Banks expand their
lending activities during periods of economic growth, and contract lending when
the economy contracts. When banks without adequate capital run into trouble
they can either raise more capital or cut back on lending. If they cut back on lending,
businesses may find financing more expensive to obtain or unavailable at
all.
The 2007-2008
financial crisis exposed weaknesses in the balance sheets of many financial
institutions across the globe. Bank lending practices were risky, while bank capital
was not always enough to cover losses. Some financial institutions became known
as “too big to fail” because they were systemically important. To reduce the
likelihood of banks running into trouble during economic downturns, regulators
began requiring banks to build up capital buffers outside periods of stress.
To give banks
enough time to create adequate capital buffers, Basel Committee member
jurisdictions announce planned increases twelve months in advance. If economic
conditions allow a decrease in required capital buffers those reductions take
place immediately.
Capital buffers identified in Basel III reforms include
countercyclical capital buffers, which are determined by Basel Committee member
jurisdictions and vary according to a percentage of risk weighted assets, and
capital conservation buffers, which are built up outside periods of financial
stress
Bank of international settlement describes it in following words
“The financial crisis has provided a vivid reminder
that losses incurred in the banking sector can be extremely large when a
downturn is preceded by a period of excess credit growth. These losses can
destabilize the banking sector and spark a vicious circle, whereby problems in
the financial system can contribute to a downturn in the real economy that then
feeds back on to the banking sector. These interactions highlight the
particular importance of the banking sector building up its capital defenses in
periods where the risks of system-wide stress are growing markedly. As capital
is more expensive than other forms of funding, the building up of these defenses
may have the additional benefit of helping to moderate excessive credit growth
when economic and financial conditions are buoyant.
The countercyclical
buffer proposal set out in this document is designed to ensure that banking
sector capital requirements take account of the macro-financial environment in
which banks operate. It should be viewed as an important internationally
consistent instrument in the suite of macro prudential tools at the disposal of
national authorities. It should be deployed when excess aggregate credit growth
is judged to be associated with a build-up of system-wide risk to ensure the
banking system has a buffer of capital to protect it against future potential
losses. This focus on excess aggregate credit growth means that jurisdictions
are likely to only need to deploy the buffer on an infrequent basis, perhaps as
infrequently as once every 10 to 20 years; although internationally-active
banks will likely find themselves carrying a small buffer on a more frequent
basis, since credit cycles are not always highly correlated across the
jurisdictions to which they have credit exposures. Over time the operation of
the proposed buffer should provide lessons in how other macro prudential tools
could be implemented in a more internationally harmonized way.”
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