Do regulatory proposals for banks to add buffer capital in good times offer something for others?
A new consultative document released for comment by the Bank for International Settlements’ Basel Committee builds on earlier suggestions that banks build up or conserve capital during good times as a “buffer” to allow them to continue to extend credit in down turns. The countercyclical buffer would be tied to a credit-to-GDP guide of the country or countries in which a bank has credit exposure. Regulators would calculate the aggregate private sector credit-to-GDP ratio of each country and then come up with a net credit-to-GDP gap, or the difference between the current ratio and its long-term trend. This gap would translate into a buffer capital requirement, with a threshold limit, say, 2% of risk weighted assets.
The theory behind this approach is that banks should be encouraged to build up capital when funding is relatively cheap, moderating excessive credit growth in the process; and draw on this capital buffer when credit is dear to continue the flow of credit to the market, mitigating systemic risk in the process. Essentially, at some point within 12-months after a credit-to-GDP gap trigger point is reached, prudential bank regulators would require banks to raise additional capital, reign in lending, or transfer assets to build up their buffer. Similarly, if a bank should fall below the required buffer level of capital, it would be given 12 months to build it back up.
The proposed plan would work with other capital requirements, so that banks would be subject to a minimum Tier 1 capital requirements of say 4% of risk weighted assets; an additional capital conservation buffer, say an additional 2% of risk weighted asset, in order to avoid restrictions on distributions of capital and a countercyclical capital buffer add-on of, say, another 2%, when credit-to-GDP rations exceeded long-term trend lines.
The same would also happen in reverse. If credit-to-GDP ratios were below the long-term trend, banks would be encouraged to draw down the buffer. Further, if losses were incurred by a bank, they would be taken first against the countercyclical buffer, then the capital conservation buffer and then against Tier 1 capital. Regulators might be allowed more discretion to reverse the buffer, since as the Basel document notes, credit and GDP may not always contract simultaneously, so the gap analysis might be augmented by looking at TED or CDS spreads which may or may not provide better indications of credit contraction depending on the circumstances.
Broader market ramifications
While regulators would have ample discretion as when to ask banks to build up or draw down buffers, and banks would be given 12 months to react, there would be inevitable capital market distortions. Buffer triggers, for example, might exacerbate crowding out effects created by financial institutions needing to raise capital en masse, particularly around refinancing cliffs. Certain institutions might also be targeted based on a trigger point and see their relative cost of capital rise in anticipation. Meanwhile, non-regulated financial firms would surely step into the breach to win business as banks are told to turn off credit spigots and build up their buffers.
On the flip side, bank customers could monitor the credit-to-GDP gap exposures of key credit banks and use this to determine when funding windows may be closing for new lines or bridge loans for a strategic acquisition. In response, non-banks could not only turn to non-regulated sources of credit, but they also might consider countercyclical buffer frameworks of their own. For example, corporates could trim cash distribution and build up excess cash in response to credit-to-GDP ratios triggers. The problem is that, much like the situation now, the availability of cash on the balance sheet, or capital to lend, does not automatically lead to countercyclical investment or credit expansion when economic ratios suggest this is needed. For-profit institutions still want expected returns to drive the deployment of capital, whether they have a buffer to draw on or not.