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.
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.
- 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