capital conservation Vs countercyclical buffer

[Kavita.bhangdia]

Hi David,

What is the different between the above two ?

Also total equity buffer ( capital conservation + tier 1) = 7%.

But countercyclical buffer also talks about adding 2.5% of Tier 1 equity.. Is this something over and above 7%.. ?

Please confirm.

Thanks,
Kavita

 

[David Harper CFA FRM]

Hi @Kavita.bhangdia

The capital conservation buffer (aka, CCB) is different than the countercyclical buffer (aka, CCYB), they only have in common the value 2.5%. See the phase in arrangement below (http://www.bis.org/bcbs/basel3.htm); this exhibit includes CCB because, while technical not a minimum capital requirement, it does represent required Tier 1 capital, such that meaningful ratios include 7.0% (ie., minimum CE Tier 1) and 10.5%. CCYB is in addition, so yes, CCYB is over and above the 7.0% minimum common equity Tier 1.

CCB is mandatory, it is "designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred. The requirement is based on simple capital conservation rules designed to avoid breaches of minimum capital requirements" ... and "129. A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the regulatory minimum capital requirement. Capital distribution constraints will be imposed on a bank when capital levels fall within this range. Banks will be able to conduct business as normal when their capital levels fall into the conservation range as they experience losses. The constraints imposed only relate to distributions, not the operation of the bank." (http://www.bis.org/publ/bcbs189.htm)

CCYB could be zero; it ranges from 0 to 2.5%: "142. Banks will be subject to a countercyclical buffer that varies between zero and 2.5%to total risk weighted assets.50 The buffer that will apply to each bank will reflect the geographic composition of its portfolio of credit exposures. Banks must meet this buffer with Common Equity Tier 1 or other fully loss absorbing capital or be subject to the restrictions on distributions set out in the next Section." Rationale is:

V. Countercyclical buffer.
A. Introduction
136. Losses incurred in the banking sector can be extremely large when a downturn is preceded by a period of excess credit growth. These losses can destabilise the banking sector and spark a vicious circle, whereby problems in the financial system can contribute to a downturn in the real economy that then feeds back on to the banking sector. These interactions highlight the particular importance of the banking sector building up additional capital defences in periods where the risks of system-wide stress are growing markedly.
137. The countercyclical buffer aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. It will be deployed by national jurisdictions when excess aggregate credit growth is judged to be associated with a build-up of system-wide risk to ensure the banking system has a buffer of capital to protect it against future potential losses. This focus on excess aggregate credit growth means that jurisdictions are likely to only need to deploy the buffer on an infrequent basis. The buffer for internationally-active banks will be a weighted average of the buffers deployed across all the jurisdictions to which it has credit exposures. This means that they will likely find themselves subject to a small buffer on a more frequent basis, since credit cycles are not always highly correlated across jurisdictions." (http://www.bis.org/publ/bcbs189.htm)

Here is updated status of CCYB @ http://www.bis.org/bcbs/ccyb/

I hope that helps!

 

[Stamov]

Hi there.
I thought I might continue on the topic as I am having difficulties myself .In the GARP 2016 offical practice test ( I still have it ) question 80 is:

Item Value
Risk-Weighted assets 3480
Common equity Tier 1 (CET 1 ) capital 145
Additional Tier 1 capital 50
Total Tier 1 capital 195
Tier 2 capital 98
Tier 3 capital 0
Total capital 293

Assuming that all Basel III phase-ins have occurred and that the bank's required countercyclical (CCYB) buffer is 0.95%, which of the capital ratios does the bank satisfy?

a) CET 1 capital only
b) CET 1 capital ratio plus the capital conservation buffer only
c) CET 1 capital ratio plus the capital conservation buffer and the countercyclical buffer.
d) None

Answer:
CET 1 ratio: 145/3480 = 4.2% below min of 4.5% (i understand this)
CET 1 + CCB = 4.2% + 2.5% = 6.7% below min of 7% (i understand this)
CET 1 + CCB + countercyclical buffer does not meet the additional CCYB of 0.95%=(4.5%+2.5%+0.95=7.95%) << I know the CCYB is between 0% and 2.5%, but what benchmark must be met here, that the bank fails to? I mean for the others the benchmark is 4.5% and 7%.

I just don't get the answer given. Btw I have copied the question and the explanation as they appear in the exam. Its all I have to work with.

Cheers,
Alex

 

[David Harper CFA FRM]

Hi Alex (@Stamov ) Please note that the capital conservation buffer (CCB), as I noted above, requires additional core Tier 1 equity such that the 4th row in Basel's exhibit is significant: Minimum common equity plus capital conservation buffer = 7.0%, is a function of 4.5% + 2.5%. So, in the (your) answer, I don't think it should be "CET 1 + CCB = 4.2% + 2.5% = 6.7% below min of 7% (i understand this)" but rather "CET 1 = 4.2% is also below 7.0%. FWIW.

Re: your question, did you notice the question provides the assumption (emphasis mine): "Assuming that all Basel III phase-ins have occurred and that the bank’s required countercyclical buffer is 0.95%, which of the capital ratios does the bank satisfy?" ... You are correct that Basel does not hard-wire the CCYB, per Hull (emphasis mine):

"Countercyclical Buffer In addition to the capital conservation buffer, Basel III has specified a countercyclical buffer. This is similar to the capital conservation buffer, but the extent to which it is implemented in a particular country is left to the discretion of national authorities. The buffer is intended to provide protection for the cyclicality of bank earnings. The buffer can be set to between 0% and 2.5% of total risk-weighted assets and must be met with Tier 1 equity capital." -- Hull. Risk Management and Financial Institutions (Wiley Finance) (p. 359). Wiley. Kindle Edition.

... so the answer, from my perspective, is using the assumption given to conclude "... and does not meet the additional countercyclical buffer of 0.95% (= 4.5% + 2.5% + 0.95 = 7.95%)."
... however, the only thing I notice is that the CCYB actually does not require core Tier 1 and can use Additional Tier 1. Here the additional Tier 1 of 50/3,480 = 1.44%, so I think technically that would be available for CCYB, which leads me to a similar doubt that you have. Ultimately, I think this question is confusing because superficially the CCYB can be covered by Additional Tier 1 but it's also appears to be moot because CET1 isn't met, sorry Thanks!

 

[[email protected]]

Hi David,

I am glad I no longer work for a bank because these %s are driving me crazy... Can you check my logic please:

4.5 % mandatory equity/"core" + 2,5% mandatory CCB = 7 %. Both come from the same capital sources i.e. common equity and retained earnings.

HOWEVER, the CCB by definition is "built-up" and "drawn-down" depending on stress levels, so I assume (?) is not subject to a minimum i.e. during a stress period, it could be zero?

The above table tells us that minimum tier 1 ("core" + additional) needs to be 6%. This means that if we have the minimum mandatory 4,5% "core" and zero CCB (due to stress), then the difference is 1,5% additional (non-cumulative preferred etc).

Extra "core" (above 4,5%) that is not deemed categorised CCB (not sure if I would categorise differently due to div restrictions covered below?) would mean we do not need as much "additional" tier 1 to meet the 6% minimum, but vice versa is not possible because core cannot < 4,5%.

Then we need a minimum total of 8, which brings in tier 2 (debt subordinated to depositors etc). The table mentions this 8% excluding the buffers.

So, to achieve this in the cheapest way, without breaking rules = 4,5% (core) + 1,5% (additional) + 2% (tier 2) = 8%

On top of this, I need 2,5% CCB (when times are good) and the CCYB 0-2,5% (set at supervisor discretion). The former comes from tier 1 "core". The latter can come from tier 1 "additional". If the actual requirements of these buffers are not met (i.e. at least the CCB), then I will have restrictions in paying dividends. For CCB, the restriction looks to "core" capital (equity) only. I am restricted to not paying any dividends (100% retained) up to 5,125% (well above the 4,5% minimum) due to the expectation of always having some CCB. At 7% (4,5% + full CCB), I am free to distribute w/o restrictions.

To have my full distributing freedom (banking braveheart), I therefore need the 8% mentioned above + the full 2,5% CCB.

This assumes no CCYB, when I regain freedom (assuming the maximum 2,5% is imposed) at the 7% above + 2,5% = 9%

Thanks