Build up CCyB gradually over financial cycle, says ECB paper

Macro-prudential authorities should encourage banks to build up their counter-cyclical capital buffers (CCyB) over the financial cycle, preferably when banks are highly profitable, new research from the European Central (ECB) Bank shows.

A positive neutral CCyB creates more macro-prudential space, which can be useful after a financial shock. The paper says the Covid-19 pandemic made clear that such financial shocks “may occur at any stage of the financial cycle”. With climate change accelerating and geopolitical tensions rising, such shocks are likely to become more commonplace.

Researchers Luis Herrera, Valerio Scalone and Mara Pirovano say even a partially built-up CCyB helps cushion against the effects of a shock, as a higher buffer makes banks less likely to default. This keeps the risk level and default costs in the economy contained, the researchers argue.

Banks comply with higher capital requirements in three ways: reducing credit supply, accumulating more capital via retaining earnings and issuing new equity. But when they are not profitable, they will “resort to more deleveraging to comply with higher capital requirements”, the researchers say.

Higher bank profitability thus reduces the peak negative impact of higher capital requirements on GDP and lending. Therefore, the CCyB should be built up “from an early point, gradually, over the financial cycle, so it reduces the costs of build-up for the economy”, they say.

A more gradual build-up would provide macro-prudential authorities with greater leeway to make capital available for use when needed by releasing the accumulated buffers in the event of adverse shocks, the researchers add.