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    BIS on Role of Capital and Liquidity Buffers in Easing COVID Crisis

    April 24, 2020

    BIS published a short note or bulletin that explores the conditions under which the release of prudential buffers might help address the shock caused by the COVID-19 pandemic. The note first assesses the impact of the economic fallout from the crisis and the related policy measures on banks. It then reviews the design and usability of prudential buffers, before moving on to discuss how the relaxation of such buffers can support bank credit. Thus far, the prudential authorities have sought to support the flow of credit to firms, households, and governments, most notably by relaxing banks’ constraints on the use of liquidity and capital buffers.

    The note further highlights that for banks to continue playing a positive role in the supply of funding during the recovery, they should maintain usable buffers for a long period, as losses from a severe recession will take time to materialize. Bank counterparties, market participants, and the public need to remain convinced that  buffers in the banking systems will help them weather economic stress. If past experience is any guide, buffers will be needed for quite some time. However, no matter how aggressive, the release of available buffers is unlikely to suffice on its own to compensate fully for the recession-induced erosion of capital.

    For example, the CCyB put in place by BCBS jurisdictions before the COVID-19 crisis was set no higher than 2.5% of risk-weighted assets, with the CCyB of most jurisdictions being well below that level. Even tripling this amount by tapping into other buffers—while keeping some resources unused—would be only just enough to absorb the losses estimated in central bank stress tests. In recent versions of those exercises, recession-induced capital erosion was calculated to rise to 4.0% to 7.5% of risk-weighted assets (US, UK, and EU). Given that the impending global recession is likely to match or exceed the most adverse scenarios embedded in these past exercises, capital erosion may be much larger, even if governments intervene to support banks (for example, with guarantees).

    A buffer release will be most effective if included within a general strategy for managing the evolution of the pandemic’s economic impact with a portfolio of tools. Lessons from the past indicate that this strategy should have a medium-term horizon and combine transparency, effective market discipline, and preservation of intermediation capacity. It should help to avoid a financial crisis that will worsen the macroeconomic problem. Reading through this lens the messages from successful resolution of past banking crises, the restoration of credit flows to the real economy will be short-lived if banks become weighed down with bad assets and no buffers. Furthermore, government guarantee schemes should require banks to keep “skin in the game,” thus both protecting the solvency of the public sector and leveraging the ability of lenders to discriminate between good and bad credit. Preserving monetary and fiscal space is key, as the resilience of banks is likely to depend for a long time on a combination of buffers and non-prudential policies.

     

    Related Link: Bulletin

     

    Keywords: International, Banking, COVID-19, Bulletin, Macro-Prudential Policy, Capital Buffers, LCR, CCyB, Procyclicality, Regulatory Capital, Liquidity Risk, BIS

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