Capital buffer

Capital buffer is the capital that financial institution is required to hold in order to meet minimum capital requirements. Regulations on financial markets define minimum capital requirements that have to be hold by the banks or insurance companies in order to preserve liquidity. If no capital buffer was defined, banks could lend all the money and have nothing left to pay to depositaries.

If the capital buffer is lower than required, the bank should cub back lending or raise more capital. In case of former solution lending can become more expensive or unavailable to businesses. It is worth to say that capital buffer should depend on the state of the business cycle (Kashyap and Stein, 2004).

Capital Buffers and the Financial Crisis

Before 2010 banks often used risky strategy while lending money to individuals of companies that weren't able to pay them back. In 2007-2008, the financial crisis recovered that many financial institutions do not have sufficient resources to cover their liabilities. Banks provided risky loans to companies that, in their opinion, would not be able to bankptcy, because they are large and mean a lot for economy. Unfortunately, these large companies have become insolvent. That resulted e.g. in collapse of Lehman Brothers.

Basel III

In July 2010 The Basel Committee published a document about countercyclical capital buffer proposal (BCBS, 2010a). Capital buffers were established in official regulatory standards for protecting banking sector from term of excess of credit growth. The consultative document also regulated how to implement a buffer for banks operating in different jurisdictions, as well as the rules that should govern decisions regarding the buffer and its interaction with the capital protection buffer. Based on this document banks are subject to restrictions on capital distributions (dividends, share repurchases, and discretionary bonus payments to staff) if they do not implement the additional capital requirement.

Banks have motivation to hold capital buffers as an insurance against disturb of the regulatory minimum capital requirement (Marcus 1984; Milne and Whalley 2001; Milne 2004). It is worth to say that difference between Banks capital and the capital which Banks may lose determines the optimum capital buffer (Milne and Whalley 2001). According to this the optimum capital buffer depends on the expectation that the regulatory minimum will be disturb. Thus, banks with higher credit risk have higher capital buffers. In the literature, Bank with lower capital buffer has worse opinion and less confidence in the market. Banks usually have more capital to avoid the costs associated to market discipline and supervisory intervention if they have less resources than the regulatory minimum capital ratio (Furfine, 2001).According to the above information excess capital is an insurance against costs that may arise due to unexpected loan losses and difficulties in optaining new capital.

Examples of Capital buffer

• Common Equity Tier 1 (CET1): CET1 is a key measure of the financial strength of a company. It is one of the three components of the Tier 1 capital ratio, which is used to measure the amount of equity capital that a bank has relative to its total assets. It includes common stock, retained earnings, and other equity instruments such as perpetual preferred stock.
• Additional Tier 1 (AT1): AT1 is a form of subordinated debt that is counted as part of a bank’s Tier 1 capital. It is typically issued in the form of bonds, and is intended to provide a buffer against losses that could be incurred in the event of a bank failure.
• Tier 2 Capital: Tier 2 capital consists of a variety of items that may be used to supplement a bank’s Tier 1 capital. It includes items such as subordinated debt, hybrid instruments and allowances for loan losses. This type of capital is usually less expensive for a bank to obtain than Tier 1 capital.

Advantages of Capital buffer

The advantages of capital buffer are:

• It provides a cushion for unexpected losses and helps to ensure a financial institution’s solvency.
• It helps to protect depositors from losses due to financial institution’s insolvency.
• It provides a buffer to absorb unexpected losses from bad loans or investments.
• It helps to reduce the risk of a financial institution’s failure.
• It helps to ensure stability of the financial system by providing a buffer against any potential losses.
• It helps to create incentives for financial institutions to manage their risk more effectively.
• It helps to protect consumers against potential losses due to mismanagement of their financial assets.

Limitations of Capital buffer

The limitations of capital buffer include:

• High capital requirements may lead to decreased profitability as the institutions need to maintain a certain ratio of capital to assets. This may result in reduced lending and can hinder economic growth.
• Capital buffers can create a moral hazard, as institutions may be less likely to manage their risks properly if they know they have a cushion to absorb losses.
• Capital buffers may increase funding costs and lead to increased borrowing costs for borrowers, reducing access to credit.
• Capital buffers may lead to decreased liquidity as institutions must maintain a certain amount of liquid assets to meet capital requirements.
• Capital buffers may be inefficient in times of crisis, as it can be difficult to determine the appropriate level of capital to have in reserve. Additionally, the time it takes to build up capital reserves can be too long to be of use in a crisis.

Other approaches related to Capital buffer

Capital buffers are important for financial institutions to meet minimum capital requirements. Apart from this, there are several other approaches related to capital buffer, such as:

• Risk-based capital adequacy: Risk-based capital adequacy is the amount of capital that a financial institution must hold in order to protect itself against potential losses and other market risks.
• Stress testing: Stress testing is a process of assessing the impact of a potential extreme event on a financial institution’s balance sheet. It helps in determining the risk associated with a particular financial institution and helps in assessing the capital buffer needed to protect it against potential losses.
• Asset-liability management: Asset-liability management is the process of managing the balance sheet of a financial institution by analyzing the balance between its assets and liabilities. This helps in determining the optimal capital buffer needed to protect the institution from potential losses.
• Capital adequacy ratios: Capital adequacy ratios are used to measure the level of capital held by a financial institution relative to its total assets. These ratios are used to assess the capital buffer needed for a financial institution to remain solvent.

In summary, capital buffers are important for financial institutions to meet regulatory requirements. Other approaches related to capital buffer include risk-based capital adequacy, stress testing, asset-liability management, and capital adequacy ratios. These approaches help in assessing the capital buffer needed by an institution to remain solvent and protect itself against potential losses.

Capital buffer — recommended articles

Capital Base — Bank reserve requirements — Liquidity risk — Assets funding strategy — Debenture Redemption Reserve — Reserve capital — Concentration risk — Non current liability — Free Reserves

References

• Jokipii, T., Milne, A. kg. (2007). The cyclical behaviour of European bank capital buffers Journal of Banking & Finance 32(8), 1440-1451
• Lindguist, KG. (2004). Banks’ buffer capital: how important is riskJournal of International Money and Finance 23(3), 493-513
• Peura, S., Jokivuolle, E. (2003). Simulation based stress tests of banks' regulatory capital adequacy Journal of Banking & Finance 28(8), 1801-1824.
• Repullo, R., & Saurina Salas, J. (2011). The countercyclical capital buffer of Basel III: A critical assessment CEPR Discussion Paper No. DP8304

Author: Joanna Kruk