Analysis of the Effectiveness of the liberalisation of the countercyclical capital buffer during the Covid-19 pandemic: Prudential misconceptions of capital and liquidity requirements

By Dominik Grave (Runner-up in the Monetary Economic Competition)

1. Monetary policy during the Covid-19 pandemic

This paper analyses the support measures implemented by the European Central Bank (ECB) to counteract the impact of the Covid-19 pandemic. It is argued that capital and liquidity requirements enable countercyclical lending but are restrained by commercial banks´ perceived uncertainty during the Covid-19 pandemic. Per the proverb “You can lead a horse to water, but you can´t make him drink” the relief of capital buffers and the provision of liquidity equip banks with sufficient lending capacities but cannot reduce the uncertainty by which they are constrained (BBC, 2012). Therefore, regulations must be adjusted to include a permanent and sufficiently large backstop that reduces the perceived uncertainty and enable more efficient and countercyclical lending.

The ECB´s measurements implemented during the Covid-19 pandemic include instruments that help the economy absorb the shock of the current crisis, keep borrowing rates affordable, and support access to credit for firms and households. They also ensure that lending is not negatively affected by short-term concerns, increase commercial banks´ lending capacity and preserve financial stability through international cooperation (European Central Bank, 2021). This paper focuses on those measurements implemented to increase commercial banks´ lending capacities and enable countercyclical lending.

To increase commercial banks´ lending activities, the ECB´s supervision provided temporary capital relaxations and operational relief in reaction to the Covid 19 pandemic. This allowed banks to operate temporarily below the capital requirements defined by the Pillar 2 Guidance (P2G) and the Liquidity Coverage Ratio (LCR) (European Central Bank (a), 2020). According to the ECB, these measures are particularly effective since the countercyclical capital buffer has been swiftly and immediately relaxed by national macroprudential authorities. To meet Pillar 2 Requirements (P2R), commercial banks are also allowed to use Additional Tier 1 and Tier 2 Capital in the calculation of Common Equity Tier 1 (CET1) (European Central Bank (a), 2020). Thereby, banks are expected to use the freed capital from the relaxation of the countercyclical capital buffer to increase the overall loan origination and act countercyclically to reduce the adverse impact of the Covid-19 pandemic on the overall economy.

2. The regulatory framework of Basel III

It is argued that the decrease in capital requirements, as part of the ECB response to the Covid-19 pandemic, will not lead to an increase in lending on a one-by-one basis since risk indicators such as non-performing loans (NPLs) worsen, and credit conditions tighten. Thereby, uncertainty increases and lending becomes riskier for commercial banks that tend to lend procyclical.

The relaxation of countercyclical capital buffers relates to the Basel III requirements that are based on three different pillars, including minimum capital requirements, a supervisory review process, and market discipline (Basel Committee on Banking Supervision, 2021). The relief in capital requirements addresses the first pillar entailing minimum capital requirements which contain 4.5% of Risk-Weighted Assets (RWA) as Common Equity Tier 1 (CET1) and 1.5% of RWA as Additional Tier 1. The CET1 includes common shares, stock surpluses, and retained earnings, while the Additional Tier 1 includes CET1 and preferred shares. The Tier 2 must contain at least 2% of RWA and includes subordinated debt and general loan loss reserves (Bank for International Settlements, 2019). Additionally, there are three further buffers implemented to ensure that banks contain sufficient capital. They include a systemically important financial institution buffer requiring additional capital reserves of 1%-3.5% of RWA, a capital conservation buffer that requires reserves of 2.5% of RWA and, a countercyclical capital buffer of 0%-2.5% of RWA (Basel Committee on Banking Supervision, 2021).

3. Relaxation of the countercyclical capital buffer

In France, the countercyclical capital buffer stood at 0.50% by the end of 2019 and was reduced to 0.00% by the first quarter in 2020. In Germany, the countercyclical capital buffer stood at 0.25% by the end of 2019 and was reduced to 0.00% by the first quarter of 2020. In Sweden, the countercyclical capital buffer stood at 2.50% by the beginning of 2020 and was reduced to 0.00% (European Systemic Risk Board, 2022). This indicates that national authorities swiftly relaxed the countercyclical capital requirements for commercial banks. According to the ECB, the relaxation of the countercyclical capital buffer has freed a total of 120 billion EUR of capital which banks could use to increase their lending by 1.8 trillion EUR and counteract the adverse impact of the Covid-19 pandemic on the overall economy (European Central Bank (a), 2020). The total amount of outstanding loans of all credit institutions in the EU increased from 19.3 trillion EUR in 2019 Q4 to 23.3 trillion EUR in 2021 Q3 resulting in an overall increase of 4 trillion EUR (European Central Bank, 2022). This increase indicates the effectiveness of measures implemented by the ECB to counteract the impact of the Covid-19 pandemic. Simultaneously, commercial banks in the EU reported a tightening of credit standards resulting from lower risk tolerance and an increased risk perception caused by a deterioration of the general and firm-specific economic outlook (European Central Bank (b), 2020). This creates a conflict, whereby the measurements implemented by the ECB aim at increasing the lending rates while at the same time commercial banks want to pursue restrictive lending policies due to the uncertainties imposed by the Covid-19 pandemic. Therefore, the lowering of capital requirements to enable an increase in lending should be accompanied by further additional measurements that counteract the tightening of credit standards. In times of economic booms, the risk-taking of commercial banks should be reduced, while in times of financial distress and economic busts, the risk-taking should be increased to provide sufficient liquidity. Equipping commercial banks with more liquidity does not automatically incentivize increases in lending in times of financial uncertainty. Therefore, commercial bank lending could be amplified if regulators raise banks´ incentives to engage in lending practices despite the increased uncertainty caused by the Covid-19 pandemic.

4. Enhancing liquidity requirements for commercial banks

To incentivize risk-taking behaviour in times of financial distress loan loss provisions for banks and the LCR could be enhanced in regulatory terms. During the Covid-19 pandemic, banks face a constant threat of higher NPLs and cliff effects if moratoria and guarantees on loans end. Despite recent amendments to the Regulation (EU) 2019/630 regarding minimum loss coverage of non-performing exposures, the Covid 19 pandemic has shown that banks are greatly concerned about the tightening of credit conditions (European Parliament, 2019; European Central Bank (b), 2020). The LCR is a tool that has been implemented to:

“promote the short-term resilience of the liquidity risk profile of banks […] by ensuring that they have sufficient HQLA [High-Quality Liquid Assets] to survive a significant stress scenario lasting 30 calendar days“

(Basel Committee on Banking Supervision, 2013, p. 4).

However, the LCR undermines the correlation between consumers and corporations defaulting on their loans. The Covid-19 pandemic has greatly indicated that increasing NPL ratios in the economy are triggered by the same cause. For such a systemic trigger of increased NPL ratios, the LCR is not satisfactory for banks to ensure sufficient liquidity. Therefore, current liquidity reserves do not suffice to decrease commercial banks´ uncertainty and increase more efficient procyclical lending. To incentivize risk-taking behaviour during financial distress, commercial banks must have a buffer for NPLs that is sufficiently large to increase lending to consumers and corporations without facing liquidity or solvency issues. This could have been achieved if commercial banks had a higher LCR and loan loss provisions to conduct riskier lending practises and contribute to a stronger resilience and faster recovery during the pandemic. Therefore, the relaxation of the countercyclical capital buffer must be accompanied by enhanced and countercyclically accumulated loan loss provisions and LCRs to incentivize the actual provisioning of credit to firms and households by decreasing the uncertainty faced by commercial banks. Either the increase in the LCR and loan loss provisions or the set-up of additional funds should function as a permanent backstop that could be used in times of financial distress to back a potential incline in NPL ratios.

Similar to current liquidity requirements, the capital conservation buffer also lacks the purpose of a permanent backstop for two reasons: First, banks view this buffer rather as an additional layer that prevents them from dropping below the 8% threshold and don’t want to deprive it. Therefore, the capital buffer is seemingly smaller than perceived in the first place since banks are barely able to utilize it at all. Second, the latest ECB bank survey has indicated that banks are still worried about the tightening of credit conditions (European Central Bank (b), 2020). Therefore, a permanent backstop containing increased liquidity and capital reserves could incentivize risk-taking behaviour in times of financial distress and enhance the monetary policy transmission channel by smoothing bank lending to consumers and corporations.

5. Conclusion

The analysis has shown that commercial banks have been able to act countercyclically during the Covid-19 pandemic and increased their lending to consumers and corporations. Thus, the expansionary monetary policy conducted by the ECB proved successful in providing liquidity to the market to counteract some of the severe economic effects implied by lockdowns, closed factories, supply shortages, and travel restrictions. Nonetheless, this paper argues that equipping banks with more liquidity to lend disregards the increase in uncertainty during financial distress that causes banks to delay their lending activities. To account at least partly for this issue, commercial banks in the EU should increase their loan loss provisions in times of economic booms. The LCR is an important measurement in maintaining the resilience of the financial system, but it cannot restore commercial banks´ confidence in lending during an event as severe as the Covid-19 pandemic with correlated NPL ratios. Implementing a permanent backstop with enhanced loan loss reserves, particularly designed to counteract increases in NPL ratios, could help increase confidence in the commercial banking sector and thereby facilitate credit supply in times of financial distress. Therefore, a review of the liquidity requirements may lead to more countercyclical risk-taking behaviour of commercial banks during economic busts and could increase the overall financial stability.

This article was written by Dominik Grave as his submission in the Monetary Economic Competition 2021/22.

This article was judged by Sir Charles Bean, the Former Chief Economist and Former Deputy Governor for Monetary Policy at the Bank of England.

“The author does a good job of explaining what the ECB and various national authorities did. And he is right that merely relaxing regulatory requirements during ‘bad’ times does not guarantee that banks will take advantage of it and lend more. However, this is complicated territory to unpick. The author notes that euro-area lending rose by €4 trillion during the first year of the pandemic, whereas the ECB’s own analysis suggests that the reduction in counter-cyclical capital buffer permitted less than €2 trillion extra lending.”

A short excerpt of comments by Professor Charles Bean

This article was reviewed by Anna Clarey (President of the Central Banking Society).

References

Bank for International Settlements. (2019). Minimum capital requirements for market risk. Published by: BIS. Retrieved from:

https://www.bis.org/bcbs/publ/d457.htm. Accessed on: 17th of January 2022.

Basel Committee on Banking Supervision. (2013). Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools. Published by: BIS. Retrieved from: https://www.bis.org/publ/bcbs238.pdf. Accessed on: 18th of January 2022.

BBC. (2012). You can lead a horse to water… Published by: BBC Learning English. Retrieved from:

https://www.bbc.co.uk/worldservice/learningenglish/language/2012/09/120924 _todays_phrase_horse_to_water.shtml. Accessed on: 20th of January, 2022.

European Central Bank (a). (2020). ECB Banking Supervision provides further flexibility to banks in reaction to coronavirus. Published by: ECB. Retrieved from:

https://www.bankingsupervision.europa.eu/press/pr/date/2020/html/ssm.pr200 320~4cdbbcf466.en.html. Accessed on: 15th of January 2022.

Basel Committee on Banking Supervision. (2021). Basel Committee on Banking Supervision reforms — Basel III. Published by: BIS. Retrieved from: https://www.bis.org/bcbs/basel3/b3_bank_sup_reforms.pdf. Accessed on: 17th of January 2022.

European Central Bank (b). (2020). The euro area bank lending survey — Third quarter of 2020. Published by: ECB. Retrieved from: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/html/ecb. blssurvey2020q3~a04de75e7f.en.html. Accessed on: 17th of January 2022.

European Central Bank. (2021). Our response to the coronavirus pandemic. Published by: ECB. Retrieved from:

https://www.ecb.europa.eu/home/search/coronavirus/html/index.en.html. Accessed on: 16th of January 2022.

European Central Bank. (2022). Loans reported by Credit institutions in the euro area (stock). Published by: ECB Statistical Data Warehouse. Retrieved from: https://sdw.ecb.europa.eu/quickview.do?SERIES_KEY=117.BSI.Q.U2.N.R.A2 0.A.1.U2.0000.Z01.E. Accessed on: 18th of January 2022.

European Parliament. (2019). Regulation (EU) 2019/630 of the European Parliament and of the Council of 17 April 2019 amending Regulation (EU) No 575/2013 as regards minimum loss coverage for non-performing exposures. Official Journal of the European Union. Published by: Official Journal of the European Union. Retrieved from: https://eur-lex.europa.eu/legal

content/EN/TXT/PDF/?uri=CELEX:32019R0630&from=EN. Accessed on: 19th of January 2022.

European Systemic Risk Board. (2022). Countercyclical capital buffer. Published by: Retrieved from:

https://www.esrb.europa.eu/national_policy/ccb/html/index.en.html. Accessed on: 16th of January 2022.