26 April 2023

ECB: A positive neutral rate for the countercyclical capital buffer – state of play in the banking union

This article discusses the possible implementation of a positive neutral rate for the countercyclical capital buffer (CCyB).. it explains why a positive neutral rate is needed to enhance the effectiveness of the current macroprudential framework.

1 Lessons learned on capital buffers during the pandemic

Experience from the coronavirus (COVID-19) pandemic has sparked further discussion on the functioning of bank capital buffers, although the banking system has proved to be resilient overall. Banks continued to perform their core functions throughout the COVID-19 crisis, which included ensuring a constant flow of credit and avoiding adverse feedback loops between the financial system and the real economy. This was also due to the comprehensive policy response – in the form of strong monetary, fiscal and prudential support measures – which prevented credit risk from materialising at an aggregate level. Given the impact of these extraordinary support measures, questions have arisen about how the prudential framework would have worked in their absence.^[1] One of the focal points of this debate is the functioning of capital buffers, which are placed on top of minimum capital requirements and subsumed in the combined buffer requirement (CBR).^[2] These buffers are meant to act as shock absorbers, enabling banks to absorb losses while continuing to provide key financial services to the real economy in times of stress.^[3] However, several observations from the pandemic suggest that buffers may not be fully effective in meeting this objective under the current set-up.

First, evidence from the pandemic suggests that banks may be unwilling to “dip into” their non-released capital buffers when losses materialise, which means that the buffers may not fulfil their intended role as shock absorbers. The Basel framework specifies that capital buffers “can be drawn down as losses are incurred”, and that banks should be able to “conduct business as normal when their capital falls into the conservation range”.^[4] Accordingly, in the early stages of the pandemic, prudential authorities made considerable efforts to reassure banks that the buffers could be used in case of need.^[5] However, empirical evidence using micro-level data shows that proximity to the CBR was associated with lower growth in credit supply and stronger risk weight reductions over the course of the pandemic, both of which helps limiting potential reductions in risk-weighted capital ratios.^[6] This did not result in any credit supply constraints at the aggregate level, thanks in part to the extensive support measures that prevented widespread loss materialisation. Nevertheless, it suggests that banks are reluctant to use their capital buffers, preferring to maintain some headroom above the CBR to safeguard against a potential breach should losses materialise. This has the potential to induce broader systemic and adverse effects in terms of reduced credit supply, for example in scenarios where a larger share of banks experience losses and subsequently become capital-constrained.

Second, releasable buffers such as the CCyB effectively reduce concerns about buffer usability, although the build-up of buffers explicitly intended for release was very limited prior to the pandemic. Following the release of a capital buffer, banks can operate with lower capital ratios without breaching the CBR, so that possible impediments to buffer usability – for instance relating to market stigma or automatic distribution restrictions – are reduced or removed.^[7] Couaillier et al. (2022b) show that the prudential capital relief measures in the banking union effectively supported bank credit supply during the pandemic, consistent with lower concerns about relative balance sheet expansions that reduce capital ratios.^[8] The effects of the relief measures were particularly strong for capital-constrained banks with little capital headroom above the CBR, suggesting that the relief prevented reductions in lending that could otherwise have resulted from banks’ reluctance to breach the CBR. However, as shown in Chart 1, the bulk of the relief was provided by ad hoc microprudential adjustments, some of which did not reduce the threshold at which automatic distribution restrictions kick in.^[9] Banking union authorities released more than €140 billion in capital, amounting to roughly 1.5% of aggregate risk-weighted assets. However, only €20 billion of the release was due to macroprudential adjustments, of which only €6 billion was due to domestic CCyB releases.^[10] The main reason for this striking imbalance is that the build-up of macroprudential buffers had been very limited ahead of the pandemic, so macroprudential authorities had little ammunition to provide relief to the banking sector when the shock occurred.^[11] While the capital relief worked as intended, it was not provided via the measures originally envisaged for this purpose, and it cannot be taken for granted that similar ad hoc microprudential adjustments (such as the frontloading of the change in the composition of the Pillar 2 requirements (P2R)) would be available in future crises.^[12]

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