The Countercyclical Capital Buffer

This post uses a recent BCBS working paper as a stepping off point for a broader examination of how the countercyclical capital buffer (CCyB) can help make the banking system more resilient. The BCBS paper is titled “Towards a sectoral application of the countercyclical capital buffer: A literature review – March 2018” (BCBS Review) and its stated aim is to draw relevant insights from the existing literature and use these to shed light on whether a sectoral application of the CCyB would be a useful extension of the existing Basel III framework under which the CCyB is applied at an aggregate country level credit measure. The views expressed in Working Papers like this one are those of their authors and do not represent the official views of the Basel Committee but they do still offer some useful insights into what prudential supervisors are thinking about.

Key points

1. I very much agree with the observation in the BCBS Review that the standard form of the CCyB is a blunt instrument by virtue of being tied to an aggregate measure of credit growth
2. And that a sectoral application of the CCyB (operating in conjunction with other sector focussed macro prudential tools) would be an improvement
3. But the CCyB strategy that has been developed by the Bank of England looks to be a much better path to pursue
4. Firstly, because it directly addresses the problem of failing to detect/predict when the CCyB should be deployed and secondly because I believe that it results in a much more “usable” capital buffer
5. The CCyB would be 1% if APRA adopted the Bank of England strategy (the CCyB required by APRA is currently 0%) but adopting this strategy does not necessarily require Australian banks to hold more capital at this stage of the financial cycle
6. One option would be to align one or more elements of APRA’s approach with the internationally harmonised measure of capital adequacy and to “reinvest” the increased capital in a 1% CCyB.

First a recap on the Countercyclical Capital Buffer (aka CCyB).

The CCyB became part of the international macro prudential toolkit in 2016 and is intended to ensure that, under adverse conditions, the banking sector in aggregate has sufficient surplus capital on hand required to maintain the flow of credit in the economy without compromising its compliance with prudential requirements.

A key feature in the original BCBS design specification is that the buffer is intended to be deployed in response to high levels of aggregate credit growth (i.e high relative to the sustainable long term trend rates) which their research has identified as an indicator of heightened systemic risk. That does not preclude bank supervisors from deploying the buffer at other times as they see fit, but responding to excess credit growth has been a core part of the rationale underpinning its development.

The BCBS Review

The BCBS Review notes that the CCyB works in theory but concedes there is, as yet, virtually no empirical evidence that it will work in practice. This is not surprising given that it has only been in place for a very short period of time but still important to remember. The BCBS Review also repeatedly emphasises the point that the CCyB may help to mitigate the credit cycle but that is a potential side benefit, not the main objective. Its primary objective is to ensure that banks have sufficient surplus capital to be able to continue lending during adverse economic conditions where losses will be consuming capital.

The Review argues that the CCyB is a useful addition to the supervisor’s tool kit but is a blunt instrument that impacts all sectors of the economy indiscriminately rather than just targeting the sectors which are the source of systemic concern. It concludes that applying the CCyB at a sectoral level might be more effective for three reasons

• more direct impact on the area of concern,
• stronger signalling power, and
• smaller effects on the wider economy than the Basel III CCyB.

The Review also discusses the potential to combine a sectoral CCyB with other macro prudential instruments; in particular the capacity for the two approaches to complement each other;

Quote “Generally, macroprudential instruments that operate through different channels are likely to complement each other. The literature reviewed indicates that a sectoral CCyB could indeed be a useful complement to alternative sectoral macroprudential measures, including borrower-based measures such as LTV, LTI and D(S)TI limits. To the extent that a sectoral CCyB is more effective in increasing banks’ resilience and borrower-based measures are more successful in leaning against the sectoral credit cycle, both objectives could be attained more effectively and efficiently by combining the two types of instruments. Furthermore, there is some evidence that suggests that a sectoral CCyB could have important signalling effects and may therefore act as a substitute for borrower-based measures.”

A Sectoral CCyB makes sense

Notwithstanding repeated emphasis that the main point of the CCyB is to ensure banks can and will continue to support credit growth under adverse conditions, the Review notes that there is not much, if any, hard empirical evidence on how effective a release of the CCyB might be in achieving this. The policy instrument’s place in the macro prudential tool kit seems to depend on the intuition that it should help, backed by some modelling that demonstrates how it would work and a pinch of hope. The details of the modelling are not covered in the Review but I am guessing it adopts a “homo economicus” approach in which the agents act rationally. The relatively thin conceptual foundations underpinning the BCBS version of the CCyB are worth keeping in mind.

The idea of applying the CCyB at a sectoral level seems to make sense. The more targeted approach advocated in the Review should in theory allow regulators to respond to sectoral areas of concern more quickly and precisely than would be the case when the activation trigger is tied to aggregate credit growth. That said, I think the narrow focus of the Review (i.e. should we substitute a sectoral CCyB for the current approach) means that it misses the broader question of how the CCyB might be improved. One alternative approach that I believe has a lot of promise is the CCyB strategy adopted by the Bank of England’s Financial Policy Committee (FPC).

The Bank of England Approach to the CCyB (is better)

The FPC published a policy statement in April 2016 explaining that its approach to setting the countercyclical capital buffer is based on five core principles. Many of these are pretty much the same as the standard BCBS policy rationale discussed above but the distinguishing feature is that it “… intends to set the CCyB above zero before the level of risk becomes elevated. In particular, it expects to set a CCyB in the region of 1% when risks are judged to be neither subdued nor elevated.”

This contrasts with the generic CCyB, as originally designed by the BCBS, which sets the default position of the buffer at 0% and only increases it in response to evidence that aggregate credit growth is excessive. This might seem like a small point but I think it is a material improvement on the BCBS’s original concept for two reasons.

Firstly, it directly addresses the problem of failing to detect/predict when systemic risk in the banking system requires prudential intervention. A lot of progress has been made in dealing with this challenge, not the least of which has been to dispense with the idea that central banks had tamed the business cycle. The financial system however retains its capacity to surprise even its most expert and informed observers so I believe it is better to have the foundations of a usable countercyclical capital buffer in place as soon as possible after the post crisis repair phase is concluded rather than trying to predict when it might be required.

The FPC still monitors a range of core indicators for the CCyB grouped into three categories.

• The first category includes measures of ‘non-bank balance sheet stretch’, capturing leverage in the broader economy and in the private non-financial (ie household and corporate) sector specifically.
• The second category includes measures of ‘conditions and terms in markets’, which capture borrowing terms on new lending and investor risk appetite more broadly.
• The third category includes measures of ‘bank balance sheet stretch’, which capture leverage and maturity/liquidity transformation in the banking system.

However the FPC implicitly accepts that it can’t predict the future so it substitutes a simple, pragmatic and error resilient strategy (put the default CCyB buffer in place ASAP) for the harder problem of trying to predict when it will be needed. This strategy retains the option of increasing the CCyB, is simpler to administer and less prone to error than the BCBS approach. The FPC might still miss the turning point but it has a head start on the problem if it does.

The FPC also integrates its CCyB strategy with its approach to stress testing. Each year the stress tests include a scenario:

“intended to assess the risks to the banking system emanating from the financial cycle – the “annual cyclical scenario”

The severity of this scenario will increase as risks build and decrease after those risks crystallise or abate. The scenario might therefore be most severe during a period of exuberance — for example, when credit and asset prices are growing rapidly and risk premia are compressed. That might well be the point when markets and financial institutions consider risks to be lowest. And severity will be lower when exuberance has corrected — often the time at which markets assess risks to be largest. In leaning against these tendencies, the stress-testing framework will lean against the cyclicality of risk taking: it will be countercyclical.”

The Bank of England’s approach to stress testing the UK banking system – October 2015 (page 5)

The second reason  I favour the FPC strategy is because I believe it is likely to result in a more “usable” buffer once risk crystallizes (not just systemic risk) and losses start to escalate. I must admit I have struggled to clearly articulate why this would be so but I think the answer lies partly in the way that the FPC links the CCyB to a four stage model that can be interpreted as a stylised description of the business cycle. The attraction for me in the FPC’s four stage model is that it offers a coherent narrative that helps all the stakeholders understand what is happening, why it is happening, what will happen next and when it will happen.

The BCBS Review talks about the importance of communication and the FPC strategy offers a good model of how the communication strategy can be anchored to a coherent and intuitive narrative that reflects the essentially cyclical nature of the banking industry. The four stages are summarised below together with some extracts setting out the FPC rationale.

Stage 1: The post-crisis repair phase in which risks are subdued – the FPC would expect to set a CCyB rate of 0%

FPC rationale: “Risks facing the financial system will normally be subdued in a post-crisis repair and recovery phase when the financial system and borrowers are repairing balance sheets. As such, balance sheets are not overextended. Asset and property prices tend to be low relative to assessed equilibrium levels. Credit supply is generally tight and the risk appetite of borrowers and lenders tends to be low. The probability of banks coming under renewed stress is lower than average.”

Stage 2: Risks in the financial system re-emerge but are not elevated – the FPC intends to set a positive CCyB rate in the region of 1% after the economy moves into this phase.

FPC rationale: ‘In this risk environment, borrowers will not tend to be unusually extended or fragile, asset prices are unlikely to show consistent signs of over, or under, valuation, and measures of risk appetite are likely to be in line with historical averages”. As such, it could be argued that no buffer is required but the FPC view is that a pre-emptive strategy is more “robust to the inherent uncertainty associated with measuring risks to financial stability”. It also allows subsequent adjustments to be more graduated than would be possible if the CCyB was zero.

Stage 3: Risks in the financial system become elevated: stressed conditions become more likely – the FPC would expect to increase the CCyB rate beyond the region of 1%. There is no upper bound on the rate that can be set by the FPC.

FPC rationale: “As risks in the financial system become elevated, borrowers are likely to be stretching their ability to repay loans, underwriting standards will generally be lax, and asset prices and risk appetite tend to be high. Often risks are assumed by investors to be low at the very point they are actually high. The distribution of risks to banks’ capital at this stage of the financial cycle might have a ‘fatter tail’ [and] stressed outcomes are more likely.”

Stage 4: Risks in the financial system crystallise – the FPC may cut the CCyB rate, including where appropriate to 0%.

FPC rationale: “Reducing the CCyB rate pre-emptively before losses have crystallised may reduce banks’ perceived need to hoard capital and restrict lending, with consequent negative impacts for the real economy. And if losses have crystallised, reducing the CCyB allows banks to recognise those losses without having to restrict lending to meet capital requirements. This will help to ensure that capital accumulated when risks were building up can be used, thus enhancing the ability of the banking system to continue to support the economy in times of stress.”

The March 2018 meeting of the FPC advised that the CCyB applying to UK exposures would remain unchanged at the 1% default level reflecting its judgement that the UK banking system was operating under Stage 2 conditions.

Calibrating the size of the CCyB

The FPC’s approach to calibrating the size of the CCyB also offers some interesting insights. The FPC’s initial (April 2016) policy statement explained that a “CCyB rate in the region of 1%, combined with other elements of the capital framework, provides UK banks with sufficient capital to withstand a severe stress. Given current balance sheets, the FPC judges that, at this level of the CCyB, banks would have sufficient loss-absorbing capacity to weather a macroeconomic downturn of greater magnitude than those observed on average in post-war recessions in the United Kingdom — although such estimates are inherently uncertain.”

The first point to note is that the FPC has chosen to anchor their 1% default setting to a severity greater than the typical post war UK recession but not necessarily a GFC style event. There is a school of thought that maintains that more capital is always better but the FPC seems to be charting a different course. This is a subtle area in bank capital management but I like the the FPC’s implied defence of subtlety.

What is sometimes lost in the quest for a failure proof banking system is a recognition of the potential for unintended consequence. All other things being equal, more capital makes a bank less at risk of insolvency but all other things are almost never equal in the real world. Banks come under pressure to find ways to offset the ROE dilution associated with more capital. I know that theory says that a bank’s cost of equity should decline as a result of holding more capital so there is no need to offset the dilution but I disagree (see this post for the first in a proposed series where I have started to set out my reasons why). Attempts to offset ROE dilution also have a tendency to result in banks taking more risk in ways that are not immediately obvious. Supervisors can of course intervene to stop this happening but their already difficult job is made harder when banks come under pressure to lift returns. This is not to challenge the “unquestionably strong” benchmark adopted by APRA but simply to note that more is not always better.

Another problem with just adding more capital is that the capital has to be usable in the sense that the capital ratio needs to be able to decline as capital is consumed by elevated losses without the bank coming under pressure to immediately restore the level of capital it is expected to hold. The FPC strategy of setting out how it expects capital ratios to increase or decrease depending on the state of the financial cycle helps create an environment in which this can happen.

Mapping the BOE approach to Australia

APRA has set the CCyB at 0% whereas the BOE approach would suggest a value of at least 1% and possibly more given that APRA has felt the need to step in to cool the market down. It is important to note that transitioning to a FPC style CCyB does not necessarily require that Australian banks need to hold more capital. One option would be to harmonise one or more elements of APRA’s approach to capital measurement (thereby increasing the reported capital ratio) and to “reinvest” the surplus capital in a CCyB. The overall quantum of capital required to be unquestionably strong would not change but the form of the capital would be more usable to the extent that it could temporarily decline and banks had more time to rebuild  the buffer during the recovery phase.

Summing up

A capital adequacy framework that includes a CCyB that is varied in a semi predictable manner over the course of the financial cycle would be far more resilient than the one we currently have that offers less flexibility and is more exposed to the risk of being too late or missing the escalation of systemic risk all together.

Tell me what I am missing …