Overlap between banks’ capital buffers and minimum requirements

During the recent economic shocks caused by the Covid-19 pandemic and the more recent inflation surge, the EU banking system proved resilient and continued to provide lending to the real economy. In addition to the support provided to the economy by the public interventions, the strengthened macroprudential and microprudential frameworks put in place after the 2008 crisis played a crucial role. 

Capital buffers play an important role for financial stability, as their increase in good times and their release in a contraction of the economic cycle should allow banks to continue financing the real economy, thus avoiding that a recession becomes a depression. However, during recent economic downturns, empirical evidence suggested that many banks did not use the capital buffers[1] as allowed by the macroprudential rules, possibly also because of the fiscal, monetary and prudential support provided to the real economy by European and national authorities. It is difficult to ascertain what would have happened without this support, and whether capital buffers would have performed their shock-absorbing role. In addition, banks might have been unwilling to dip into the usable buffers in the aftermath of the start of the pandemic because of fear of stigma or of enhanced supervisory scrutiny and measures[2]. A lively debate has started among regulators and other stakeholders on the degree of the so-called buffer usability – that is, the ability and willingness of banks to use their capital buffers to keep lending to the economy. 

The question of how to facilitate an increase of the usability of buffers in the banking sector has become part, in Europe, of a wider discussion on the potential review of the macroprudential framework[3]. This discussion may also have an impact on one of the key tools to ensure that failing banks can be resolved without adversely affecting financial stability – the minimum requirement for own funds and eligible liabilities (MREL). 

The buffer usability may be limited by the overlap between the combined buffer requirements and the minimum prudential or resolution requirements. This is because the same capital resources are used for the two different frameworks. Thus, the risk-based capital buffers cannot always be used without breaching the leverage ratio requirement or the MREL requirement when expressed as leverage exposure amount. For example, the leverage ratio can be met with CET1 and AT1. If a bank has sufficient AT1 to fully comply with the leverage ratio requirement, no CET1 needs to be used for the leverage ratio and therefore no overlap with risk-weighted capital buffers occurs. In contrast, if the bank has insufficient AT1 to meet the leverage ratio in full, the remaining part of the leverage ratio would need to be met with CET1 and an overlap between the CET1 component of the leverage ratio requirement and risk-weighted capital buffers may arise. A similar dynamic happens in the context of MREL between the risk-weighted and the leverage framework. 

In this regard, one has to acknowledge, in the first place, that the possible multiple uses of capital for buffers and minimum requirements is an inherent feature of the prudential framework, which was designed in this way by the co-legislators. The existing set-up foresees that the macroprudential and microprudential frameworks complement each other to foster financial stability in the Banking Union. In this set-up, banks are subject to a risk-based capital requirement, and also to the leverage ratio, as well as to the recovery and resolution framework. The leverage ratio has been designed to constrain the build-up of banks’ leverage in a way that better protects against model risk and measurement error, while the MREL has been conceived to facilitate the orderly resolution of distressed banks. Another cornerstone of the Basel-III agreement was the introduction of capital buffers, whereby banks need to conserve capital before getting close to breaching minimum requirements. This multi-restrictive framework creates overlaps between different requirements. 

A working paper by De Bosio and Loiacono (2023) on capital buffer usability[4] shows that, on aggregate, buffer usability may be limited by the combined application of the prudential leverage ratio and MREL requirements and is estimated to be in the range 22% to 51% for the SRB banks, depending on the approach used. The complexity of the current design requires to consider how to limit the overlap between the macro prudential policy and the prudential and resolution requirements, so as to increase buffers’ usability and improve the capacity of the financial system to absorb shocks. The key questions are how to make the framework more effective in tackling systemic risks, smoothen the economic cycle, and eventually redesign it in view of the interaction with the minimum capital and resolution requirements. 

In this context, targeted rebalancing of certain existing requirements could be considered in order to mitigate the limitations from the existing multitude of buffers. A stronger separation between buffer and minimum requirements would ensure that buffers would be fully usable and that their overall size would be more easily identifiable for banks and authorities. A dedicated ESRB report on usability of banks’ capital buffers[5] provides a starting point to discuss options for reducing the overlap with minimum requirement. There could be merit in exploring some avenues. For example, macroprudential authorities could regularly communicate their expectation that banks should maintain a certain level of buffer usability. This option would give banks the discretion to decide how this level should be achieved, for example by issuing specific instruments to improve buffer usability, or by adjusting their RWAs. The advantage of this approach is that it would reduce the size of the overlaps in a flexible manner. On the other hand, this arrangement would not intervene on the structural reasons behind the existence of overlaps. As regards the MREL regime, banks could be required to hold a minimum amount of eligible liabilities, corresponding for example to the recapitalisation component, to mitigate the buffer overlap with MREL. If banks largely use eligible liabilities to comply with MREL rather than CET1, the overlap between the buffers and non-risk-based MREL declines, and thus buffer usability would increase. This proposal would require a legislative change, and need to be adequately calibrated to minimise side effects. In particular, challenges for accessing debt markets in some jurisdictions and for some banks might make the issuance of the required amount of eligible liabilities difficult or costly. 

In addition to these options, revisions that are more fundamental may be considered. For example, there have been other proposals to radically simplify the design of capital buffers, providing greater flexibility[6]. 

Any potential proposal to modify the current setting should be based on the collection of robust evidence to understand how institutions have adjusted their capital and liability positions in response to the developments of the regulatory framework. Furthermore, it is important that any potential adjustments on this issue be introduced only after reaching a shared view in international fora like the Financial Stability Board and the Basel Committee, in order to ensure a level playing field at international level. The SRB would expect that any changes reduce the complexity of the framework and allow greater flexibility without undermining its robustness. 

PDF
| 1.03 MB
| Publishing date:
16/10/2023
| Decision date:
17/10/2023

Staff Working Paper Series #2 – Measures of banks’ capital buffer usability under prudential and resolution requirements in the Banking Union