The FSB recently announced that it will carry out a review, in conjunction with the standard-setting bodies, of the regulatory system’s performance during the pandemic. The review will examine, among other things, the use of capital and liquidity buffers by financial institutions, and how well crisis management and operational resilience arrangements have functioned. An interim report will be provided to the G20 in July 2021 and a final report in October.
The FSB review is very welcome, as achieving as much consensus as possible will help improve preparedness ahead of the next crisis (or indeed another wave of COVID-19).
This review is very welcome, as achieving as much consensus as possible will help improve preparedness ahead of the next crisis (or indeed another wave of COVID-19). In addition, consensus at the G20 level on the lessons to be learnt will be crucial in maintaining the maximum possible degree of regulatory coherence. However, four questions in particular will need to be addressed if the review is to be effective:
- Burden-sharing. Where should private sector self-insurance end and public sector insurance begin?
Regulators and supervisors face a crucial dilemma in deciding how far banks should be asked to rely on their own buffers. In early 2020, central banks offered lending facilities which in effect provided as much market liquidity as needed. The judgment at the time was that bank buffers might not be able to cope with the tail risks stemming from the pandemic. But in reviewing the regime governing banks’ buffers, it is important that the FSB provide greater clarity about the degree to which banks should aim to self-insure against future events, and when public authorities should be expected to provide additional backstops (and on what terms).
- Size. How big should the buffers be? What level of stress should be covered, and for how long should the protection last?
The size of buffers should be determined by the results of stress tests demonstrating the ability of each bank to survive events of a certain magnitude for a minimum amount of time. The current buffers were calibrated based on the experience of the 2008–09 global financial crisis (plus other, earlier banking crises). The ongoing COVID-19 crisis provides additional experience for calibration. However, in developing new stress tests to reflect this, account will need to be taken of the decision on the appropriate split between mobilizing banks’ own buffers and providing additional support from the public sector, should similar crises occur in the future.
At present stress-testing practices vary widely across jurisdictions, with differences in criteria including the severity of the crisis, its length (nine quarters in the US, five years in the UK), and the translation of stress scenarios into losses. While some variation in scenarios is desirable, since different banking systems face different risks, more coordination across jurisdictions is required – especially if new systemic risks, such as pandemics, are to be accounted for. Indeed, the US Federal Reserve has already incorporated pandemic risk into its CCAR programme.
- Disclosure. What should be publicly disclosed about the buffers? When? How?
Richer information about the size of banks’ buffers should be disclosed in all jurisdictions at regular intervals to the public and regulatory authorities, since this increases trust in the banking system. Disclosure to the public could be made at the same time as the publication of quarterly financial results. All banks already disclose how much capital they hold in excess of prescribed regulatory minimums, and most disclose the extent to which their compliance with the liquidity coverage ratio exceeds the regulatory proscribed minimum.
Additional questions the FSB review should address include the potential role of the authorities in disclosing information about individual banks on a standardized basis, or in requiring banks to disclose detailed information in a standardized filing. In effect, this would indicate the desired level of comparability of data for public scrutiny. The buffers do contain a component that is discretionary to the regulator, reflecting results from stress tests and risk management capabilities. Regulators should consider making public that discretionary component, accompanied by an explanatory narrative, which would be not unlike the US Federal Reserve’s practice of providing explanations when a bank has failed (or conditionally passed) the CCAR exercise.
- Use. When should the buffers be used? Who determines when they are used? Who agrees to do so? How quickly do buffers need to be rebuilt after being drawn upon?
Current regulations provide the least amount of guidance on the use of buffers and the speed of their replenishment. During the period of market volatility in March–April 2020, some regulators encouraged the use of the buffers whereas others cautioned against it. Usage of any amount of buffer in excess of the regulatory minimum should be determined by the affected bank itself.
Regulators seem frustrated that banks are reluctant to ‘use’ the buffers when they are needed, namely to facilitate the extension of credit in a downturn. But banks’ use of a buffer for additional lending sends a very different signal to that conveyed by removal of the buffer requirement by the authorities. This suggests that countries should make more liberal use of countercyclical capital buffers that can be readily removed by authorities. By contrast, if a given bank dips into one of its buffers when other banks are not doing so, this risks sending an adverse signal about that bank – hence the reluctance of participants to draw down those buffers.
The FSB’s review for the G20 will need to draw on inputs from local banking regulators, government finance ministries and the banking sector. It may make sense in the first instance to focus on the advanced economies. These typically saw the largest fiscal and monetary interventions in response to the initial COVID-19 economic shock, which means that the interaction between policy interventions and capital and liquidity buffers is particularly complex. The analysis will need to draw on data from the first half of 2020, to understand the situations of individual banks before the crisis, what actions were taken at the height of the first wave of COVID-19, and what banks’ situations were at the end of the first half of 2020. This would produce a solid fact base and enable ‘what if’ analyses to be run. Completing the report in the autumn of 2021 could enable any regulatory changes to be implemented when local capital and liquidity buffers for 2022 are set. Given the risk that the COVID-19-related economic shock will continue through subsequent phases, it is important that local regulators do not delay implementation or dilute the proposals.
