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Explain why the capital conservation buffer and countercyclical buffer were created, calculate both, and note how G-SIBs (globally systemically important banks) are treated differently.

FRM® Part II · Operational Risk and Resilience · Solvency, Liquidity, and Other Regulation After the Global Financial Crisis · FRM2.ORR.22.e

The idea

After the crisis banks kept paying dividends and bonuses while losses eroded capital, and the rules made lending more cyclical. Basel III therefore added two buffers, both held in CET1 on top of the 4.5% baseline minimum. The capital conservation buffer is a fixed 2.5% of RWA. As a bank dips into it, limits on dividends, buybacks and bonuses tighten, so capital is built in good times and can be used in bad times. The countercyclical buffer is 0 to 2.5% of RWA, set by national authorities when credit growth is excessive and released in downturns. A bank's own figure is the average of the jurisdictional rates, weighted by its private-sector credit exposures in each. G-SIBs, the globally systemically important banks, must also hold a surcharge of 1% to 3.5% of RWA in CET1 according to their bucket. Adding the pieces together gives the full CET1 requirement for a bank. Total = 4.5% + 2.5% + countercyclical rate + G-SIB surcharge. National rules, phase-in and institution-specific add-ons can make the requirement actually applied differ.

Formulas

Bank-specific countercyclical buffer

CCyB = Σ w × CCyBj

w
the share of the bank's private-sector credit exposures in jurisdiction j
CCyBj
the buffer rate set in jurisdiction j

Weights come from private-sector credit exposures; the result is added to the CET1 requirement.

Basel III CET1 requirement

CET1 req = 4.5% + 2.5% + CCyB + S

CCyB
the bank's weighted countercyclical buffer rate
S
the G-SIB surcharge, zero for other banks

Multiply by RWA for the amount. Leaving out the conservation buffer or the surcharge understates the requirement.

A practice question

From the question bank, with the reason each wrong option is wrong.

What is the main purpose of the Basel III capital conservation buffer?

  1. To build capital in good times for use in stress, limiting distributions as the buffer is used - correct
  2. To raise the permanent minimum CET1 ratio so that banks can never fall below the 7% levelWhy not: The buffer is meant to be drawn down in stress, with distribution limits, not to act as a hard minimum.
  3. To force banks to hold more liquid assets against their expected 30-day net cash outflowsWhy not: That is the liquidity coverage ratio, a separate Basel III measure.
  4. To lower capital requirements automatically when credit growth in the economy is strongWhy not: That reverses the idea: buffers rise, not fall, when credit growth is excessive.

After the crisis banks paid out earnings while capital eroded. The conservation buffer holds back dividends, buybacks and bonuses as a bank's CET1 falls into the buffer range, so capital is available in stress.

A harder one

A bank has private-sector credit exposures of USD 60 billion in country X where the countercyclical buffer is 2.0%, USD 30 billion in country Y where it is 1.0%, and USD 10 billion in country Z where it is 0%. The bank's countercyclical buffer requirement is closest to:

  1. 1.0%Why not: Takes a simple average of the three rates instead of weighting by exposures.
  2. 2.0%Why not: Applies the highest jurisdictional rate to the whole book instead of an exposure-weighted average.
  3. 1.5% - correct
  4. 0.5%Why not: Reverses the weights, assigning the largest weight to the lowest rate.

Weights are 60%, 30%, 10%. Buffer = 0.6 x 2.0 + 0.3 x 1.0 + 0.1 x 0 = 1.5%.

The hardest tier

A G-SIB in the bucket with a 2.0% surcharge has risk-weighted assets of USD 1200 billion and CET1 of USD 108 billion (9.0% of RWA). Its weighted countercyclical buffer is 1.0%. Against the full Basel III CET1 requirement, the bank has:

  1. A shortfall of USD 12 billion - correct
  2. A surplus of USD 12 billionWhy not: Leaves out the G-SIB surcharge, so the requirement looks like 8.0%.
  3. A shortfall of USD 30 billionWhy not: Uses the top-bucket 3.5% surcharge instead of the bank's 2.0% bucket.
  4. A shortfall of USD 54 billionWhy not: Builds the requirement on the 8% total capital minimum, though the buffers and surcharge must be met in CET1 on top of 4.5%.

Required CET1 = 4.5% + 2.5% + 1.0% + 2.0% = 10.0% x 1200 = 120. Held 108. Shortfall = 12.

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