Banking and Finance Law Daily Reforms worked ‘well’ during COVID; changes to capital buffers recommended
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Wednesday, April 7, 2021

Reforms worked ‘well’ during COVID; changes to capital buffers recommended

By Jacob Bielanski

Looking at the pandemic as a "stress test," the study found very little "new" lending had occurred—possibly due to large banks’ vulnerability to investor sentiment discouraging the use of emergency buffers intended for that purpose.

The Board of Governors of the Federal Reserve has published a study it commissioned, looking at the COVID-19 pandemic as a "stress test," with a general finding that liquidity and capital requirements allowed banks to weather the shock; however, capital buffers may not be functioning as regulators intended.

The authors of the study point to the fact that none of the largest banks had dipped into their capital buffers as of the third quarter of 2020, despite unified efforts to encourage buffer use at the onset of the pandemic by federal regulators in order to continue lending "in a safe and sound manner." Study authors suggest this comes from banks being vulnerable to investor sentiment, noting the largest banks appeared "quite concerned" about potential reactions to their falling below buffer requirements. "This suggests a gap in how the capital buffers work in practice and how regulators intend them to perform," study authors wrote.

Regulators intended capital buffers, and similar requirements instituted in the wake of the 2008-2009 financial crisis, to act cyclically, with regulators increasing buffer levels during expansion and decreasing levels during a crisis, with the intention of maintaining lending. Countercyclical measures instituted by U.S. regulators only had a "modest" effect, as study authors observed most of the lending through the pandemic coming as a result of drawdowns on already-open corporate credit lines, as opposed to "new" lending. Study authors also noted that the U.S. was unique among the major economies analyzed in the study, in that it never activated, pre-COVID, the Countercyclical Capital Buffer (CCyB) recommended by the Basel Committee. The Federal Reserve therefore had to resort to "emergency rulemakings" on bank capital requirements to create a similar countercyclicality effect. Activating that buffer in the future would give the U.S. "room" to cut capital requirements in future downturns.

Study authors also suggested that the "stigma" of capital buffer penalties potentially discourage banks from dipping into the emergency capital. Penalties for capital buffer drawdowns include a stop to dividend payouts, executive bonuses and share buybacks. Researchers suggested halting these incentives for all banks as part of any regulator’s emergency buffer decrease as one way to help banks avoid sour investors as a result of lowered buffer levels.

Despite these concerns, study authors concluded overall that post-crisis reforms performed "well" through the early months of the COVID-19 crisis. Banks entered the pandemic with "robust capital and liquidity levels," according to researchers, which enabled the industry to weather the initial shock, thus enabling continued lending and financial intermediation.

Though the study was conducted by staff of the Federal Reserve, the central bank noted that such research is often preliminary and "circulated to stimulate discussion and critical comment." Authors’ findings were not intended to imply "concurrence" among the Board of Governors or the Fed staff, a disclaimer linking the study warned.

MainStory: TopStory CapitalBaselAccords Covid19 FederalReserveSystem FinancialIntermediaries FinancialStability PrudentialRegulation

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