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ROLE AND SIGNIFICANCE OF CAPITAL BUFFERS- NEED OF THE HOUR: MRIGANC MISHRA


WHAT IS A CAPITAL BUFFER?

The term ‘capital buffers’ refers to any of a bank’s capital holdings that are in excess of the regulatory minimum.[1] In simple terms, banks and financial institutions are required to hold a certain amount of capital (as buffers), in addition to other minimum capital requirement.              It is pertinent to note that Capital Buffers differ from, and may exceed the reserve requirements set by the Central Bank.

A Capital Buffer is built up outside periods of financial stress- which means Banks and Financial Institutions are supposed to hold a certain amount of capital with them when the economy is booming and growing rapidly. Its main purpose is to protect the banking sector against losses from changes in economic conditions. Therefore in unforeseen circumstances (i.e. Financial Crisis), the banks may use this capital to cover the bridge of financial losses.

BASEL III NORMS (HISTORY)

Basel III is a comprehensive set of measures developed by the Basel Committee on Banking Supervision (BCBS)[2]. In December 2010, the Committeereleased official regulatory standards for the purpose of creating resilient banking system.[3]The financial crisis of 2007-2008 exposed weaknesses in the balance sheets of many banks. Therefore, to address this shortcoming, Basel III introduced two buffers that shall apply to all banks- Capital Conservation Buffer (CCB) AND Counter-cyclic Capital Buffer (CCyB).[Under Basel III, banks are subjected to a total minimum capital requirement of 8% of risk-weighted assets. India, against the stipulated 8%, is subjected to 9% of the total minimum capital requirement.]

CCB- This ensures banks have an additional layer, a “soft- cushion” perhaps to fall back on that can be drawn when losses are incurred. It shall be met with Common Equity Tier 1 (CET 1) Capital only.

CCyB-It is intended to protect the banking sector against losses that could be incurred by cyclical system risks increasing in the economy.[4]

CAPITAL BUFFERS DURING GLOBAL FINANCIAL CRISIS

Banks expand their lending during periods of economic growth, and contract lending when the economy slows down.[5] A standard aftermath involved in a Global Financial Crisis is the depreciation of the value of a bank’s assets (loans). When the value of a bank’s assets falls below the value of its debt (deposits and bonds), the value of the bank to its owners becomes negative, and the bank becomes insolvent.[6]To prevent this insolvency, the Capital Buffers can help the banks and financial institutions to have sufficient capital to absorb the losses. Buffering Covid-19 losses:- The Covid-19 Pandemic has been a massive shock to the world economy. The sharp downward revision to the economic outlook and investors’ retrenchment have sent asset prices plummeting and inflicting market losses on banks.[7] However, this is where the significance of Buffer Capital is highlighted.To avoid amplifying stress, the banks all over the world have been relying on buffers to absorb elevated losses for as long as the slump persists.[8] After the Pandemic ceases to exist, the banks will still need buffers that they can fall back on in order to facilitate the rebound as robust counterparties and reliable intermediaries.[9]

The banks job is not done yet. They are yet to face the behemoth challenges that will keep growing, for the Financial Crisis of 2007-2008 has showed us that credit loss remains elevated for several years after recessions end. According to the Bank of International Settlements (BIS), the main policy levers for tackling this economic meltdown are monetary, fiscal and prudential buffers. Buffers were not designed for the active management of the economy, however it can support bank lending. Capital Buffers, together with minimum capital requirements, provide absorbing capacity for losses that exceed the level of banks’ loans.

Indian Context-Despite the prevalence of the Covid-19 Pandemic, the RBImay not implement the countercyclical capital buffer (CCyB) framework for probably another year. The RBI said, that the decision of implementing the CCyB would normally be pre-announced, and that it is not necessary to activate the framework for another year. This move comes as a result of implementing the Ways and Means Advances (WMA) framework. It is a facility for both Centre and states to borrow from the RBI. These borrowings are meant to help them temporarily for the mismatches in cash flows of their receipts and expenditures. However, In July- 2020, the RBI Governor said that the economic impact of the Covid-19 pandemic may lead to higher NPAs. He goes on to highlight the importance of Capital Buffers and says that building buffers and raising capital in such a situation becomes imperative to strengthen the internal defences of financial intermediaries against the risks and to ensure credit flow.[10] A recapitalisation plan for public sector banks and private banks has therefore become necessary, said the governor.

CONCLUSION

The Financial crisis of 2007-2008 has given us some important lessons. Firstly, the government should legislate and implement guaranteed schemes that require banks to keep their engines running even during an economic downturn, to protect the solvency of the banks and keep lending capital to the real economy. Secondly, the banks’ resilience depends upon the Capital Buffers built up during the period of economic boom. The restoration of credit to the real economy will be short-lived if banks are weighed down with bad assets and no buffers.[11] Lastly, a buffer release will be most effective if the banks combine transparency and effective market discipline in their strategies to deal with the Financial Crisis, and avoid a situation that could worsen the macroeconomic problem. 


[1] Volume 38, Oscar Carvallo Valencia and Alberto Ortiz Bolanos, “Bank Capital buffers around the world: Cyclical Patters and the effect of market power”(2018)

[2] Financial Stability Institute (FSI) Connect, “The capital buffers in Basel III- Executive Summary” (2019)

[3] Julia Kagan, “Capital Buffer”, (last visited on 12th August, 2020, 8:57pm) (https://www.investopedia.com/terms/c/capital-buffer.asp)

[4] “Countercyclical capital buffer”, (last visited on 12th August 9:15pm), (https://www.eestipank.ee/en/financial-stability/countercyclical-capital-buffer)

[5]Supra

[6] “Countercyclical Capital Buffers and Financial Crises”, (last visited on 13th August, 2020, 2:03pm) (https://www.stlouisfed.org/on-the-economy/2019/august/countercyclical-capital-buffers-financial-crises)

[7] Mathias Drehmann, Marc Farag, Nikola Tarashev and Kostas Tsatsaronis, “Buffering Covid-19 losses- The role of Prudential Policy” (2020)

[8]id.

[9]Supra

[11]Supra

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