As COVID-19 spread, policymakers around the world prioritised measures designed to limit the spread of the disease and save lives, but at considerable economic cost. Financial markets have withstood the initial demand for liquidity, but continued credit provision will be crucial as businesses will require funds to tide them through until an economic recovery takes hold. Governments and central banks in many jurisdictions have taken extraordinary steps by guaranteeing emergency loans and easing capital constraints that would otherwise keep banks from lending. But much depends on the actions of banks.
The starting point
After the reforms that followed the 2008-2009 financial crisis, banks were in much better shape at the start of the COVID-19 pandemic. According to the IMF’s Financial Soundness Indicators, the financial sector’s overall regulatory capital to risk-weighted assets ratio for the US, the UK, France, and Germany were all above 15%, having increased over the previous decade. Regardless, banks were not completely immune to the economic impact of the crisis. Returns were already under pressure pre-COVID-19 (European banks’ returns on assets and equity have fallen over the last decade to below 0.5%), and the current crisis has created new pressures, e.g. use of maintained credit lines by corporate clients has forced banks to acquire more cash (EBA 2020). Against this backdrop, bank managers may reasonably decide to adopt a cautionary stance to protect their balance sheet.
This logic, however understandable, rests on a fallacy of composition. If all banks retrench at once, credit provision would be cut across the board, causing more businesses to fail and amplifying the downturn. Such procyclicality has motivated a set of reforms which included the creation of capital ‘buffers’ on top of capital ‘requirements’ (BCBS 2010). Whereas ‘requirements’ have to be met on an ongoing basis, ‘buffers’ can, at least in principle, be drawn down by banks when needed. But often there is a formal cost to their use: the more banks dig into their buffer the tighter the restrictions they face on paying dividends and bonuses or making share repurchases. The idea is that such constraints force banks to increasingly retain their earnings, keeping these earning available to bolster their capital position (Beck et al. 2020).
The buffer that is explicitly designed to support lending during a downturn is the Basel III countercyclical capital buffer (CCyB) of 0-2.5% of risk-weighted assets. In theory, the buffer is activated during good times (up to 2.5%), nudging banks to accumulate capital that they can draw down in bad times when the buffer is released (down to 0%, or ‘deactivated’). Another buffer, the capital conservation buffer (CCoB) of 2.5% of risk-weighted assets, is also intended to be available for draw down in bad…
