February 22, 2019

BIS published a paper that studies optimal bank capital requirements in a model of endogenous bank funding conditions. The paper develops a model of optimal bank capital and derives implications for bank capital regulation. The study finds that requirements should be higher during good times such that a macro-prudential "buffer" is provided.

However, whether banks can use buffers to maintain lending during a financial crisis depends on the capital requirement during the subsequent recovery. The reason is that a high requirement during the recovery lowers bank shareholder value during the crisis and thus creates funding-market pressure to use buffers for deleveraging rather than for maintaining lending. Therefore, buffers are useful if banks are not required to rebuild them quickly. The following are the two key policy implications of the study:

  • The first main policy implication is that banks should build up capital buffers during normal times. The idea is to make banks more resilient to loan losses as a way of reducing the severity of financial crises and of lowering their frequency. Intuitively, a small reduction in loan supply during normal times—because of costly capital buffers—is traded off against a large reduction during times of financial crisis.
  • The second main policy implication is that banks should be given ample time to rebuild capital buffers following a financial crisis and that regulation should increase bank profitability in that process. The idea is to raise the prospect of future profitability during the financial crisis with a view to increasing a bank's access to outside funding and reducing the severity of a financial crisis. Intuitively, a small reduction in loan supply during the recovery—because of temporarily elevated bank profit margins—is traded off against a large reduction during the financial crisis.

These policy implications can be compared with recent changes in recommendations for bank regulation under Basel III. First, the analysis suggests that market-imposed capital requirements are lower during financial crises for given bank borrower default rates. Adherence to rigid micro-prudential capital requirements at all times may, therefore, not be optimal. Giving banks some discretion in calculating risk-weighted assets during times of crisis can be justified for this reason—since bank margins are high when aggregate bank equity is low. Second, there should be a buffer on top of market-imposed capital requirements—augmenting voluntary bank loan-loss provisioning—that can be used to stabilize lending when bank equity is low. However, no equity payouts are allowed when this buffer is being used. This buffer resembles the capital conservation buffer under Basel III. Third, there should be an additional buffer that can be used when the first one is depleted. It can be used for lending. It can also be used for dividend payouts—or, equivalently, it is “released”—but only once the first buffer has been rebuilt. This additional buffer resembles the countercyclical capital buffer (CCyB) under Basel III.

The CCyB under Basel III is time-varying and, therefore, can potentially be designed to take into account these implications. The analysis reveals that it is crucial for the regulator to raise bank future profitability temporarily during the time when banks use the additional buffer to pay out dividends. The reason is that otherwise dividend payouts in the face of low bank equity would threaten bank solvency. 

 

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Keywords: International, Banking, Basel III, Capital Requirements, CCyB, CCB, Macro-prudential Policy, BIS

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