Countercyclical Capital Buffer: Doing the Math

Countercyclical Capital Buffer: Doing the Math

On October 24th, the Federal Reserve Board announced that it would not raise the countercyclical capital buffer (CCyB) above zero at this time.1  We think that was a good decision, in large part because we have serious doubts about the likely efficacy of the CCyB under any circumstances (TCH comment letter found here).  But in this note, we assess the net benefit of raising the CCyB using the estimates of the costs and odds of a financial crisis from the Bank for International Settlements (BIS).  Even using their numbers, we estimate the cost of raising the CCyB to currently be about twice the stated benefit.

Purpose of the CCyB

On September 8, 2016, the Federal Reserve finalized the framework it will follow when setting the CCyB.2   The CCyB is a macroprudential tool that allows the Federal Reserve to raise capital requirements for large banking organizations by up to an additional 2.5 percentage points when the risks of a financial crisis are judged to have meaningfully increased.

Macroprudential policy tools can reduce the economic costs of financial crises in two ways: (i) they can reduce the odds of a crisis, or (ii), they can reduce the cost of a crisis if one occurs.  In promulgating the CCyB, the Fed emphasized the potential for the buffer to reduce the costs of the crisis rather than the odds.  Specifically, in describing the purpose of the CCyB, the Fed says the “CCyB is designed to increase the resilience of large banking organizations when the Board sees an elevated risk of above-normal losses.”  The rationale then adds, “…the CCyB also has the potential to moderate fluctuations in the supply of credit over time.” (emphasis added).3

The Basel Committee on Bank Supervision, the body that designed the CCyB, appears to see the potential benefits similarly.  The consultative document that proposed the CCyB states

…the aim is to ensure that the banking sector in aggregate has the capital on hand to help maintain the flow of credit in the economy without its solvency being questioned, when the broader financial system experiences stress after a period of excess credit growth.4

The document goes on to state

In addressing the aim of protecting the banking sector from the credit cycle the proposal may also help to lean against the build-up phase of the cycle in the first place…This potential moderating effect on the build-up phase of the credit cycle should be viewed as a positive side benefit, rather than the primary aim of the proposal. (fn. The transmission mechanism between required bank capital buffers and the impact on the price and demand for credit is not yet well understood.) (emphasis added).5

Somewhat confusingly, however, other Basel Committee and BIS documents state that there is no evidence to support the view that raising capital requirements for banks reduces the cost of financial crises.  In particular, the primary reference for the potential impact of the Basel III regulatory reforms states

Higher capital and liquidity standards are likely to reduce not just the probability, but also the severity of banking crises. …Surprisingly, there is no extant academic research on this issue. …The data suggest that lower capital-to-asset ratios and lower liquidity ratios are associated with higher output losses during the ensuing crisis. Unfortunately, the relationship is relatively weak, with the implied regression coefficient not statistically different from zero…In the spirit of conservatism, these possible benefits are not included in the calculation of net benefits…effectively assuming that tougher standards have no impact on the severity of crises.6

A more recent BIS publication that assessed the net economic value of TLAC summarized the same evidence a bit more definitively

“…studies have found that the cost of crises is largely unaffected by increases in regulatory capital and liquidity requirements.” (emphasis added)7

The net benefit of raising the CCyB

Nevertheless, given that the stated purpose of raising the CCyB is to reduce the cost of a financial crisis if one occurs, we use the BIS’s estimates of the odds of a crisis; the cost of a crisis; the reduction in cost if the CCyB were raised; and the annual cost of imposing higher capital requirements to estimate the benefit and cost of raising the CCyB.  As shown in the technical appendix, we find that the cost of such an increase exceeds the benefit by a wide margin.  In particular, the benefit of raising the CCyB by            1 percentage point at this time would be $420 billion while the cost would be $920 billion.  This divergence occurs because, if the CCyB is increased, the cost accrues continuously during normal times while the benefit only accrues in the unlikely event that there is a crisis.8

The benefit of raising the CCyB is higher, and the cost lower, when the odds of a financial crisis are higher.  Costs currently exceed the benefit because of the decline in the odds of a financial crisis that has occurred as a result of the post-crisis regulatory reform.  An increase in the CCyB would only provide a net economic benefit if the annual odds of a crisis rose from the BIS’s current estimate of 2 percent per year to 4.3 percent, near the levels estimated to have prevailed before the post-crisis regulatory reforms.9  

Download Technical Appendix

3 12 CFR Part 217, Appendix A, p.4.
4Consultative Document, Countercyclical capital buffer proposal, July 2010, Basel Committee on Banking Supervision, p.2.
 5 P.3
6 “An assessment of the long-term economic impact of stronger capital and liquidity requirements,” August 2010, Basel Committee on Banking Supervision, p.17.
“Assessing the economic costs and benefits of TLAC implementation,” November 2015, Bank for International Settlements, p.25.
8 Lars Svensson has made a similar point about using monetary policy to reduce the likelihood of a financial crisis.  See, for example, “Cost-benefit analysis of leaning against the wind:  Are costs larger also with less effective macroprudential policy?,” June 2015.
9“An assessment of the long-term economic impact of stronger capital and liquidity requirements,” p.9.