instrument to manage economic cycles or asset prices. Where appropriate those may be best addressed through fiscal, monetary and other public policy actions. It is important that buffer decisions be taken after an assessment of as much of the relevant prevailing macroeconomic, financial and supervisory information as possible, bearing in mind that the operation of the buffer may have implications for the conduct of monetary and fiscal policies.

Second, the credit/GDP guide is a useful common reference point in taking buffer decisions. It does not need to play a dominant role in the information used by authorities to take and explain buffer decisions. Authorities should explain the information used, and how it is taken into account in formulating buffer decisions.

Third, assessments of the information contained in the credit/GDP guide and any other guides should be mindful of the behaviour of the factors that can lead them to give misleading signals. In assessing a broad set of information to take buffer decisions in both the build-up and release phases, authorities should look for evidence as to whether the inferences from the credit/GDP guide are consistent with those of other variables. Some examples of other variables that may be useful indicators in both phases include: various asset prices; funding spreads and CDS (credit default swap) spreads; credit condition surveys; real GDP growth; and data on the ability of non-financial entities to meet their debt obligations on a timely basis.

Fourth, promptly releasing the buffer in times of stress can help to reduce the risk of the supply of credit being constrained by regulatory capital requirements. When a decision is taken to release the buffer in a prompt fashion, it is recommended that the relevant authorities indicate how long they expect the release to last. This will help to reduce uncertainty about future bank capital requirements and give comfort to banks that capital released can be used to absorb losses and avoid constraining asset growth.

Fifth, the buffer is an important instrument in a suite of macro-prudential tools at the disposal of the authorities. When excess aggregate credit growth is judged to be associated with a build up of system-wide risks, authorities should deploy the buffer, possibly in tandem with other macro-prudential tools, in order to ensure the banking system has an additional buffer of capital to protect it against future potential losses. Alternative tools - such as loan-to-value limits, interest rate qualification tests or sectoral capital buffers - may be deployed in situations where excess credit growth is concentrated in specific sectors but aggregate credit growth is judged not to be excessive or accompanied by increased system-wide risk.

On the calculation methodology concerning bank specific buffers, BCBS notes that the buffer that will apply to an internationally active bank will reflect the geographic composition of the bank's portfolio of credit exposures. Internationally active banks will look at the geographic location of their private sector credit exposures (including non-bank financial sector exposures) and calculate their counter-cyclical capital buffer add-on as a weighted average of the add-ons that are being applied in jurisdictions to which they have an exposure. Through this process, a bank loan to a private sector entity located in any given jurisdiction will attract the same buffer requirement, irrespective of the location of the bank providing the loan.

As an example, says BCBS, assume that the published counter-cyclical buffer add-ons in the United Kingdom, Germany and Japan are 2%, 1% and 1.5% of risk weighted assets, respectively. This means that any loans to UK counter-parties, irrespective of the location of the bank making the loan, will attract a buffer requirement of 2% in respect of these loans. Similarly, loans to German and Japanese counter-parties will attract buffer requirements of 1% and 2% respectively.

As a consequence, a bank with 60% of its credit exposures to UK counter-parties, 25% of its credit exposures to German counter-parties and 15% of its credit exposures to Japanese counter-parties would be subject to an overall counter-cyclical capital buffer add-on equal to 1.68% of risk weighted assets.

While communicating buffer decisions is key to promoting accountability and sound decision-making, BCBS acknowledges that some authorities may currently have little experience in publicly commenting on macro-financial conditions, much less explaining future buffer decisions. As a result, it would be reasonable to give them some time to gain experience in operating the buffer and to develop a communications strategy before taking on the task of publicly explaining buffer decisions.

To provide this flexibility, it is proposed that the buffer framework be implemented through a combination of minimum standards and best practice guidance:

-- The minimum standards would describe: (a) the mechanics of the buffer approach, i. e. the information the banks need to comply with the rules; and (b) the information that all authorities will be expected to disclose, i. e. any changes to the counter-cyclical capital buffer in effect in their jurisdiction, and on a regular and timely basis the credit/GDP data used to calculate the common reference guide.

-- The best practice guidance would set out recommendations on how authorities can best promote accountability and transparency regarding buffer decisions. This guidance would recommend that authorities should over time develop a communication strategy. It would also mention the role of a new Basel Committee subgroup, which would facilitate learning about the logic used in determining buffer decisions and make recommendations to the Committee on updates to the best practice guidance.

The minimum standards would ensure that the counter-cyclical capital buffer regime is operationalised within a set time-frame. The best practice guidance would make it clear that publicly explaining buffer decisions is the recommended ultimate goal, but in a way that provides authorities with flexibility to develop their communication strategies over an appropriate time-frame.

According to BCBS, encouraging the banking sector to build-up capital to meet the objective described above, rather than simply ensure solvency through periods of stress, represents a significant departure from how prudential regulation has been implemented in many jurisdictions. This increases the importance of a dialogue with industry and other stakeholders, to ensure that the aim and mechanics of the proposal are fully understood.

Given the novelty of the proposal, the BCBS believes that it would be prudent for it to formally evaluate the buffer's performance in due time. To properly assess the performance of the counter-cyclical capital buffer, any evaluation would ideally take place after most Committee-member jurisdictions have gained experienced over a full credit cycle with the proposal in place. +