All you wanted to know about counter-cyclical capital buffer

The headlines for the last couple of weeks have mostly been around the exponentially increasing number of Covid-19 cases and how governments and central banks world over are deploying unusual weapons to fight the economic fallouts of the pandemic. Central banks have resorted to a wide array of tools, aside from reductions in the Cash Reserve Ratio (CRR) and repo rates. The Bank of England mentioned one such unusual tool, announcing a cut in the counter-cyclical capital buffer (CCCB) to 0 per cent, from 1 per cent currently. On April 2, the financial regulatory authority of Germany also followed suit and cut the CCCB to 0 per cent from 0.25 per cent. The RBI, however, has decided that it is not necessary to activate the CCCB at this point in time.

Following Basel-III norms, central banks specify certain capital adequacy norms for banks in a country. The CCCB is a part of such norms and is calculated as a fixed percentage of a bank’s risk-weighted loan book.

However, one key respect in which the CCCB differs from other forms of capital adequacy is that it works to help a bank counteract the effect of a downturn or distressed economic conditions. With the CCCB, banks are required to set aside a higher portion of their capital during good times when loans are growing rapidly, so that the capital can be released and used during bad times, when there’s distress in the economy.

The CCCB is supposed to be in the form of equity capital, and if the minimum buffer requirements are breached, capital distribution constraints such as limits on dividends and share buybacks can be imposed on the bank.

Although the RBI had proposed the CCCB for Indian banks in 2015 as part of its Basel-III requirements, it hasn’t actually required the CCCB to be maintained, keeping the ratio at zero per cent ever since. This is based on the RBI’s review of the credit-GDP gap, the growth in GNPA, the industry outlook assessment index, interest coverage ratio and other indicators, as part of the first monetary policy of every financial year.

Apart from acting as a buffer that can be drawn upon during distress, the CCCB also helps head off systemic risks by curbing unruly bank credit growth. Systemic risks refer to events that can, besides impacting individual banks, shake up the financial system. The financial crisis of 2008-09 is an example of how systemic risks can play out — individual defaults in subprime mortgages and a credit crunch for banks sparked the biggest financial crisis of all time in the US. After the financial crisis, the Basel committee, comprised of banking regulators, came up with the Basel-III norms, which set new regulatory standards on bank capital adequacy and liquidity. The CCCB was introduced as a part of those norms.

When an economy is booming, you usually have a variety of lenders, from NBFCs to banks to others, knocking at your door to offer loans. One might not even want to resort to approaching a bank, considering the speed of credit approval that other lenders may offer. However, the tables turn when the economy is facing a distress, and most sources dry up. This can be disastrous, considering that businesses and households need more financial support during such times. Hence comes the need for banks to increase their credit during times of distress. The CCCB ensures that central banks can direct bankers to release more credit by freeing up capital, when distress situations arise. In India, the RBI’s move to not to impose the CCCB on banks from 2015 has meant they don’t have any capital buffer to draw on. But not activating it now can help banks keep up the credit flow in the economy.

While banks may prefer to go with the flow, tools like the CCCB come in handy for the regulator to nudge them to swim against the tide.

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