Blog: Looming slowdown casts doubt on countercyclical capital –

If you are reading this now, it’s too late.

The Bank of England is forecasting a recession later this year and early next, as a spike in energy prices squeezes households and businesses alike. Other central banks are less bearish at the moment, but their economies are hardly immune from the shocks caused by Russia’s invasion of Ukraine.

A weaker economy means worse asset quality for banks. More write-downs could lead to a depletion of capital. Less capital could cause banks to pull on the leash and scale back lending. This, in turn, would aggravate any economic downturn.

But bank regulators have a plan. Or at least, they devised one as part of the global Basel III prudential standards agreed in the wake of the 2008 financial crisis. The plan is a countercyclical capital buffer (CCyB) that can be raised when the economy is running hot, and then cut back to zero to encourage banks to maintain credit to clients during a slowdown.

“If they could collectively agree to support the economy, then they lose less money, but each individual bank may say: ‘Well, everybody else can keep lending, we’ll stop and then we’ll be fine’,” says a former prudential regulator. “So you’ve got a bit of a prisoner’s dilemma, and that can lead you to the banks deleveraging, particularly small banks.”

Which takes us back to the beginning. If regulators are expecting the economy to slow from here, they should already be cutting the countercyclical buffer. Instead, some of them – including the BoE – are still raising it following the exit from Covid-induced lockdowns.

Some of this is idiosyncratic. When writing the standards that created the CCyB after 2008, the Basel Committee on Banking Supervision could not have envisaged a scenario in which two exogenous risks – pandemic and war – hit the banking sector with an interval of only a few months. Both had the potential to hurt asset quality (although the impact of Covid was mitigated by government intervention); neither of them was the product of overheated lending that might have needed cooling down with a dose of CCyB.

But some of the problems with the buffer appear to be more fundamental, including a 12-month time lag to raise it, and regulators’ reluctance to use it during the good times. Some jurisdictions such as the US never introduced a non-zero CCyB at all during the recovery from the 2008 crisis. And they still haven’t, which means there is no buffer to cut ahead of the next downturn.

“The tools at the disposal of banking supervisors at the moment to face potential recession are not very strong and not very powerful,” says Ignazio Angeloni, a professor at the European University Institute, who was a member of the board of the European Central Bank’s single supervisory mechanism until 2019. “The reason is that the countercyclical capital buffer has been used very sparingly; there is very little room if at all on the capital side to accommodate a potential recession.”

This kind of tool should be refined, but should not be reversed”

Andrea Resti, Bocconi University

And perhaps regulators simply overestimated the effectiveness of this macroprudential policy lever. Banks don’t seem to have factored it into their capital planning, which is often fixed on a longer timeline than the cycle of the economy and CCyB.

“Fundamentally, it is flawed because it is an attempt to apply academia-style thinking to a real-world problem,” says a former bank treasurer.

The former regulator is more diplomatic, but still somewhat sceptical: “I think it was always a bit of a long shot for it to work; the banks still have to make their own decisions about how much lending they can do.”

The pandemic already triggered doubts, as banks showed little sign of deploying the extra capital headroom they had gained from regulators cutting buffer requirements.

“The supervisors could tell banks to lend less, but they can’t instruct them to lend more,” says the former regulator. “The bank could just say: ‘Well, that’s not our commercial judgement’; there’s nothing a supervisor or national authorities can do about that.”

Some, however, contest that the framework didn’t fail during Covid – many businesses simply didn’t want to take out fresh loans at a time when demand for their products and services was so uncertain.

And there are signs that some regulators are seeking ways to enhance the operation of the CCyB, rather than abandoning it altogether. That approach gets a thumbs-up from Andrea Resti, a professor at Bocconi University who advises the European parliament on bank regulation.

“The CCyB was a step in the right direction, because this idea that you want to make capital requirements countercyclical is something that was missing from the original Basel II,” says Resti. “To me, it makes a lot of sense, so this kind of tool should be refined, but should not be reversed.”

The debate on how to improve the CCyB is only just beginning. The European Commission ran a targeted consultation between October 2021 and March 2022 calling for advice on how to improve the EU’s macroprudential capital buffers. The Basel Committee on Banking Supervision is also evaluating the effectiveness of the framework, with the possibility of changes ahead.

You shouldn’t start from here

If you want evidence of regulators’ lack of consensus on how to use the CCyB, look no further than the current very diverse range of buffers applied in different jurisdictions that appear to be facing similar economic conditions.

Bulgaria, the Czech Republic, Luxembourg, Norway and Slovakia all currently have positive CCyBs. Authorities in France, Germany, the Netherlands, Sweden and the UK have all scheduled increases in their CCyBs from now until the end of next year.

With economic storm clouds gathering, authorities that have pre-announced CCyB hikes could turn about face and cancel the scheduled increases, in the hope of prompting banks to relax their grip on capital. The head of capital management at a European bank says this might be effective, as banks like to plan ahead in terms of their appetite and pricing for new loans.

Adrian Docherty

Adrian Docherty, BNP Paribas

The diverging path of CCyBs partly reflects a lack of consensus about the trajectory of growth and inflation, and its impact on bank balance sheets. The major central banks in Europe and the US have all been hiking interest rates in response to a jump in inflation, while still indicating the price rises could be transitory. Setting the CCyB poses the same challenges in terms of responding to macroeconomic forecasts as setting interest rates themselves.

“To be countercyclical, you have to do some very odd things. You’ve got to stand up in the middle of the party and say: ‘Right, I’m going home’,” says Adrian Docherty, head of bank advisory at BNP Paribas.

And for the CCyB, there’s an extra layer of complexity translating the macro scenarios into bank financial performance. In theory, both rising prices and interest rate hikes are good for bank profits. The problem is if the pressures prove too much for customers, which leads to missed loan repayments, increased credit loss provisioning and downward pressure on capital.

“With the current situation, it’s still quite uncertain the way it will play out,” says a head of capital management at a European bank. “I think it is possible but not yet fully determined whether the current macro-environment actually will lead to widespread dropping in capital ratios.”

Read the signs

The process is even more uncertain at the moment, because each jurisdiction can choose its own criteria for setting the buffer.

“Maybe the CCyB is killed through discretion when it comes to the way that national authorities identify whether the credit cycle is overheating,” says Resti.

Angeloni thinks the CCyB has to respond automatically to economic indicators. But there is no consensus about what indicators to use.

The Basel Committee has suggested using the credit-to-GDP ratio. By comparing the long-term trend of the credit-to-GDP ratio, CCyB-setters can determine whether the rate should increase if the indicator is higher than its long-term average, or decrease if the ratio is lower than its long-term average. Most regulators combine this measure with other indicators such as real estate prices and bond spreads.

But Antti Makkonen, a senior ministerial adviser for banking and finance legislation at the Finnish Ministry of Finance, points out a potential drawback to the credit-to-GDP ratio: the effects of higher inflation. Since the ratio uses nominal GDP, which grows with inflation, a sharp rise in prices increases the denominator of the credit-to-GDP ratio.

“[With] higher inflation, it typically means that the monetary policy should be stricter, but then actually, the credit-to-GDP ratio works in the opposite way,” says Makkonen, speaking to in a personal capacity. “So, according to that indicator, the countercyclical buffer should be loosened, not tightened – the dominance of the credit-to-GDP could be reconsidered.”

The former treasurer is even more critical, questioning if any macroeconomic variables are really suitable.

“Whether it’s GDP, inflation, unemployment, trade figures, almost everything really, they are all backward looking indicators,” says the former bank treasurer. “Practically speaking, it’s very difficult to get the timing right, and getting it wrong risks harming the economy.”

He gives the example of the run-up to the financial crisis. For the CCyB to work, should have been significantly raised well before the credit bubble burst, but he questions how many people would have suggested the market was overheating in – for instance – 2006.

“The timing issue makes CCyB a potentially very damaging exercise in pointlessness,” says the former treasurer.

The slow road

Just to add to the timing difficulties, any increases in the CCyB must be announced a year before they come into force. That has put the BoE in a particularly tight spot: it announced rises in the buffer in December 2021 and July 2022, which will now take effect right at the point where the monetary policy committee is expecting a recession.

“Authorities could consider shortening the timeframes for the rate setting to go live from 12 months to six months or less,” says Monsur Hussain, head of financial institutions research at Fitch Ratings. “At the moment, these are not yet contemplated in the Basel standards, but if they were changed as part of the global evaluation review, then it could allow for more proactive and timely use of CCyB.”

A senior capital manager at a UK bank believes the idea “makes sense”.

Monsur Hussain, Fitch Ratings

Monsur Hussain, Fitch Ratings

But others are much less supportive – indeed they fear such a change could make the buffer even less effective.

The Dutch central bank DNB and Swedish supervisory authority Finansinspektionen are both scheduling CCyB increases next year. Spokespeople for both regulators dismiss the idea of shortening the implementation time, because it would give banks less time to prepare. If a bank would potentially end up too close to its total capital requirement including buffers following a CCyB hike, it would need time to build up capital from retained earnings.

One possible way around the problem of timing CCyB increases is the idea of a positive cycle-neutral buffer, which establishes a non-zero level during normal economic conditions, without needing signs of credit-fuelled overheating. The BoE, DNB and Finansinspektionen have all stated they will set a positive neutral rate. This means there will always be some room for rate setters to lower the CCyB and provide banks with a reprieve when times get tough.

Makkonen supports a positive neutral rate as a way to separate monetary and macroprudential policy, and to harmonise the setting of CCyBs among jurisdictions. If a European authority were to set a CCyB cycle-neutral reference rate, individual nations would then need to adopt that rate or provide an explanation if they chose to deviate.

“It’s a step towards harmonisation that could also take into account the national specificities,” says Makkonen.

Does not compute

Even if the methodology for setting the rate is improved, it still won’t resolve one fundamental problem: whether banks are willing or able to factor the CCyB into their capital planning process.

Bankers say they don’t manage their capital ratios according to their minimum requirements as they stand at the time. Instead, they focus on what they expect prudential requirements to be in a few years’ time. That partly reflects the time needed to build up capital levels, but also the importance of pricing credit to generate an average return on capital over the life of the loan.

“So if supervisors are committed to increasing requirements again in two or three years, then any temporary release of buffers doesn’t really do much in terms of supporting some of the term lending you want to see,” says the head of capital management. “It may support an interim line of emergency credit, but if you want the real economy to stay afloat in recession, you want to support long-term investment.”

Docherty of BNP Paribas agrees banks won’t actively reduce their capital ratios just because a cut in the CCyB is announced. If the relief is only temporary, then banks will act as if the buffer is still there.

“Planning and budget committees don’t sit down and say: ‘Oh, our regulatory capital requirements have gone down by half a per cent, let’s increase the lending targets,’ that is not what happens,” says Docherty. “If capital requirements were to be changed over the medium to long term, then people could plan around that, but as we’ve seen with people putting capital requirements back to where they were pre-Covid, it’s basically a one- or two-year timeframe.”

This also shows how the idea of shortening the time required to implement a CCyB increase could make the framework even less effective. If the buffer can rise again quickly, banks may just ignore a cut.

“Potentially, if they release it they could decide in the next quarter to activate it again, so there is some uncertainty, and I think maybe the authorities setting buffers underestimate the degree of inertia within banks,” says the head of capital management at the European bank.

Scaring the horses

During the pandemic, bankers complained that inconsistent messaging made it more difficult to tune their capital management to national policy objectives. Regulators encouraged banks to lower their capital ratios, but at the same time banned dividend payments temporarily, on the basis that it might eat into capital ratios.

That inconsistent message also feeds into market perceptions, making banks more cautious about capital management. There is a reputational risk associated with not being seen to support the local economy, but that is likely to be outweighed by investor fears of banks loading up on credit risk at a time when borrowers are more likely to default.

“Well, why aren’t banks reducing their solvency ratios?” Docherty asks rhetorically. “Because that would be nuts, that would mean you are increasing your risk exposure at the worst possible time; the markets would kill you for that.”

The market response is likely to be even sharper in Europe, where the capital requirements directive (CRD) caps the amount of dividends banks can pay out if the distribution would take them below their combined regulatory minimum requirement, including buffers. That rule – known as the maximum distributable amount (MDA) – makes banks very reluctant to run too close to their combined minimum capital requirement, dampening the reaction to a cut in the CCyB.

The logic of the CCyB is to have an automatic stabiliser based on the cyclical situation

Ignazio Angeloni, European University Institute

“The current perception in the market, and probably rightfully so, is that entering into that territory would be very damaging to the franchise,” says the head of capital management.

The UK has already relaxed the MDA rule post-Brexit, making the risk of a sharp dividend cut less severe. Unless the EU follows suit, the MDA is likely to remain a more powerful influence on bank capital management than the CCyB.

One other reform suggested by bankers meets with short shrift from current and former regulators: to make the CCyB more predictable for capital management purposes by fixing it for a more extended period of time that coincides better with bank strategic planning.

“If you’re going to do that, just get rid of the countercyclical capital buffer,” says the former bank regulator. “The whole point of it is you can move it up and down with the cycle. If you want to guarantee it’s not going be put up for five years, well just forget it and just put on an average capital buffer.”

Angeloni of the European University Institute agrees: “It doesn’t sound very good to my ear because the logic of the CCyB is to have an automatic stabiliser based on the cyclical situation.”

Makkonen points to the speed with which economic activity snapped back and inflation picked up after the pandemic. This shows the impracticality of fixing the CCyB over a longer time period.

“The entire idea of the countercyclical buffer is to adapt based on the economic conditions, and as we’ve seen during and after the pandemic, the situation – for example, in housing markets – can change very rapidly,” says Makkonen. “So a time period of five years is just too long.”

Editing by Philip Alexander

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