Countercyclical Capital Buffers and Financial Crises

Many economists argue that the rapid growth of credit—especially among households—contributed to the global financial crisis and subsequent recession. An Economic Synopses essay asks: Could higher bank capital requirements in good times help prevent future financial crises?

In the essay, economist Miguel Faria-e-Castro explored the potential effects of the countercyclical capital buffer (CCyB) and concluded: “My analysis shows that the CCyB framework can prevent financial crises or at least attenuate the effects of recessions.”

Capital Buffers

Capital refers to funds owned by a bank’s shareholders. Faria-e-Castro noted that when the value of a bank’s assets (mostly loans) falls below the value of its debt (deposits and bonds), the value of the bank to its owners (capital) becomes negative, and the bank becomes insolvent.

“Since bank insolvency can spread to other financial institutions (and cause a crisis), regulators set a minimum capital requirement, which forces banks to hold more capital than shareholders might otherwise prefer,” he explained. “This capital serves as a buffer between the value of a bank's assets and its debt.”

Countercyclical Capital Buffer

Faria-e-Castro noted that many of the new Basel III rules concerned bank capital requirements.Faria-e-Castro noted that, in response to the financial crisis, national authorities from around the world agreed upon a new set of rules in an effort to better regulate the financial system. The new set of rules is known as Basel III. One such rule was the CCyB. He explained that the CCyB forces banks to hold more capital during periods when their assets grow rapidly.  

“In other words, the CCyB is designed to be activated during good times, when banks are lending a lot,” Faria-e-Castro wrote. “During a recession, bank assets are likely to lose value; the extra capital buffer can then help ensure that banks have sufficient capital to absorb those losses.”

He noted that the Federal Reserve Board of Governors sets the CCyB rate in the U.S. but has not raised it above 0% since the rule was formally introduced in September 2016.

Potential Effects of this Buffer

In a 2019 working paper, Faria-e-Castro studied whether implementing the CCyB would have helped insulate the U.S. economy from the effects of the 2007-09 financial crisis.Faria-e-Castro, Miguel. “A Quantitative Analysis of Countercyclical Capital Buffers.” Working Paper No. 2019-008, Federal Reserve Bank of St. Louis, 2019. He found that using the CCyB could have helped prevent a financial crisis and a large drop in consumption around 2007 and 2008, but it could not have prevented the subsequent slump.

In other words, he said, this regulatory tool could have helped prevent the financial crisis, but not the Great Recession. “Rather, the use of this tool would have allowed the U.S. economy to experience a ‘soft landing,’” he added.

While the CCyB framework may help buffer the effects of crises, Faria-e-Castro noted that there are also costs to raising bank capital requirements. For example, he noted that this policy may reduce corporate investment and economic growth by constraining bank lending. In addition, he pointed out that tighter bank regulation may induce intermediation to migrate to the “shadow banking” sector.

Notes and References

¹ Faria-e-Castro noted that, in response to the financial crisis, national authorities from around the world agreed upon a new set of rules in an effort to better regulate the financial system. The new set of rules is known as Basel III.

² Faria-e-Castro, Miguel. “A Quantitative Analysis of Countercyclical Capital Buffers.” Working Paper No. 2019-008, Federal Reserve Bank of St. Louis, 2019.

Additional Resources

• Economic Synopses: Can Countercyclical Capital Buffers Help Prevent a Financial Crisis?
• On the Economy: Corporate Debt Since the Great Recession
• On the Economy series: Supervising Our Nation’s Financial Institutions