Courtesy of Mete Feridun
Under Basel III, national authorities are allowed to introduce additional capital requirements of up to 2.5% of total risk-weighted assets to ensure that their respective national banking systems have an additional buffer of capital. This buffer provides protection against potential future losses that may arise during downward phases of credit cycles, while simultaneously maintaining the flow of credit in the economy. Known as the countercyclical buffer requirement (CCyB), this rule was phased in from 2016 to 2019.
A New Macroprudential Tool: The Sectoral Countercyclical Capital Buffer
Considering that corporate and mortgage credit cycles may not always be well synchronized, the Basel Committee on Banking Supervision (the Committee) has also introduced a separate and more targeted macroprudential tool to address these segments. This is an optional and complementary requirement known as the sectoral countercyclical capital buffer (SCCyB). Building on the existing CCyB framework, the SCCyB focuses on the imbalances on credit and asset markets, which are often confined to a specific market segment such as two sub-segments of real estate lending, residential and commercial real estate, or non-real estate related private non-financial corporate and household lending.
In other words, national authorities are allowed to temporarily impose the SCCyB’s additional capital requirements to directly address the build-up of risks in specific sectors. While the SCCyB sounds promising, there have been a number of challenges and uncertainties associated with its implementation. These challenges include potential spillovers to other credit segments, increased complexity, and the need for an overall risk assessment identifying both broad-based and more targeted cyclical systemic risks. To address these issues, the Committee published a document in November 2019, providing guidance to support jurisdictions that voluntarily opt to implement a SCCyB and to facilitate consistent implementation across the world.
The Relationship Between the SCCyB and the CCyB
From a regulatory perspective, the key question remains whether the SCCyB and the CCyB should be considered substitutes or complements. In theory, national authorities are allowed to (1) switch between the SCCyB and the Basel III CCyB, or (2) activate both the SCCyB and the Basel III CCyB at the same time. The Committee essentially leaves it to the national authorities to decide whether to activate the SCCyB, activate the CCyB, or activate both at the same time. However, this decision should be based on an assessment demonstrating that imbalances are confined to a specific credit segment and that the adding up of buffer rates does not result in double counting of risk.
Of course, the regulatory view on which buffer is the preferred tool may change over time based on their risk assessments. So national authorities are required to identify a transparent set of indicators that have the ability to act as early warning indicators for sectoral imbalances in their home countries to guide their SCCyB. From a macroprudential standpoint, it is equally important to establish a transparent communication strategy with respect to their assessment of broad-based versus more targeted cyclical systemic risks.
Depending on the particularity of the national economy, the SCCyB may be a better option than the CCyB. The SCCyB will likely be the better option when confined imbalances are combined with low economic growth, high uncertainty about future economic developments, or subdued credit growth in other credit segments. When national authorities are making the decision whether to use the SCCyB or the CCyB, the Committee requires national authorities to take into account the possible role of spillovers to other credit segments. Because of this requirement, national authorities must develop the capability to detect any signs of significant imbalance spillovers or a high probability of loss spillovers. In the case of such spillovers, national authorities should consider whether the SCCyB provides sufficient resilience against imbalances and should likely give preference to the CCyB.
Another important consideration is the pace at which a national authority decides to release the SCCyB when sectoral cyclical risks materialize. The pace of the implementation should allow banks to absorb losses and maintain lending to the real economy. On the other hand, when sectoral cyclical risks do not materialize but recede more slowly, a gradual release of the SCCyB could be a better option.
It will take time for national authorities to master the SCCyB. And even though implementation remains optional, problems may arise if the SCCyB is applied inconsistently across jurisdictions. For example, the SCCyB may distort the level playing field between domestic and foreign banks within the same jurisdiction and inadvertently lead to systemic risks. Therefore, the Committee’s standard-setting and research-based working groups should stay focused on the global implementation of the SCCyB.
Disclaimer: The views and opinions expressed in this blog are those of the author and do not necessarily reflect the official views and opinions of PwC.