Europe’s regulators play ‘time the downturn’ with CCyB

Caught in a pincer by runaway inflation and an energy crisis, Europe faces a deep and protracted recession. Eurozone banks are tightening lending conditions and raising borrowing costs just as firms and savers seek credit to stay afloat.

It’s the kind of perfect storm that would, at first glance, warrant a 2020-style relaxation of capital buffers, to provide banks – whose funding costs have soared since the start of the year – with more dry powder for lending.

Instead, the continent’s banks are headed for progressively more stringent capital requirements over the next 12 months, as regulators from the UK to Finland and Bulgaria line up hikes in the local countercyclical capital buffer (CCyB).

As the name implies, the CCyB – a Common Equity Tier 1, risk-based requirement – is intended to ratchet up during phases of runaway credit expansion, so that banks have enough capital to absorb losses when the winds change direction and systemic risk rises. Conversely, regulators can lower the CCyB to free up capital for lending when the economy needs a booster credit shot, as they did at the outbreak of the pandemic.

The catch: when the CCyB is raised, banks have a 12-month heads-up to meet the new requirements. But economic shocks can materialise far faster than that. The most recent CCyB hike decisions will only take effect in July or August 2023, by which time Europe’s national economies may be in full recession. So what is the rationale for tightening buffers here?

Ukraine and inflation were the principal motivations for the most recent CCyB hikes, but supercharged real estate prices had started to worry regulators before then. Collateral valuations and an overreliance on “lower for longer” expectations were also factored in. On several fronts, national regulators have had strong justification for raising buffers.

It is also true that major losses from the inflation and energy crises were – as of June – yet to materialise on banks’ books, with most provisions attributable to precautionary model adjustments. Regulators may think they’re still in time to cajole banks into stocking up on capital, before writedowns hit books in earnest next year.

Most glaringly, the most recent shocks regulators have had to contend with – a pandemic and a war – were entirely unpredictable through regular macroeconomic analysis. Prudential watchdogs can’t be expected to plan for when the credit cycle next gets hijacked.

That is the reason why, unlike raises, CCyB cuts apply immediately, the moment they’re announced. When businesses and savers seek emergency loans, you don’t want to hamstring capital that could fund lending – though any increase in loan supply effectively depends on banks’ commercial judgement.

Effectively, the CCyB framework, predicated on a game of “time the downturn”, is undergoing its first real-life test under the most abnormal economic conditions. Its design remains undoubtedly elegant – just one that may already be obsolete a decade from inception, as an era of macroeconomic co-operation and efforts to regulate credit supply gives way to one marked by geopolitical tensions and supply shocks.