December 07, 2018

At the Peterson Institute for International Economics in Washington D.C., the FED Governor Lael Brainard summarized the financial stability outlook, highlighted areas where financial imbalances seem to be building, and touched on the related policy implications. The focal point of her discussion was the need to impose countercyclical capital buffers (CCyB) on large banks.

Although the resilience of banking system has increased substantially, the financial vulnerabilities associated with corporate debt are building against a backdrop of elevated risk appetite, said Ms. Brainard. The appetite for risk among financial market participants rose notably over 2017 and much of 2018, while corporate borrowing has reached new heights amid rapid growth and deteriorating underwriting standards in riskier segments, such as leveraged lending. FED has two important tools that can respond somewhat to the rising vulnerabilities and these are the design of stress-test scenarios and the countercyclical capital buffer (CCyB). She also highlighted several potential advantages to building additional resilience through the CCyB:

  • First, the countercyclical capital requirements are intended to lean against rising risks at a time when the degree of monetary tightening needed to achieve the same goal could be inconsistent with sustaining the expansion.
  • Second, the banks that are subject to the CCyB could achieve a modest buffer simply by safeguarding the capital they have built up or by reducing payouts moderately.
  • Third, the CCyB is a simple, predictable, and slow-moving tool that applies equally across all large banks. It does not single out shortfalls in particular banks or result in hard-to-predict volatility in individual banks' stressed capital requirements.
  • Most importantly, the additional capital implied by the CCyB across the system can be released when conditions deteriorate to ensure the ability of large banks to lend into a downturn. A number of countries have raised their CCyB setting above zero and FED can learn from their experiences, which have generally been positive.

She added that at a time when cyclical pressures have been building and bank profitability has been strong, it might be prudent to ask large banking organizations to fortify their capital buffers, which could subsequently be released if conditions warrant. According to her, "Reinforcing capital buffers during the strong part of the cycle means that banks will have a cushion to absorb losses and remain sound during a subsequent downturn. Thicker capital buffers help bolster the confidence of market participants when conditions deteriorate, helping prevent the downward spiral from a loss of confidence.” During the downturn, the extra buffers can be released to enable banks to continue lending and help mitigate the severity of the downturn. Past evidence suggests that the market on its own is unlikely to provide incentives for banks to build necessary buffers when times are good and this is because market sentiment becomes overconfident when risk is starting to build. Finally, she added that, although the U.S. financial system is much more resilient than before the crisis, the banking system's "core capital and liquidity buffers have yet to be tested through a full cycle." 

 

Related Link: Speech

Keywords: Americas, US, Banking, Regulatory Reform, CCyB, Financial Stability, FED

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