18.10.2021
Identifying lessons from the current crisis on the prudential
framework for the banking system
Opening remarks at the Third Conference on Financial Stability organised by the Banco de
España and CEMFI
Pablo Hernández de Cos
Governor
Ladies and gentlemen, good afternoon.
Let me welcome you all to this Third Conference on Financial Stability, jointly organised by
the Banco de España and the Centro de Estudios Monetarios y Financieros (CEMFI). This
is the first physical conference we have been able to organize since the start of the
pandemic and we all hope that this can also mark our return to normality, where physical
interactions become the norm again and not the exception.
I would like to start by expressing my gratitude to Rafael Repullo, director of CEMFI, and to
all the members of the scientific committee, responsible for promoting the conference and
selecting the papers included in the programme. As in the previous two editions, you have
assembled a commendable set of papers that combine empirical and theoretical evidence
to explain some of the key events of these current extraordinary times. I am sure that the
task of the scientific committee in selecting the twelve papers to be presented has not been
a straightforward one, given the almost 150 submissions received.
And, of course, let me also thank our keynote speaker, Randal Quarles, for his willingness
to attend our conference, and to Markus Brunnermeier, Jon Cunliffe and Jean-Pierre
Landau, participants in our panel on Central Bank Digital Currencies and Financial Stability,
for their readiness to join us today. I would further like to extend my gratitude to both the
presenters and discussants of the different sessions we will be staging over these two days.
Preliminary lessons learned from the COVID-19 pandemic
Indeed, many of the papers that will be presented in this conference fit perfectly well with
some of the main current priorities of both regulators and supervisors at the global level.
As a way to frame the discussion, let me use these initial remarks to refer briefly to the work
of the Basel Committee on Banking Supervision (BCBS). And, in particular, on the efforts
devoted to identify lessons learned from the impact of the current crisis on the functioning
of the prudential framework for the banking system. The COVID-19 has been the first global
test of the Basel reforms implemented after the Great Financial Crisis (GFC). So the debate
has already started about whether or not these reforms have performed as intended. To
contribute to this debate, the BCBS published last July a preliminary report on this topic1,
whose conclusions have also contributed to a broader report prepared by the FSB.2
But before describing the main features of this work, let me stress upfront three important
considerations that make it difficult to extract robust or definitive conclusions at this stage.
First, the origin of the current shock is significantly different from the Global Financial Crisis
(GFC) that motivated the Basel III reforms. The Basel III standards were not designed with
a global pandemic in mind, but rather a crisis induced by the financial cycle.
Second, this shock has been accompanied by extensive and extraordinary monetary and
fiscal support measures that, to a large extent, have also limited the impact on the banking
sector.
Third, the crisis is far from over and its final impact on the banking sector and financial
stability will foreseeably materialise as support measures are unwound.
With these considerations in mind, let me focus on three topics tackled in the COVID-19
early lessons report I referred to, and which are also generating discussions and reflections
in global fora: (i) banking resilience; (ii) buffer usability; and (iii) procyclicality.
Resilience of the banking system during the pandemic
A key objective of prudential regulation in general, and of the Basel framework in particular,
is to build a resilient banking system that is able to absorb shocks and continue to support
economic activity in the event such shocks materialize.
In this regard, the global banking system entered the COVID-19 pandemic on a more
resilient footing than in the run-up to the GFC with stronger capital and liquidity levels,
bolstered by the Basel III reforms. And one year and half into the crisis, banks ́ capital and
liquidity positions remain strong.
While market measures of bank resilience suggest that some banks experienced financial
strains early in the pandemic, when market liquidity deteriorated and bank funding costs
increased sharply, no internationally active bank has so far failed or required significant
public sector funding since the onset of the pandemic. And the banking system has broadly
maintained its provision of lending and other critical services to households and business.
Disentangling the effects of the regulatory framework on overall bank resilience from the
extraordinary support measures applied during the pandemic is difficult. However, there are
already some pieces of evidence that stress the importance of the role played by the former.
First, we examined the extent to which Basel III reforms contributed to bank resilience by
looking at the relationship between regulatory measures and market-based resilience
metrics (for instance banks ́ credit default swap (CDS) spreads) and/or lending. The analyses
suggest that banks with higher capital ratios suffered smaller increases in CDS spreads in
response to the pandemic. And it also indicates that more strongly capitalised banks
showed greater increases in lending to businesses and households than other banks.
Further, there is some additional evidence pointing out that the uptake of public support
measures, such as loan guarantee programs, was higher for better-capitalised banks.3
On the role of the leverage ratio, while it has not yet been implemented by all member
jurisdictions and was not binding for most banks during the pandemic, we examined
whether banks that had a smaller amount of capital above leverage ratio requirement and,
when applicable, buffers, were less active that other banks in financial market intermediation
during the pandemic. In general, bank positions in government bond and repo markets
remained stable or rose in response to the rapid surge in client demand for liquidity at the
onset of the crisis, though there is some evidence that leverage ratio requirements may have
reduced banks' incentives to mitigate the large imbalances that emerged in some markets.
In this respect, several jurisdictions temporarily exempted central bank reserves from the
leverage ratio calculation, which eased banks' balance sheet constraints on their
intermediation capacity.
Another preliminary finding relates to the positive impact of dividend payment restrictions
introduced by several jurisdictions last year. While such measures are not part of the Basel
framework or any international standard, empirical results obtained for the case of the
Spanish banking sector show that these restrictions, which could be viewed as akin to an
increase in capital for banks, resulted in a positive impact on the supply of bank credit.
Results also suggest that this measure complemented public support measures adopted in
the form of public guarantees and has prevented the capital releases implemented by the
prudential authorities from leading to higher dividend distribution to shareholders.4
Overall, we can conclude that the global banking system has been able to complement and
support monetary and fiscal authorities' efforts to maintain economic activity during the
pandemic, helping to absorb the shock rather than amplifying it, in opposition to what
happened during the GFC.
Notwithstanding these positive conclusions on resilience of the banking sector, let me also
add that the job is far from being finished. The outstanding Basel III reforms, which were
finalised in 2017, are aimed at addressing significant fault lines in the global banking system,
the gravity of which remain as important today as it was pre-pandemic. Indeed, the primary
objective of these reforms is to restore credibility in the risk-weighted capital framework by
reducing excessive variability in banks' modelled capital requirements and developing
robust risk-sensitive standardised approaches which, besides, would also serve as the
basis of the output floor.
Given the "exogenous" nature of the Covid-19 shock, these vulnerabilities were not tested
during this pandemic. But it is clear that, if left unaddressed, they will expose material
shortcomings in the banking system in future financial crises.
We have to see the outstanding Basel III reforms as a necessary complement to the
previous. In this regard, a recent analysis by the ECB5 suggests that the GDP costs of
implementing these reforms in Europe are modest and temporary, whereas their benefits
will help to permanently strengthen the resilience of the economy to adverse shocks. It also
finds that potential deviations from the globally agreed Basel III reforms - for example, with
regard to the output floor - would significantly dilute the benefits to the real economy.
At the political level, G20 Leaders have repeatedly called for their full, timely and consistent
implementation. Now is therefore the time for action.
Usability of capital and liquidity buffers
The Basel III framework added an important new feature to regulatory standards in the form
of capital and liquidity buffers.
As you very well know, the capital buffer framework comprises the capital conservation
buffer (CCoB), the countercyclical capital buffer (CCyB) and buffers for systemically
important banks. While each of these buffers seek to mitigate specific risks, they share
similar design features and have two objectives: first, to ensure that banks absorb losses in
times of stress without breaching their minimum requirements; and second, to help maintain
the flow of credit to the real economy in a downturn by lending to creditworthy businesses
and households.
Following the outbreak of COVID-19, the Basel Committee has been closely monitoring the
use of buffers and has consistently repeated that a measured drawdown of these buffers is
both anticipated and appropriate in a period of stress like the current crisis, and that until
the crisis is over, supervisors will provide banks with sufficient time to restore these buffers,
taking account of economic, market and bank-specific conditions.
The question at stake is whether the capital buffer framework functioned as expected during
the pandemic. Again, the answer is not straightforward.
On the one hand, most banks maintained capital ratios well above their minimum
requirements and buffers during the crisis. But this has been very much influenced by the
mitigating effect derived from the extensive fiscal and monetary support provided to
borrowers, the supervisory authorities' decisions to reduce capital requirements and the
already mentioned restrictions on capital distributions.
On the other hand, some evidence suggests that banks may have been hesitant to use their
regulatory capital buffers had it been deemed necessary in practice. Regression results from
a detailed study from the euro area, for example, indicate that banks with less capital
headroom tended to lend less during the pandemic when compared to those with more
leeway. This study also finds that there was a relatively larger decline in average risk weights
at banks with less capital headrooms, perhaps in an attempt to defend capital ratios.
Importantly, the analysis indicates that the buffer threshold appears to have been the
constraint forcing banks to adjust their behaviour, as lower capital ratios alone did not drive
the results. And a bank ́s proximity to buffers also appears to have affected the cost of
lending: while all banks in the euro area sample lowered lending rates, the lower a bank ́s
capital headroom, the weaker the reduction on loans.
However, the reasons behind these results are unclear: is this due to banks' uncertainty
about their potential future losses? Is it due to the lack of a more formal "forward guidance"
by supervisors on the expected restoration of any buffers drawn down? Is it related to
banks' low profitability? To wider market stigma? Or is it the result of the overlapping
dynamics of different requirements? There is a clear need for more research to disentangle
which of these potential reasons is the correct one since the optimal policy response might
also differ.
As to the issue of "releasable" buffers, namely, buffers that can be formally "deactivated"
or turned off by authorities, the preliminary analysis suggests that the release of such buffers
had a positive effect on lending during the pandemic. This includes the release of the CCyB
by jurisdictions that had positive rates prior to the pandemic, in addition to the release of
other domestic or supervisory buffers. Again, disentangling the effect of these releases is
not easy, given the range of support measures adopted. But detailed econometric results
for the euro area suggest that banks adjust their internal targets cyclically, raising them
when macro-financial conditions deteriorate and lowering them following a reduction in
capital requirements6. During the pandemic, banks with capital below their target tended to
reduce their lending in order to reduce their risk weighted assets and increase their CET1
ratio. And the regulatory releases may have prevented a cyclical rise in capital targets, which
could have negatively affected credit supply.
These findings, together with supervisors' survey responses, also suggest that it may be
beneficial to consider whether there is sufficient releasable capital in place to address future
systemic shocks. The pandemic was an exogenous shock unrelated to the preceding credit
cycle. In the future, if authorities have not experienced a previous cyclical increase in risk
meriting the activation of the CCyB, there may not be adequate releasable buffer capital if
an exogenous shock were to occur. In addition, the release of a positive CCyB in the event
of an exogenous shock, such as the pandemic, may result in less capital being available for
the future materialization of systemic risks related to ongoing cyclical vulnerabilities.
Let me now turn to the usability of liquidity buffers. Here, the most pertinent buffer is that
required by the Liquidity Coverage Ratio (LCR), which seeks to ensure that banks can
withstand short-term liquidity stress7.
And again, the evidence to date is somewhat mixed.
During the March 2020 market turmoil, when the financial market stress was most intense,
banks in most jurisdictions experienced downward pressure on their liquidity buffers. Draws
on credit lines by customers were the most common and material source of outflows. And
deposit inflows were the most common mitigant to liquidity outflows.
However, some banks took management actions (such as borrowing from central banks)
too to preserve LCR levels well above the 100% ratio. The extent to which banks took such
actions depended on their business models, with banks that relied more on unsecured
wholesale money markets particularly impacted. The subsequent public support measures
by central banks and governments significantly reduced liquidity pressures. At the same
time, these management actions adopted by banks as a defensive strategy against liquidity
stress do not appear to have contributed materially to the wider disruption in financial
markets that prompted central banks to intervene in March 2020.
So, all in all, the conclusion taken by the Basel Committee is that, while there might be some
issues with the buffer framework in terms of its usability, at this stage it is too early to draw
firm conclusions regarding buffer usability and further empirical analysis is needed before
considering whether any adjustments to the current framework are warranted.
Cyclicality of specific Basel capital requirements
Moving to the potential (pro)cyclicality of the Basel III framework, the issue at stake is well
known: credit loss provisioning tends to increase during economic downturns, resulting in
a decline in bank capital levels. In order to maintain required capital ratios, banks may have
to reduce lending at the same time that lending is needed to stimulate economic activity.
Thus, the possibility that capital requirements could result in (pro)cyclical lending activity is
a cause for concern. Similarly, capital requirements regarding banks' market activity may
also increase during periods of market volatility, leading banks to reduce their trading
activity and potentially undermining market liquidity.
Let me highlight that for the purposes of our evaluation on this topic we have been focusing
on how and to what extent some capital requirements co-move with risk. This is quite
different from considering pro-cyclicality, which would assess if, and to what extent, capital
requirements amplify the economic cycle; we cannot therefore draw any conclusions yet on
any causal effects.
The analysis conducted to date has focused on two aspects: fist, credit risk including
movements in loan loss provisions, and second, movements in market risk.
On the first issue, we know that, in the aftermath of the GFC, accounting standard-setting
bodies introduced expected credit losses (ECL) standards to replace incurred loss (IL)
approaches. The move from backward-looking IL to forward looking ECL standards was
intended to strengthen financial stability by addressing the "too little, too late" problem of
delayed loss recognition.
The pandemic has highlighted concerns regarding the potential cyclicality of the way ECL
standards interact with capital requirements. These concerns stem in part from the manner
in which ECL approaches use forward-looking economic scenarios to assess loan losses.
Generally, it is difficult to predict turning points in normal business cycles using
macroeconomic models, let alone the path that unanticipated and unprecedented events,
such as the pandemic, could take. A sudden change in economic outlook could lead to a
sharp rise in provisions and deductions from capital, potentially leading to procyclical
lending behaviour. On the other hand, ECL approaches also offer a degree of flexibility,
allowing banks to form judgments regarding what might be "reasonable and supportable"
forecasts and providing for the use of management overlays based on expert judgment
regarding loss models outputs. This flexibility, if exercised appropriately, can help banks
fairly present credit risk expectations and mitigate potential sudden changes in provisioning.
Again, here, one should take into account that, early on in the pandemic, regulatory
authorities acted pre-emptively to moderate the potential capital impact of ECL
provisioning. Specifically, authorities communicated with banks and auditors to ensure they
took extensive public sector support measures into account when forming their views
regarding the likely economic trajectory and implications for significant increases in credit
risk. Regulatory authorities also extended the transition period for the introduction of
regulatory capital deductions of provisions.
With all these caveats in mind, the results of the analysis performed by the Basel Committee
suggest that the introduction of ECL accounting helped banks recognize loans losses earlier
on that the IL approach. They also show that the extensive governmental support measures
for borrowers significantly dampened the impact of the economic contraction on banks'
capital, in line with the guidance provided by authorities. Additionally, measures taken to
delay the recognition of credit provisions in the measurement of regulatory capital also
deferred the impact. As such, it is too early to draw clear lesson regarding cyclicality of
capital requirements arising from provisioning.
Regarding the market risk framework, the analysis indicates that the heightened financial
market volatility caused by the Covid-19 outbreak in the first quarter of 2020 led to
significant rises in market risk capital requirements for those banks using internal model
approaches (IMA). This increase in capital requirements, largely reflecting the risk sensitivity
of the current Basel 2.5 market risk framework, resulted from: (i) an increase in their value-
at-risk (VaR) measures; (ii) a larger number of observed backtesting exceptions that, in turn,
led to higher capital multipliers to be applied to these VaR measures; and (iii) updates of the
stressed financial period to be used by banks for their stressed VaR (SVaR) calculations.
And this led supervisors in several jurisdictions to take targeted measures to address such
sources of cyclicality, including temporary reductions of additional capital requirements
under IMA, for example by allowing banks to discard backtesting exceptions and/or not
requesting that they update their stressed financial period to the Covid-19 pandemic.
Looking ahead, however, it is expected that revisions to the current framework agreed to in
January 2019 (the FRTB) will mitigate the primary sources of cyclicality. While sources of
cyclicality in the future framework remain, including backtesting exceptions and constraints
on modellability, supervisors may respond if concerned regarding excessive cyclicality.
Conclusion
All in all, I would draw two main conclusions from this important preliminary evaluation.
First, the evidence suggests that the Basel reforms have achieved their broad objective of
strengthening and safeguarding the resilience of the banking system. Banks and the
banking system would have faced greater stress derived from an unprecedented global
economic downturn had the Basel III reforms not been adopted, thus reducing their ability
to provide financing to the real economy.
Second, some features of the Basel reforms, including the functioning of capital and liquidity
buffers, the degree of countercyclicality in the framework and the treatment of central bank
reserves in the leverage ratio, merit further reflection and analysis.
Research work by the academic community - such as many of the papers that will be
presented in this conference - would help contribute to the Committee's ongoing work
aimed at drawing firmer conclusions on these issues.
Let me now finish by giving the floor to our well-known keynote speaker, Randal Quarles.
Mr. Quarles is currently a member of the Board of Governors of the Federal Reserve System
and served until very recently as Vice-Chair for Supervision. Randal is also Chair of the
Financial Stability Board since December 2018.
I would like to take this opportunity to commend his leadership of the FSB over the last two
years, including his success in weathering the storm by displaying a strong ability to respond
to the unprecedented challenges posed by COVID-19, by promoting coordination of the
international regulatory response to the effects of the pandemic on the financial system, and
by also ensuring that we sustain a forward-looking approach towards the important risks
and vulnerabilities ahead. It is our privilege to have him here with us today.
Randal, many thanks once again for accepting our invitation. The floor is yours.