Following the COVID shock, supervisors encouraged banks to use capital buffers to support the recovery. However, banks have been reluctant to do so. Provided the market expects a bank to rebuild its buffers, any draw-down will open up a capital shortfall that will weigh on its share price. Therefore, a bank will only decide to use its buffers if the value creation from a larger loan book offsets the costs associated with a capital shortfall. Using market expectations, we calibrate a framework for assessing the usability of buffers. Our results suggest that the cases in which the use of buffers make economic sense are rare in practice.
This paper analyses banks' ability to use capital buffers in the euro area, taking into account overlapping capital requirements between the risk-based capital framework and the leverage ratio capital framework from 2016 to 2022. This analysis is the first to quantify buffer usability in multiple jurisdictions and across various bank types, identify key drivers of buffer usability and assess the impact of various policy measures using longer time series. The paper shows that while both risk-based and leverage frameworks play a key role in enhancing the resilience of the banking system and ensuring financial stability, their simultaneous application creates interactions that may affect the functioning of capital buffers. In this regard, we investigate to what extent banks could have drawn down regulatory capital buffers in the risk-based framework without breaching current leverage ratio requirements, which is in line with the approach to buffer usability taken in ESRB (2021b). We show that buffer usability was partially constrained in the period examined and is expected to remain so under the current regulatory framework and if risk weight densities (RWDs) remain low. This finding indicates that the leverage ratio constitutes an effective backstop to the risk-based framework, both as regards minimum requirements and capital buffers. Limited buffer usability was identified especially for global systemically important institutions (G-SIIs) that rely largely on internal modelling approaches to calculate risk-based capital requirements, leading to comparably low risk weights and making the leverage ratio relatively more binding. Adding to previous contributions, we find that banks' ability to use capital buffers fluctuated over time, generally increasing before 2019 and decreasing after the start of the coronavirus (COVID-19) pandemic, with substantial heterogeneity across countries. Furthermore, we provide new insights into the relationship between the RWD of a bank and its buffer usability and find that there is a critical RWD range between 25% and 50% for which buffer usability is limited and very sensitive to RWD changes. Additionally, we perform a counterfactual analysis that investigates how a positive neutral countercyclical capital buffer and leverage ratio buffers would have changed buffer usability over time. Finally, we assess the impact of the implementation of the new Basel capital standards (Basel III) and find that full implementation of Basel III will materially increase the usability of capital buffers for G-SII.
Capital buffers are key macroprudential policy instruments. Regulatory capital buffers ("the buffers") were introduced after the global financial crisis to mitigate systemic risk. Buffers help to ensure the resilience of banks and to conserve their capital by placing constraints on distributions if buffers are breached. Unlike minimum requirements, buffers can be drawn down when losses have to be absorbed during times of stress and are replenished thereafter. Using buffers may thus cushion the financial cycle, especially in the case of the countercyclical capital buffer (CCyB), which is designed to be released by the authorities in a downturn. Banks might not always be able or willing to use their buffers. For the purpose of this report, the "usability" of buffers and excess capital means that banks are able to deplete their buffers without triggering a breach any parallel minimum requirements. The minimum requirements include the leverage ratio (LR), the minimum requirement for own funds and eligible liabilities (MREL) or the risk-weighted capital framework for the upcoming leverage ratio buffer for global systemically important institutions (G-SIIs), also referred to as the G-SII buffer. Even if buffers are usable from this perspective, banks might be unwilling to use them. Banks' willingness to use buffers is beyond the scope of this report and may also depend on factors other than buffer usability.1 However, investigations into banks' willingness to use buffers need to take into account potential regulatory impediments that might be an important reason why banks do not use buffers. Thus, both the ability and the willingness to use buffers may limit the capacity for buffers to cushion shocks. When buffers overlap with parallel minimum requirements, buffer usability is inevitably constrained. EU banking regulation ("the banking package") establishes three parallel frameworks, each with minimum capital requirements: the risk-weighted capital requirements framework aimed at increasing the resilience of banks; the supplementary leverage ratio requirements constraining the build-up of leverage, mitigating the risk of destabilising deleveraging processes and safeguarding against model risk and measurement error; and the framework to facilitate the resolution of failed banks without putting public funds at risk. These three frameworks apply simultaneously, with each of them playing an important role in contributing to the resilience of the banking system. However, the banking package also allows multiple uses of capital across these three frameworks, which in some instances includes the buffers.
An important role for bank capital is that of a buffer against unexpected losses. As uncertainty about these losses increases, the theory predicts an increase in the optimal level of bank capital. This paper investigates this implication empirically with U.S. Commercial Banks data and finds statistically significant and robust evidence supporting it. A counterfactual experiment suggests that a decline in uncertainty to the lowest level measured in the sample generates an average reduction in bank capital ratios of slightly over 1 percentage point. However, I also find suggestive evidence that the intensity of this precautionary motive is stronger during recessions. From a policy perspective, these results suggest that the effectiveness of countercyclical capital requirements during bad times will be undermined by banks desire to hold more capital in response to increased uncertainty.
The year-long consultations on Basel II mirror the international popularity of capital requirements as a regulatory instrument. Yet, the impact of capital re quirements on banks' behavior is not fully understood. The aim of this study is to contribute to this understanding by answering the following questions: How do banks adjust capital and risk after an increase in capital requirements? How do banks adjust their regulatory capital buffer over the business cycle? And what is the impact of banks' charter value on the regulatory capital buffer? The research undertaken for this study has benefited from support in terms of ideas, research facilities, and, not least, financial funding. My thanks go first of all to Claudia M. Buch for her constant encouragement, her continuous guidance, and her confidence in my research ideas. My thanks go also to the Kiel Institute for World Economics and its staff for providing a very fertile academic ground for my research and for providing excellent research facilities. In fact, conduct ing this study would not have been possible without the support of my colleagues at the Kiel Institute and elsewhere. In particular, I am grateful to Horst Siebert for providing me the freedom to pursue this topic. My special thanks go to Jorg Breitung, Kai Carstensen, and Dieter Urban for providing input on econometric issues. I am also grateful to Andrea Schertler for the long and productive discus sions I had on various parts of this study.
We find that larger US bank holding companies (BHCs) hold lower quality capital buffers than their smaller peers. US BHCs' capital buffer quality is found to be a function of their operational complexity, risk-weighted assets and profitability. We, however, find no evidence that large US BHCs trade-off capital buffer quality with their liquid asset investments. On average, US BHCs narrow the gap between their actual and target buffer quality by 49.5 per cent per quarter. This (buffer quality) adjustment speed, however, is substantially faster than that observed in pre-GFC US studies of buffer size. The well capitalised US BHCs (top 20 percent) adjust their buffer quality 8 percent faster than poorly capitalised ones. The latter seem to face impediments in raising new capital due to higher reputation costs. The costs of adjusting buffers also seem an important explanation for holding higher quality buffers. Our results shed more light on the trade-offs associated with banks holding higher quality capital buffers.
There is a current controversy concerning the appropriate size of capital requirements for banks to mitigate systemic losses. We are the first in kind to quantify the size of capital buffers required to reduce systemic losses using loan loss provisions data for Australian banks from 2002 to 2014 and annual public accounts from 1978 to 2014. We find that first, during the stable times, banks' multi-year loan loss rates are positively related to past loss rates and lagged loan growth and are inversely related to the deposit ratio, bank size and the GDP growth rate. Taking economic downturns into consideration, loss rates are negatively related to liquidity, but are positively related to deposit funding and size. Second, we simulate the distributions of bank losses and financial system losses in Australia for future periods. In doing so, we quantify the size of capital buffers required to significantly reduce systemic losses. Our results lend support moderate capital buffer increases.
In contrast to non-financial firms, banks have undergone significant turbulence in the past decade, enduring severe financial crises and unprecedented regulatory reforms. New regulations, including heightened capital and liquidity requirements, measures to address regulatory migration, resolution authority, stress testing, and capital planning, have spurred the development of new tools to manage institutional failure. The primary goal has been to reduce the likelihood of poor performance and improve stock market valuations to restore public confidence in the industry. The banking industry plays a vital role in global economic and financial stability and is subject to intense regulatory and market scrutiny. Financial instability can be very costly for banks due to its spillover effects on other parts of the economy. Therefore, a sound, stable, and healthy financial system is essential for efficient resource allocation and risk distribution across the economy.This is the first book that comprehensively addresses a range of contemporary issues in the global banking industry, providing a thorough understanding of the challenges and opportunities faced by the sector. The book examines how banking business models, effective policies, and regulations can address these issues, covering corporate governance, asset-liability management, risk management, financial performance, and regulatory frameworks. The potential benefits of alternative banking models, including Islamic banking, and their contribution to global financial stability and resilience are also explored.Contributions from international scholars using both quantitative and qualitative methods provide new insights, recent findings, and perspectives on future bank stability and resilience in a global context. The book also presents updated evidence and debates on the impact of recent regulations and governance structures on the industry, which has undergone significant changes in response to financial turmoil and new laws and regulations aimed at enhancing bank resiliency, protecting against systematic risks, and promoting fair and ethical banking practices.
Using a sample of publicly listed banks from 62 countries over the 1991-2017 period, we investigate the impact of capital on banks’ cost of equity. Consistent with the theoretical prediction that more equity in the capital mix leads to a fall in firms’ costs of equity, we find that better capitalized banks enjoy lower equity costs. Our baseline estimations indicate that a 1 percentage point increase in a bank’s equity-to-assets ratio lowers its cost of equity by about 18 basis points. Our results also suggest that the form of capital that investors value the most is sheer equity capital; other forms of capital, such as Tier 2 regulatory capital, are less (or not at all) valued by investors. Additionally, our main finding that capital has a negative effect on banks’ cost of equity holds in both developed and developing countries. The results of this paper provide the missing evidence in the debate on the effects of higher capital requirements on banks’ funding costs.
"This paper studies optimal bank capital requirements in a model of endogenous bank funding conditions. I find that requirements should be higher during good times such that a macroprudential "buffer" is provided. However, whether banks can use buffers to maintain lending during a financial crisis depends on the capital requirement during the subsequent recovery. The reason is that a high requirement during the recovery lowers bank shareholder value during the crisis and thus creates funding-market pressure to use buffers for deleveraging rather than for maintaining lending. Therefore, buffers are useful if banks are not required to rebuild them quickly"--Abstract.
