Procyclicality seems to be the new buzz word as it exacerbates the severity of recent global financial crisis. In this regard, many prudential requirements have been recognized as causes that lead to excess cyclicality in the financial system, such as the calculation of minimum capital requirement, fair value measurement, and provisioning method.
To reduce procyclicality, the Basel Committee on Banking Supervision (BCBS) has proposed in the Consultative Document issued in December 2009 and July 2010 that banks should build-up capital buffer outside periods of stress in order to moderate the cyclicality in the financial system and to be used whenever necessary. Two types of capital buffer are introduced, i.e. capital conservation buffer and countercyclical buffer.
Conservation buffer should be available to offset losses and large enough to enable banks to maintain capital levels above the minimum requirement throughout a significant sector-wide downturn. Normally, banks can build-up capital buffer by retaining their profits and retained earnings, which means reducing discretionary distributions of earning. These activities include reducing dividend payments, share-buy-backs, and staff bonus payments. Banks may also choose to raise new capital from the private sector, as an alternative to conserve internally generated capital.
As for the countercyclical buffer, the aim is to achieve the broader macro prudential goal of protecting banking sector from the period of excessive credit growth, which has often been associated with the build-up of system-wide risk. This objective is different from that of conservation buffer which focuses on individual bank’s financial condition.
As a measure of risk at a broader level, credit-to-GDP ratio is proposed to be the best indicator. The credit-to-GDP ratio will be calculated each year. And when the gap between such ratio and its long term trend reaches a pre-specified point, the countercyclical buffer will be imposed in addition to the conservation buffer. This means that banks have to maintain their capitals at the level not less than the aggregate of minimum capital requirement plus the conservation buffer and countercyclical buffer.
According to the press release issued in September 2010, the BCBS has proposed that all banks have to maintain conservation buffer at 2.5% above the minimum capital requirement and such capital buffer must mainly comprise of common stocks and retained earnings. In addition, the level of countercyclical buffer has been set at 0-2.5% depending on national discretion. Banks who fail to maintain appropriate capital amount of both conservation and countercyclical buffers will face restrictions on distributions of their earnings.
These new requirements on capital charge are being discussed at an international level, including the G20 Summit in Seoul next month, with the proposed effective date on January 2019. The final regulations are expected to be announced by the end of 2010 or early 2011. For Thailand, international standards from BCBS are normally applied. However, the implementation guideline will be considered after the final rules are formally released, and some adjustments to better reflect Thai banking system and financial environment may be required.
The opinions expressed in this article are the author’s own and do not necessarily reflect the official opinion of the Bank of Thailand.