Transmission and effectiveness of capital-based macroprudential policies

Prepared by Markus Behn, Jan Hannes Lang and Eugen Tereanu

Published as part of the Financial Stability Review, May 2022.

An important lesson from the use of capital-based macroprudential policies in recent years is that the tightening of these policies during booms is unlikely to have a noticeable impact on credit supply and accumulation of imbalances, while the accumulated resilience and the release of buffers in the event of a slowdown produce important advantages. Capital-based policies are particularly relevant for the ECB since they are at the heart of the macroprudential tasks of the ECB as enshrined in European legislation.[1] A great example of a capital-based tool is the countercyclical capital buffer (CCyB). This instrument was designed in the aftermath of the global financial crisis to strengthen the resilience of the financial system and reduce procyclicality.[2] The adoption of capital-based policies such as the CCyB directly strengthens the resilience of the banking system by inducing banks to increase their capital ratios. Further transmission to the real economy through bank credit supply effects depends on general economic conditions and the adequacy of capital constraints in the banking sector. Although such constraints are unlikely to be binding when capital buffers are activated during economic booms, the coronavirus (COVID-19) pandemic has shown that the release of buffers and other requirements in case of slowdown can ease binding constraints and effectively support credit supply and economic activity.[3]

During periods of strong economic activity, an appropriate tightening of macroprudential capital buffer requirements is unlikely to lead to binding capital constraints on banks and therefore should not have a significant moderating effect on the supply of capital. credit or the accumulation of imbalances.[4] Banks typically meet higher capital buffer requirements by increasing their capital targets and capital ratios.[5] This directly improves their overall resilience, as more capital will be available in the banking system for a given set of exposures. In addition, capital-based measures can affect the supply of bank credit and the build-up of imbalances over the cycle. This happens if banks pass on higher funding costs to customers by raising lending rates (“price channel”, based on the observation that bank capital is generally considered to be more expensive than debt) or if they directly limit the amount of credit when they are unable to meet higher capital requirements (“quantity channel”). When economic conditions are favorable, banks tend to have a high capacity for internal capital generation through retained earnings and can also raise new capital in the markets, which reduces the likelihood that banks will be subject to to binding capital constraints. Additionally, the available capital headroom allows banks to smooth adjustments towards higher capital ratio targets over time. Therefore, the transmission through the price channel and the quantity channel should be limited in times of economic boom,[6] and the tightening of capital buffers during recoveries is likely to have small costs in terms of reduced economic activity (via the limited impact on credit supply), with consequent limited effects on the accumulation of imbalances (Table Apanel a).

In times of stress, the availability and ability to release macroprudential capital buffers can ease banks’ capital constraints and effectively support credit supply and economic activity. The materialization of systemic risk is generally associated with high economic uncertainty and large bank losses. These, in turn, lower capital ratios to bring them closer to prudential requirements and hamper banks’ internal capital generation capacity as well as their ability to raise new capital. This means that banks are more likely to experience capital constraints and react by reducing the supply of credit through the quantity channel, with potentially significant negative repercussions for the real economy. In such situations, releasing the capital buffers that were built up in good times increases capital flexibility and eases regulatory pressure on banks, allowing them to absorb losses while continuing to provide services. essential finances. This channel is particularly relevant for banks that have little capital leeway and would therefore become capital constrained without the releases (Table Apanel b).[7] Supporting bank credit supply through the release of capital buffers can, in turn, help cushion the economic downturn and avoid further losses in the banking sector.

These transmission mechanisms offer important lessons for the effectiveness of capital-based measures and the design of the macroprudential capital buffer framework. First, building up capital buffers in good times will be effective as it will strengthen the resilience of the banking system, but the dampening effect on the build-up of financial imbalances is likely to be limited. Second, and related to the first point, the economic cost of building capital buffers is likely to be low when the economy is recovering or when banking sector conditions are favourable. The possible magnitude of economic costs is an important consideration when macroprudential policies need to address vulnerabilities in a context of heightened uncertainty, as is the case in the current environment. Third, the availability and release of capital buffers during crises can effectively support credit supply and economic activity by easing potential bank capital constraints. Overall, therefore, enhancing the role of releasing capital buffers in the macroprudential framework, which includes building them when things are going well, seems like a robust policy strategy. This message is reinforced by the fact that the measurement of cyclical systemic risk is subject to uncertainty, and the pandemic has shown that large systemic shocks can occur regardless of a country’s position in the financial cycle. A higher amount of releasable capital buffers would therefore strengthen the ability of macroprudential authorities to act countercyclically when adverse shocks materialize.[8]

Table A

During booms, increasing capital buffers have little impact on economic activity and the build-up of imbalances, but freeing up capital can support credit supply in downturns, particularly for banks for which the capital requirements are binding because they have limited room for manoeuvre.

Sources: Eurostat, ECB (AnaCredit and Supervisory Banking Statistics) and ECB calculations.
Notes: Panel a: results are based on local panel projections for euro area countries from Q1 1970 to Q3 2021. Dependent variables are annual real GDP growth and proposed Systemic Risk Indicator (SRI) by Lang et al.* The projection horizon is one year ahead. The impetus is a 1 percentage point increase in the banking sector’s leverage ratio, measured as total capital divided by total assets. The effect of the impulse differs depending on whether current real GDP growth is positive or negative. Additional checks include current values ​​of real GDP growth, output gap, inflation, SRI, country-level financial stress index (CLIF), and government bond spread. ten years. Changes in the banking sector’s leverage ratio are not necessarily related to exogenous changes in prudential requirements, but controlling for a large set of current macro-financial variables in the regressions helps to isolate the impact of leverage ratio changes. which are not related to these variations. current macro-financial conditions. Panel b: Results are from bank- and firm-level regressions, including firm fixed effects to control credit demand, several bank-specific controls, and monetary and fiscal policy measures (including, among others, the bank’s post-event credit percentages I strengthen k that are subject to government moratoriums or government guarantees). The dependent variable is the change in the logarithm of bank loans I strengthen k between Q3-Q4 2019 and Q3-Q4 2020. The coefficients displayed (blue dots in the graph) are derived from an interaction between the CET1 capital release measure (the combined release of the cushion requirement (CBR) and the amendment to the Pillar 2 (P2R) requirement composition, the latter featuring a legislative change that was originally due to come into force in January 2021 as part of the latest revision of the Capital Requirements Directive) and the distance pre- pandemic (Q4 2019) versus Pillar 2 (P2G) guidance. The yellow whiskers indicate two standard deviation confidence intervals around the estimated coefficients.
*) Lang, JH, Izzo, C., Fahr, S. and Ruzicka, J., “Anticipating the crisis: a new indicator of cyclical systemic risk to assess the probability and severity of financial crises”, Occasional Paper SeriesECB, n° 219, February 2019.

Abdul J. Gaspar