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Why can banks not cushion crises?

  • Writer: Macroprudential Policy
    Macroprudential Policy
  • Jul 20, 2020
  • 6 min read

Updated: Aug 15


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Banks amplify rather than cushion financial crises because their capital and provisioning regimes are procyclical.


In good times, they distribute default risk premiums as profit due to low defaults. But when crises hit, these buffers are absent, and banks cut lending to preserve capital—worsening recessions.

While reforms like IFRS 9 and the Countercyclical Capital Buffer (CCyB) aim to introduce forward-looking safeguards, they fall short in ensuring adequate buffer accumulation.


Introduction


Modern banking systems are expected to serve both as engines of economic growth and as stabilizers in downturns. Yet, historical and empirical evidence suggests that banks often amplify economic cycles instead of cushioning them. This stems primarily from the procyclical nature of their capital and provisioning regimes. While various reforms—such as the introduction of IFRS 9 and the Countercyclical Capital Buffer (CCyB)—aim to address these systemic flaws, they remain inadequate in offsetting the buildup of risk during boom times.


Capital Buffers: Definition and Purpose


Capital buffers are regulatory requirements mandating that banks maintain extra equity capital beyond minimum thresholds to absorb financial shocks and mitigate systemic risks. These buffers act as a safety net, ensuring banks remain solvent during economic downturns without resorting to taxpayer-funded bailouts (Bank for International Settlements [BIS], 2022).


Key Types of Capital Buffers


1. Capital Conservation Buffer (CCB)

  • Purpose: Preserves capital by restricting payouts (e.g., dividends) when banks face stress (European Central Bank [ECB], 2023).

  • Requirement: 2.5% of risk-weighted assets (RWA) under Basel III (BIS, 2022).


2. Countercyclical Capital Buffer (CCyB)

  • Purpose: Adjusts capital based on credit cycles (e.g., raised during booms, lowered in recessions) (Federal Reserve, 2021).

  • Range: 0–2.5% of RWA (ECB, 2023).


3. Systemic Risk Buffer (SRB)

  • Purpose: Targets long-term risks (e.g., housing bubbles) (Financial Stability Board [FSB], 2020).

  • Example: Sweden’s 3% SRB for mortgage exposures (Sveriges Riksbank, 2022).


4. Global Systemically Important Banks (G-SIB) Surcharge

  • Applies to: Mega-banks (e.g., JPMorgan, Deutsche Bank) (Basel Committee on Banking Supervision [BCBS], 2023).

  • Range: 1–3.5% of RWA (BCBS, 2023).


Example: Eurozone Banks (2024)

Buffer Type

Requirement (%)

Source

Minimum CET1 Capital

4.5

ECB (2023)

Capital Conservation

+2.5

BIS (2022)

G-SIB Surcharge

+1.5 (avg.)

BCBS (2023)


Cyclicality in Credit Markets


Lending Booms and the Risk-Taking Channel


During boom periods, macroeconomic conditions encourage lending. Rising incomes and low default rates give banks the confidence to extend credit, often to increasingly risky borrowers. According to Borio and Zhu (2012), this “risk-taking channel” of monetary policy contributes to financial vulnerability by encouraging banks to misprice risk during expansions.

Statistical Insight: From 2003 to 2007, subprime lending in the U.S. doubled, rising from 8% to 20% of new mortgage originations (Mian & Sufi, 2009). The low delinquency rates masked the underlying fragility, which later erupted in the 2008 crisis.

Procyclical Capital Depletion During Busts


In recessions, the feedback loop reverses. Income loss and unemployment trigger loan defaults. Banks, facing losses and thinner capital buffers, cut back lending—exacerbating the downturn. This procyclicality is not incidental but systemic. According to Adrian and Shin (2010), the leverage of financial intermediaries moves procyclically, rising in booms and falling in busts, thus amplifying credit cycles.

Empirical Note: During the Global Financial Crisis, bank lending in advanced economies contracted by more than 10% over a two-year span (IMF, 2012).


Profit Distribution and the Illusion of Capital Strength


Default Risk Premiums as Shareholder Dividends


Default risk premiums embedded in loan interest rates are intended to compensate for future losses. However, in the absence of defaults during boom times, these premiums are recognized as profits and often distributed to shareholders. This practice erodes the capital cushion needed to absorb future shocks.

“Bank profits in boom times comprise the cushion that should absorb losses in bust times” — yet, this cushion is depleted before the downturn materializes.


The Fault Lines in Provisioning Rules


Insurance Analogy: Why Ex-Post Provisioning Fails


Imagine an insurer that counts all unclaimed premiums as pure profit—ignoring the rare but devastating event it insures against. Banks operate similarly when they treat low nonperforming loan (NPL) ratios as justification to minimize provisioning.


According to D'Hulster et al. (2014), provisioning rates in practice vary from 20% to 100%, depending on the loan’s delinquency period, not its inherent risk. This ex-post provisioning undermines resilience.

“Recessions resemble earthquakes. They arise once in a decade.” Yet, banks are least prepared when they hit.

IFRS 9 and Expected Credit Loss (ECL)


IFRS 9 introduces an ex-ante approach by requiring banks to provision for a 12-month ECL from loan origination. While conceptually sound, the ECL often underestimates actual risk exposure.

Data Point: In many jurisdictions, ECL provisions average less than 1% of gross loans, while peak NPLs during crises exceed 10% (BIS, 2017).


Structural Shortcomings


Even IFRS 9’s ex-ante component is limited to outstanding loans. Once a loan matures without default, its default premium is released into profits, rather than being retained as a buffer. The system thus fails to accumulate cushions proportionate to systemic risk.


Capital Regimes: Another Procyclical Trap


Inadequate Capital Coverage for Systemic Risk


Capital requirements under Basel III remain backward-looking. Even though capital is reserved at loan origination, it is a fixed percentage of outstanding loans—not a reflection of accumulated risk across the entire credit cycle.

Example: A bank operating through a 10-year expansion accumulates risk without corresponding equity growth. When the downturn hits, equity evaporates rapidly due to high leverage.


The Countercyclical Capital Buffer (CCyB)


The Basel Committee’s CCyB is designed to rise in good times and be released during downturns. Yet, in practice, its discretionary nature limits effectiveness.

Policy Gap: The U.S. Federal Reserve had set the CCyB at 0% before the COVID-19 shock and maintained it there during 2020 (Federal Reserve Board, 2020).
Theoretical Limit: The maximum CCyB of 2.5% may be insufficient to absorb losses from high-risk lending accumulated over a long boom.


The Way Forward: True Countercyclical Reform


Provisioning Based on Default Risk Premiums


An optimal framework would require banks to provision default risk premiums in full at the time they are earned—regardless of whether defaults have materialized. This would mirror insurance accounting practices and stabilize profits across the cycle.


Equity Accumulation Linked to Risk Buildup


Banks should also be required to add a portion of default risk premiums to equity. This would ensure that capital grows with credit expansion, rather than merely tracking outstanding loans.

Analogy: Just as insurers maintain catastrophe reserves despite long periods without claims, banks must retain buffers built in calm periods to survive systemic shocks.


Conclusion


The existing banking framework—based on ex-post provisioning and static capital requirements—is fundamentally procyclical. While IFRS 9 and CCyB represent steps toward reform, they fall short of ensuring that banks can withstand the inevitable busts of financial cycles.

Only by anchoring provisioning and capital requirements to default risk premiums, and enforcing mandatory buffer accumulation, can banks evolve into genuine shock absorbers rather than crisis amplifiers.


References




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