Few PolicyScope charts can generate as much fear and dread among banking regulation experts than this time series:
Volume levels are not high. Leaks are non-existent. Rhetoric barely registers.
But banking regulation experts know that a picture like this only means one thing: the banking system and the economy are under stress. The picture of fear is not merely the quantum of the delta between action and rhetoric. The sustained high level of activity stretching into April is the telltale sign of stress.
Today’s post closes out a week of analysis highlighting policy areas which have maintained or accelerated momentum in response to the COVID19 pandemic. The issue of the day is macroprudential policy in general, and the Counter-Cyclical Capital Buffer (CCyB) in particular.
This post first explains what the CCyB is and why it serves as a useful proxy for banking system stress. We then walk through the chart-based analysis using patented PolicyScope data. We close with some policy trend projection.
Background -- Macropru and the CCyB
Technically, some version of the CCyB has been a fixture of the banking regulation framework for decades if not centuries. Banking regulators have always had some discretion regarding the application of regulatory capital and other regulatory requirements, easing up during periods of stress and tightening during periods of loose credit. You can think of it as the financial regulation equivalent of monetary policy.
Uneven and unpredictable application of supervisory discretion generated problematic results over the years. From inept execution to deliberate efforts to provide competitive advantages, the informal system was prone to mistakes and abuse. After the Basel I framework established a common minimum standard internationally for regulatory capital in 1988, regulatory discretion effectively had to operate with a firm lower bound. Regulatory discretion could not deliver capital requirements below the 8% of risk weighted assets.
The Basel II framework created a more quantitative and detailed approach to measuring credit risk and the capital to cover that credit risk, but Pillar II supervisory requirements remained vague. Regulators remained free to increase capital above the international minimum standard and to decrease it, but not below the minimum standard, for a broad range of reasons.
The Basel III framework introduced intellectual rigor and clear limits on how much regulators could increase or decrease ancillary capital requirements to address system-wide (“macroprudential”) risks. A range of components were created to execute macroprudential risks, particularly the capital conservation buffer and the CCyB. While the technical process for calculating the CCYB can be convoluted, the main elments are easy to undertand.
Today’s post focuses on the CCyB because
(i) it is the composite (weighted average) of all the various macroprudential buffers a bank must hold across jurisdictions,
(ii) each jurisdiction calculates macroprudential buffers using an objective reference rate: credit to GDP;
(iii) it must be covered by Tier 1 capital (which means it has a material impact on a bank's solvency as well as liquidity), and
(iv) if a bank cannot meet the CCyB requirements then it is subject to restrictions regarding capital (and dividend) distribution.
The CCyB is is subject to a floor (zero) and a ceiling (2.5%) of risk weighted assets. While increases in the CCyB must be notified in advance, reductions can take immediate effect.
Translation: Financial regulators have the ability to release significant amounts of Tier 1 capital into credit markets during periods of financial system stress. Depending on the situation, the capital can absorb losses or support additional stimulus through credit lines. Significant periods of activity regarding the CCyB are thus synonymous with systemic stress events.
While the COVID-19 pandemic is not the first period of financial system stress since Basel III was promulgated, it is the most significant, sustained, systemic situation. While activity regarding releases of the CCyB did not generate material media attention, the data below tells us that the system so far has performed as planned.
What the Data Tells Us: The CCyB Works, But Has Limits
As a tool to manage systemic risk, the first question has to be whether CCyB policy trajectories paralleled the response to the COVID19 pandemic. The answer is YES:
The shape and slope of the COVID19 and CCyB green action lines are indeed consistent with each other. The CCyB reaction function peaks a little later than the broader COVID-19 slope, but both then level out.
This is an intuitive result which reflects the ramping up of crisis activities during March in particular. Despite significant differences in aggregate volume (the left hand scale), both CCyB and broader crisis activity maintained the same broad rhythm reflecting lulls at the weekend.
The April data illustrate the limits of CCyB policy when applied to persistent systemic stress situations:
Pandemic crisis reaction functions maintained their broad sine-wave function during April. However, CCyB policy activity remained flat and then began to taper off as the month ended. This is no surprise.
Rapid acceleration during a crisis can deliver shock-and-awe during short-lived crises. It delivers much-needed liquidity and capital relief. It provides banks with the flexibility to absorb losses.
But for longer duration systemic events such as the current pandemic, the CCyB cannot deliver sustained support for banks.
With a CCyB floor set at zero, policymakers can do little else with this macroprudential tool until a recovery begins.
Policy Implications and Trend Projection
This part of the Basel III framework has performed as expected. Policymakers released Tier 1 capital into the system, helping to bolster bank resilience amid massive volatility. The true test of the system will occur during the recovery, when regulators at the national level must make decisions about when and how much to increase the CCyB.
Neither the pandemic nor the economic crisis that pandemic mitigation measures created have yet peaked. Consequently, the tightening cycle is far off in our future.
How will we know when an easing cycle is preparing to begin? We will start to see low level activity regarding the CCyB in the research literature and in systemic risk studies. In the interim, the policy trajectory for the CCyB will remain flat.
Policymakers cannot increase this buffer without creating unwanted capital constraints on banks. They cannot decrease the buffer below zero.
The near-term policy implications are more troubling. Between March and April, regulators in all major banking markets drove the CCyB down to zero. However, comparable action cannot be taken in June or July, when second quarter data is released.
With no room left to maneuver on the CCyB, banking regulators will have to make further adjustments to other parts of the Basel III framework if the economic situation continues to deteriorate. But that is a story for another day.
BCMstrategy, Inc. is a start-up company using patented technology to automatically measure and analyze global public policy developments. The company began tracking daily global COVID19 activity in late February 2020, which means the company has captured in its time series the full global reaction cycle for this issue as it occurs. For more information and to get started using the next generation of policy intelligence tools, please visit www.policyscope.io.