Plan for bank capital buffers needs fine-tuning

July 19, 2010

Countercyclical capital buffers are a good idea. Before the financial crisis, banks held capital in reserve for expected losses, but did not set anything extra aside as credit conditions became frothier. The Basel Committee on Banking Supervision’s new consultation document wants to change this. But its initial proposals raise numerous questions.

The most basic problem is what such a buffer is actually for. One objective is to make banks safer, by giving them an additional capital cushion in the event of a crisis. But another would be to give national regulators a new tool, on top of monetary policy, with which to control the growth of credit.

If the goal is protection, then the proposal may be too heavy-handed. The Basel Committee envisages each national regulator having the power to put in place an additional buffer when it decides conditions are getting too frothy. Banks would have a year to comply, or face restrictions on their bonuses or dividends.

Such a tool would give banks an additional cushion that they could use in the event of a crisis. But uncertainty about the regulator’s intentions may prompt banks to treat the buffer as a minimum level. Fear of unsettling investors may also make it harder for banks to eat into their reserves during a downturn.

If the aim of the proposals is to avoid credit bubbles from forming, however, the proposals may not go far enough. The Basel Committee suggests that the required buffer in each country should be based on the size of its banking sector’s outstanding loans compared to its GDP. But regulators may be concerned about a bubble in one particular sector, like housing. An across-the-board capital increase might not be enough to stop runaway mortgage lending, while choking off credit to areas that are not experiencing booms.

The rules will also need to ensure that measures of bank lending do not rely too heavily on crude and backward-looking statistics. If the new rules were implemented tomorrow, for example, German banks would have less onerous requirements as the country’s recent credit boom was relatively modest. But German lenders were also among the most active buyers of structured credit securities.

The crisis showed that rigid bank rules can have unintended consequences. But the Basel Committee should also be wary of placing too much discretion in the hands of the regulators. Giving them a tool with which to take away the punch bowl is necessary. But relying on their judgement to vary banks’ capital requirements might end up neither protecting the banks or the wider economy.

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