Pandemic exposes design flaws in bank capital buffers

Shock absorbers work by converting one form of energy into another. In a car, they transform kinetic energy into heat. At a bank, capital buffers are supposed to absorb losses and power lending in an economic downturn.

That’s the theory, anyway. But it doesn’t always work in practice. Early on in the Covid-19 crisis, European authorities urged banks to run down their buffers to support local economies through the shock. The European Central Bank (ECB) said the release of various capital buffers would free up more than €20 billion of Common Equity Tier 1 (CET1) capital at systemically important banks. The top tier of banks had permission to effectively cut their CET1 ratios by over one-third.

As of the end of the second quarter, though, the weighted-average CET1 ratio of 147 European banks was 14.7%, down just 20 basis points from end-2019 – and actually rose between March and June.

Something seems to have gone wrong. European Banking Authority chairman Jose Manuel Campa admitted on October 1 that “buffer usability is clearly an issue” – specifically, that they “do not work as intended”. Instead of being seen as exhaustible reserves of funds, buffers are considered “hard requirements by the banks”, he said.

One reason is because buffers attached to risk-based capital requirements cannot be considered in isolation of banks’ other constraints – such as the leverage ratio. This ‘backstop’ requirement obliges banks to maintain a set ratio of capital to overall assets. Over the course of the coronavirus crisis, many banks were flooded with deposits and acted as intermediaries for state-backed loans. This has caused balance sheets to expand and leverage ratios to decline.

Instead of being seen as exhaustible reserves of funds, buffers are considered “hard requirements by the banks”

While weighted-average CET1 ratios barely budged over the first six months of this year, the Tier 1 leverage ratios of banks in the sample dropped 40bp to 5.1%. Banks flirting with the binding leverage ratio minimum of 3% would not be free to utilise their CET1 buffers even if these risk-based ratios were relatively healthy.

Another ‘soft’ constraint comes from shareowners and bondholders. Investors know their equity dividends, and the coupons paid out on additional Tier 1 debt instruments, come out of capital. Right now, European banks are barred from paying dividends. But investors understandably want them to retain large enough reserves to offer a worthy payday once the restrictions ease.

A third obstacle to effective buffer utilisation could be the expected credit loss accounting regime. This forces banks to divert huge amounts of retained earnings towards loan-loss reserves rather than capital. Though the coronavirus pushed regulators to suspend the capital-sapping effects of the regime for now, this is only a temporary reprieve. Concerns about future credit losses may also have discouraged banks from deploying their buffers.

Finally, banks may doubt their ability to replenish their buffers should they be depleted. The profitability of European banks has been in the doldrums for years, and the current recession means they are unlikely to generate sufficient earnings to cover credit losses, satisfy investors and top up their regulatory capital ratios all at the same time. Why would they risk losing something they can’t regain?

All these reasons are sound at the individual bank level. But replicated system-wide, it translates into a massive under utilisation of capital that could otherwise be used to support the European economy. Perhaps it’s time to retool the banking system’s shock absorbers and get them to do what they were originally designed for.