Blurred lines in bank capital standards

In the Covid-19 pandemic, the post-financial crisis bank capital framework faces its toughest test to date. Policy-makers get to see, in real time, whether their painstaking efforts over the past 12 years have made the banking sector fit enough to fight off a new recession.

At first glance, banks appear to be weathering the storm. Take the eight US global systemically important banks. Their aggregate Tier 1 risk-based capital ratio under the standardised approach fell just 65 basis points to 13.1% over the first quarter, still well above minimum requirements. Their aggregate supplementary leverage ratio (SLR) – the risk-insensitive backstop capital requirement – declined just 20 basis points to 6.2%, comfortably clear of the 5% minimum.

Eurozone lenders also seem to have taken the blows in their stride. A number even posted larger buffers in excess of their tailor-made Supervisory Review and Evaluation Process requirements at end-March compared with three months prior.

But look a little closer, and things appear less rosy. Though US banks took hefty loan-loss provisions over the first quarter, their impact on capital ratios was dulled because of generous transitional measures. Eurozone banks disclosed lustier buffers less because of their own capital accretion and more because authorities brought forward a rule change that loosened Pillar 2 constraints.

Worse, a rash of emergency relief measures threatens to undermine trust in bank capital ratios. In the US, the Federal Reserve temporarily adjusted the denominator of the SLR to exclude US Treasuries and reserve balances, making banks’ leverage ratios appear much healthier overnight. For its part, the European Union is leaning on banks to resist classifying loans as ‘unlikely to pay’, and thereby requiring higher provisions, if they are eligible for public sector support.

These, and other measures, threaten to artificially buoy capital ratios and uncouple them from financial reality. After all, just because a bank doesn’t label a loan as ‘unlikely to pay’ doesn’t mean it won’t inflict losses over time.

Though US banks took hefty loan-loss provisions over the first quarter, their impact on capital ratios was dulled because of generous transitional measures

Watchdogs have justified their interventions by saying they will support lending to the real economy. Released capital from regulatory reserves can be deployed to underwrite loans and facilitate market-making, they hope.

But in their haste, regulators run the risk of blurring the lines between capital buffers and capital requirements. Buffers can and should be reduced to free up capital in a crisis. Authorities around the world have lowered countercyclical capital buffers in recent weeks, for instance, as these are supposed to be released in an economic downturn. However, constraints such as the SLR are supposed to binding, there to absorb the write-downs expected as the coronavirus recession deepens.

Lowering minimum requirements elevates the risk of bank failure, outweighing the potential benefits of increased capital deployment. In addition, it’s unclear to what extent banks can and will use their freed capital in the first place. Researchers at the Bank for International Settlements estimate global banks have around $5.1 trillion of capital in excess of regulatory requirements that they could deploy. However, the amount they’d be willing to use for lending is likely far less than this, considering pressures from supervisors and stakeholders to maintain some cushion above their mandatory minimums.

The BIS boffins project buffer releases could end up supporting $5.3 trillion of additional loans – 6% up on the end-2019 total in an adverse scenario –  similar in scale to the US savings and loans crisis. But in a severely adverse scenario, akin to the global financial crisis, the amount of extra loans made could be as little as $1.1 trillion – less than 2% up on the baseline.

These estimates also fail to take into account real-world pressures on the banks themselves – such as the temporary nature of certain capital relief measures and expectations that discretionary buffers will need to be restored over time. If banks are nervously watching the clock for when business-as-usual capital requirements will return, they are unlikely to turn the lending spigot to full flow.

Banks’ comfort levels in releasing capital will also be based on their future earnings expectations. If they don’t believe they can make up deployed capital in fresh income, they may elect to be miserly rather than munificent. Many lenders foresee balance sheets chock-full of small business and personal loans post-crisis – not the most profitable of assets. Such a future may deter them from loosening the purse strings too much.

The Covid-19 crisis is still in its early phases, and the contours of the ensuing economic calamity are only just starting to come into focus. But all the turning off of buffers and lowering of capital requirements may end up adding little extra firepower to a banking system being sent into battle.