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    ESRB Report Outlines Options to Enhance Usability of Capital Buffers

    December 17, 2021

    The European Systemic Risk Board (ESRB) published a report on the usability of capital buffers of banks. The report concludes that banks will not always be able to use their capital buffers to absorb losses without breaching the leverage ratio (LR) requirement or the minimum requirement for own funds and eligible liabilities (MREL), which apply in parallel. Potential impediments to using capital buffers can vary depending on a bank’s systemic importance or the region in which it is operating. The report can support discussions on improving the regulatory framework, for example, in the European Commission’s macro-prudential review that is scheduled for 2022.

    The assessment presented in the report shows how banks’ ability to use their buffers could be limited and furthermore corroborate the complexity of the current regulatory framework. Limited ability to use buffers stems from the multiple use of the same capital units for both minimum and buffer requirements. This limits the effectiveness of the buffer framework and renders a holistic view of the regulatory interactions complex. The conceptual analysis also revealed that consistency with respect to the relationship between the global systemically important institution (G-SII) LR buffer and MREL-LR could be enhanced. Furthermore, the usability of leverage ratio buffers may be hampered by allowing them to be met with additional tier 1 capital, which is usable only after some common equity tier 1 capital has been consumed. Given the existence of regulatory interactions, information sharing is key to assessing limited buffer usability. The results of the empirical analyses show that, on aggregate, buffer usability will already be limited once the leverage ratio becomes binding in mid-2021 and that usability may further decline once MREL requirements apply in 2022 and 2024. The ability to use buffers will already be considerably limited by mid-2021 in several jurisdictions and might be further constrained for a material number of banks in several jurisdictions when the upcoming requirements take effect. The analyses also found a large degree of heterogeneity across regions, across countries and in particular across banks.

    The report outlines possible options for mitigating buffer overlaps. Some of the options are applicable within the current or forthcoming statutory framework, while others would necessitate statutory change. The options also differ in the degree to which they reduce the overlap, with one option ensuring full buffer usability under all circumstances (removing the multiple use of capital), while others mitigate the impediments only partially based on specific set-ups. Moreover, some options (for example, higher combined buffer requirement or higher risk-weighting measures) might also affect banks that do not show an overlap (buffers fully usable); other options (removing the multiple use of capital for buffers and parallel minimum requirements or mirroring risk-weighted buffers with leverage buffers) would have an impact only on banks with limited buffer usability. As only those mitigating options that do not adversely affect the objectives of the respective frameworks were selected for this report, the options typically lead to higher capitalization or adjustment of liability structures, which might entail costs for banks. The benefits of higher buffer usability need to be balanced against the costs of the options concerned, but against the costs of inaction—that is, in terms of limited buffer usability and hence resilience. Of the options that could be applied within the current legal framework, a higher combined buffer requirement would tend to increase buffer usability. While the actual effect would depend on the size of the combined buffer requirement increase, such an increase would also help to facilitate the use of releasable buffers. 

    The report also notes that legal changes could ensure full or significantly improved buffer usability. Removing the multiple use of capital for buffers and minimum requirements would ensure full usability by design. Mirroring all risk-weighted buffers with leverage buffers would also significantly improve overall buffer usability, according to empirical results based on the simulation. Both options would require additional resources from banks, estimated at 0.82% and 1.38% of risk-weighted assets, respectively. Moreover, increasing the quality of capital requirements would lead to a significant improvement in buffer usability, without increasing total capital requirements. The macro-prudential review to be undertaken by the European Commission in 2022 and the ongoing review of the crisis management and deposit insurance framework offer a window of opportunity for legal changes. This report does not take a stance on any increase in the capital requirements over and above what is envisaged by Basel III and any implementation of policy options should be based on a cost-benefit analysis. This report may serve as important input into discussions in this area. That said, the report can contribute to the work done by macro-prudential policy makers and its findings highlight the importance of full and timely implementation of the Basel III international regulatory framework for banks.

     

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    Keywords: Europe, EU, Banking, Systemic Risk, Macro-Prudential Policy, G-SII, Capital Buffer, Regulatory Capital, Basel, MREL, Leverage Ratio, Buffer Usability, EC, ESRB

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