Can regulating bank capital help prevent and mitigate financial downturns?

Introduction

The global financial crisis of 2008–09 significantly disrupted financial intermediation and ultimately exposed US taxpayers to losses from bank failures (Bernanke 2018). Regulatory authorities throughout the world responded by asking whether they should impose additional capital requirements on banks and, if so, in what form (BCBS 2010a).

The decision to impose such regulation is complex and involves important trade-offs. For instance, increasing minimum capital requirements on banks may help reduce losses during bank failures, but it could also constrain banks from providing credit when it is most scarce. During financial crises, limiting credit could amplify the downturn and impair the economic recovery.

Introducing “countercyclical capital buffers” could help mitigate these trade-offs (see Box 1). These buffers are capital requirements that are increased during good times and decreased during downturns. During times of financial stress, banks would have extra capital on hand and would not need to reduce lending to comply with regulatory requirements.

This note analyzes the role of countercyclical capital buffers in smoothing the supply of credit through the financial cycle. We use an analytical framework in which banks adjust their lending decisions to balance their reliance on equity and debt funding over the financial cycle (Schroth 2021). Applying the model to Canadian data, we provide some perspectives on Canada’s countercyclical macroprudential capital buffer—the Domestic Stability Buffer (DSB)—which is administered by the Office of the Superintendent of Financial Institutions (OSFI).

The intent behind OSFI’s DSB is to mandate banks to maintain higher capital buffers during good times. Our analysis shows that this can be effective in mitigating welfare losses from financial cycles. For instance, our model reveals that setting the DSB at 2.5 percent of risk-weighted assets (RWA) during good times (the top end of the range for the DSB specified by OSFI) leads to about a 30 percent reduction in welfare losses.

Box 1: Bank capital and regulatory capital requirements

Banks lend money to households and firms. They fund these lending activities through a combination of capital (equity) and debt. Capital and debt form the liability side of a bank’s balance sheet:

  • Capital is a bank’s own funds—it is the most stable funding source.
  • Debt is external financing that tends to have short-term maturity.

The role of capital in banking activities

A key role of capital is to lower the probability of bank failures. Capital acts as a buffer when economic and financial disruptions reduce the value of assets on a bank’s balance sheet. If the value of a bank’s assets becomes lower than the value of its liabilities, then the bank becomes insolvent. This is where capital comes into play.

For a given level of assets, the division of capital and debt in a bank’s liabilities matters. The larger the share of capital, the more room the bank has to absorb losses when the value of its assets goes down during an economic crisis. In practice, regulators also consider the riskiness of the assets on the bank balance sheet when setting the amount of capital needed to lower the probability of bank failures. The higher the risks, the more stringent the requirements for banks to hold capital.

Another important role of bank capital is to induce its leadership team to better manage risks. For instance, to align their incentives with those of the bank’s shareholders, bank managers often receive part of their compensation as equity shares in the firm. This way, bank managers—wanting to preserve the value of their wealth—closely watch the risk management practices in the bank’s day-to-day activities.

The role of government regulations in bank capital

For the economy as a whole, regulating bank capital helps internalize negative externalities associated with the failure of large systemic banks. The failure of one bank could cause other financial institutions to go under, compromising the health of the financial system. To address this externality, regulators typically impose higher capital requirements on banks that are more likely to cause other banks to fail, all else equal—that is, the so-called systemically important banks.1

Higher bank capital requirements reduce the severity of financial downturns. The higher the buffer created by capital, the higher the bank’s probability of surviving a downturn. Surviving banks are then well placed to continue providing credit during the recovery phase.

However, the decision of regulators to impose large capital requirements has an important trade-off. It may lead to lower economic activity during normal times. Banks facing higher bank capital requirements may choose to reduce the size of their assets to satisfy them. If most financial institutions do this, it could result in an overall reduction in the provision of credit—negatively affecting economic activity. The presence of regulatory capital requirements therefore smooths the credit cycle by limiting lending during normal times and reducing the occurrence and severity of financial downturns.

To mitigate this trade-off, banking regulators can impose a countercyclical capital buffer. This is an additional requirement to hold capital based on economic conditions:

  • During periods of economic prosperity, authorities would require higher levels of capital, as banks are in a better position to generate or raise capital.
  • During downturns, authorities would allow banks to reduce their capital without risking restrictive supervisory actions in order to continue to supply credit and facilitate the recovery.

Countercyclical capital buffers therefore provide surviving banks with incentives to not reduce their assets to comply with regulations and potentially worsen the downturn.

When banking regulators modify the countercyclical buffer, they consider the risks and vulnerabilities the economy and the financial system face. Some risk events could have a large negative impact on the economy, and capital should be accumulated before these events occur. In Canada, the Office of the Superintendent of Financial Institutions administers the countercyclical component of capital requirements, called the Domestic Stability Buffer.2

Bank capital and socially optimal regulation

A bank’s decision to fund its lending activities through either equity or debt depends on two conflicting factors:

  1. Equity is costlier than debt. Bank shareholders face greater risks than debt holders and, as a result, require a higher expected return. For example, if the credit quality of a bank’s lending deteriorated, debt holders could simply reduce their exposures by refusing to roll over their debt. In contrast, bank shareholders could face total loss.
  2. Debt holders require bank shareholders to have enough skin in the game to avoid moral hazard issues, such as misalignment between shareholders’ interests and bank managers’ actions. Equity needs to represent a large enough share of the balance sheet to ensure that banks make loans of sufficient quality. An additional benefit of higher equity is that it reduces the probability that a bank will become insolvent when its assets lose value.

These two conflicting factors create a challenging problem for banks in managing risk. When bank equity is too low, concerns about moral hazard could lead banks to be funding-constrained. However, banks want to resort to costly equity only if it is likely they could be funding-constrained.

Through their lending activities, banks seek to maximize their shareholders’ value. As a result, they may not fully internalize how their own resource allocation affects the broader economy. For instance, banks may seek higher lending returns and ignore the cost of potential defaults on the overall banking system and economy. As a result, the optimal strategy for individual banks in allocating equity and debt may not be efficient from society’s point of view. The selected capital share may only be optimal to guarantee the solvency of the bank itself.

A sound banking regulation would help determine the socially optimal mix of bank equity and debt and force banks to take into account any negative effects they bring to the overall financial system. Sound regulation can then achieve:

  • better economic outcomes (e.g., higher and less volatile economic output)
  • a more stable banking system

Schroth (2021) has developed an analytical framework of the banking sector in which he models the optimal behaviour of banks and the banking regulator. In particular, his modelling strategy captures the trade-offs mentioned above between capital and debt that banks face when choosing their capital structures. The framework also accounts for the inefficiencies inherent in bank choices relative to the socially optimal resource allocation. A key highlight from this work is that a target for regulatory capital in normal times should be higher than what banks would choose. This is the level of bank capital that is socially optimal.

Countercyclical capital buffers: The case of Canada

In this section, we apply Schroth’s (2021) analytical framework to Canadian data and consider the optimal settings of Canada’s current macroprudential banking regulation. We focus on the size of the countercyclical capital buffer in normal times. The level of Canada’s DSB ranges between 0 and 2.5 percent of RWA.3

We first calibrate the model to match Canadian data. We then proceed to various simulations in which we sequentially change the top end of the DSB range during normal times.4 For each simulation, we allow the optimal DSB to vary over the financial cycle.

From these simulations, we measure the net social benefit of a particular target level of the DSB during normal times in terms of percentage reduction in the welfare loss from financial cycles. The model measures welfare as the discounted net present value of gross domestic product (GDP). The DSB generates a net social benefit because the economic gains stemming from less frequent or severe financial downturns outweigh the costs of lower economic activity during good times.

Based on our calibrated model, we find the following (Chart 1):

  • Optimal capital buffer: The optimal size of the capital buffer during normal times is 6 percent of RWA.5 Setting the target to this level reduces the net welfare loss from financial cycles by about 60 percent.
  • 2019 bank capital buffer: According to OSFI, Canada’s largest banks in 2019 maintained, on average, a common equity Tier 1 (CET1) capital ratio of about 12 percent. This ratio is 4 percentage points above OSFI’s CET1 regulatory capital requirements, which are defined as:
    • a minimum capital requirement of 4.5 percent of RWA
    • a capital conservation buffer of 2.5 percent
    • a 1.0 percent surcharge for domestic systemically important banks
    As seen in Chart 1, a capital buffer of 4 percentage points reduces the welfare loss from financial cycles by about 50 percent.
  • Top end of the DSB’s range: Setting the target to 2.5 percent of RWA during normal times reduces the welfare loss from financial cycles by about 30 percent.

Chart 1: Net social benefits from additional bank capital buffer

Note: The regulatory capital requirements in this chart are defined as a minimum capital requirement of 4.5 percent, a capital conservation buffer of 2.5 percent and a 1.0 percent surcharge for domestic systemically important banks. All these percentages are expressed as a share of risk-weighted assets. OSFI stands for the Office of the Superintendent of Financial Institutions. The 2.5% bar shows the top end of OSFI’s Domestic Stability Buffer range; the 4% bar refers shows the observed bank CET1 capital buffer in 2019; and the 6% bar shows the capital buffer providing maximum financial stability gains.
Source: Authors' calculations

Overall, within the context of our stylized model of the banking sector, increasing the top end of the DSB range from 2.5 to 6.0 percent of RWA has the potential to bring non-trivial additional benefits in terms of financial stability.

This said, as indicated above, Canadian banks have already held, on average, more capital than the minimum required by OSFI. Banks may prefer to hold more capital for different reasons, such as:

  • lowering their funding costs
  • having more flexibility in deploying capital to take advantage of business opportunities
  • keeping up with global peers

This practice could also reflect other supervisory mechanisms we do not explicitly model.

Regardless of the reason, the banks’ current approach to capital management appears to capture most of the financial stability benefits of holding additional capital buffers. In addition, changing the top end of the DSB range may have other consequences for the financial system that our stylized model of the banking sector does not account for.6

Conclusion

From a policy standpoint, the model we use to evaluate the DSB presents the capital decision as a macroprudential consideration. Capital decisions trade off capital for economic welfare:

  • In good times, higher capital reduces economic activity.
  • In bad times, capital limits the decline of GDP by allowing banks to continue financing their lending activity.

This is an important trade-off to consider in setting countercyclical capital buffers. Such buffers provide significant support for lending during bad times at a small cost to economic activity during good times—as long as they are built up quickly during good times and rebuilt slowly following bad times.

Our analysis suggests that regulatory capital buffers, such as the DSB, can be effective in reducing welfare losses from financial cycles. Banks in Canada take a cautious approach to capital management, in large part to satisfy regulatory requirements set by OSFI.

By providing a macroeconomic perspective, our modelling approach complements additional work done by the Bank and OSFI to capture vulnerabilities in the financial system. After all, a stable and efficient financial system is essential to sustain economic growth and raise living standards in Canada.

  1. 1. For more on the capital treatment for systemically important banks, see the Office of the Superintendent of Financial Institutions’ “Total Loss Absorbing Capacity (TLAC).”[]
  2. 2. For more information on the Domestic Stability Buffer, refer to the Office of the Superintendent of Financial Institutions’ website.[]
  3. 3. The Bank for International Settlements’ Basel Committee on Banking Supervision notes that “national authorities can implement a range of additional macroprudential tools, including a buffer in excess of 2.5%, if this is deemed appropriate in their national context” (BCBS 2010b).[]
  4. 4. We adapt the calibration procedure in Schroth (2021) to the Canadian case.[]
  5. 5. Because we rely on non-parametric optimization to solve the model numerically, we are unable to report results for values of the DSB above 6 percent. This said, given that the optimal solution in the model corresponds to a DSB of 6 percent, values of the DSB above this level would yield net social benefits of less than 60 percent.[]
  6. 6. The model is a simplification of the reality faced by the banking sector. It rests on many assumptions and takes a macro perspective of the sector. The calibration of the model is aimed at reproducing the average behaviour of banks when they face various shocks. Of particular note, we infer the calibration of the cost of capital faced by banks using the banks’ actual capital holdings for given public capital requirements (both provided by OSFI) and for a given observed frequency of financial crises (estimated from international panel data). In reality, individual banks directly observe the cost of their capital. As a result of these assumptions, the policy prescriptions the model suggests should complement the expert judgment of regulatory authorities (and not substitute it) and therefore should be taken with caution.[]

References

  1. Bernanke, B. 2018. “The Real Effects of the Financial Crisis.” Brooking Papers on Economic Activity, BPEA Conference Drafts, September 13–14.
  2. Basel Committee on Banking Supervision (BCBS). 2010a. “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems.” Basel, Switzerland: Bank for International Settlements.
  3. Basel Committee on Banking Supervision (BCBS). 2010b. “Guidance for National Authorities Operating the Countercyclical Capital Buffer.” Basel, Switzerland: Bank for International Settlements.
  4. Schroth, J. 2021. “Macroprudential Policy with Capital Buffers.” Journal of Monetary Economics 118: 296–311.

Disclaimer

Bank of Canada staff analytical notes are short articles that focus on topical issues relevant to the current economic and financial context, produced independently from the Bank’s Governing Council. This work may support or challenge prevailing policy orthodoxy. Therefore, the views expressed in this note are solely those of the authors and may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank.