Jan 25 - The multiple core indicators that the UK financial policy committee will use to support its decisions for adjusting the Basel III countercyclical capital buffer (CCB) highlight the complexity in implementing the tool, Fitch Ratings says. Using several measures can improve the accuracy of the CCB tool, but the increased complexity is likely to reduce transparency, which could lead to greater divergence in its application.
A flexible capital requirement that increases in favourable, and decreases in unfavourable economic conditions, is sensible. Together with G-SIFI buffers, market and peer pressure, the CCB surcharges will encourage banks to build and maintain safer capital buffers. To foster a consistent approach, Basel and the draft Capital Requirements Directive IV, sets the credit-to-GDP gap as a reference guide for adjusting the CCB. This is the difference between the ratio of household and corporate indebtedness to GDP and its long-term trend. It is a measure we already use in our macro-prudential indicator (MPI).
If the CCB decisions were based on this factor alone, the buffer would have been activated three times over the last 50 years in the UK. It would have reached 2% in the 1970s secondary banking crisis and 2.5% in the 1990s small bank crisis. For the most recent crisis, the CCB would have been activated as early as June 2001, reaching 2.5% in September 2004. From mid-2008, it would have fluctuated between 1% and 2.5%, before being deactivated in June 2010.
But using a single metric is a blunt tool. Any lead and lag characteristics displayed must be considered in the CCB adjustment decision. It would have been unlikely for a regulator to activate a buffer in 2001, at a time when the global economy was recovering from the dotcom crash. Equally, it is difficult to determine when a crisis is over and a regulator is unlikely to remove a buffer as quickly as indicated by the ratio.
In practice, the ability of banks to increase capital immediately in the lead up to a credit bubble may be constrained. Although a one-year period to meet an increase in the CCB is proposed in the draft CRD IV, it allows for quicker implementation in exceptional circumstances. A decision to decrease the buffer can take effect immediately. But market forces may limit the ability of some institutions to deactivate this following a crisis.
Additional measures like those the UK will implement may improve the predictive accuracy of the CCB tool. This is important especially for economies where the relationship between the credit-to-GDP gap and banking crises may not hold. Where the variable is out of sync in smaller or faster-growing economies, crucial signs of economic overheating could be missed.
Last week, the financial policy committee published 16 other core indicators, including interest rates, leverage ratios, CDS premia and lending spreads, which it will use with stress tests to supplement the credit-to-GDP gap in its CCB decisions.