Bank Countercyclical Capital Buffer Under the Liquidity Coverage Ratio Regulation

Abstract

We study the interrelationship between the Basel III countercyclical capital buffer (CCyB) and the liquidity coverage ratio (LCR) requirement. We show that LCR comes with a risk-liquidity trade-off nonexistent in Basel II. Banks trade-off the advantage of a safe asset in terms of its weight contribution to LCR with its opportunity cost of a lower return or a lower weight contribution to future capital positions. We show that LCR affects the CCyB required level to dampen the cyclicality in bank actual capital ratios. We find that an add-on of 5% of the output gap changes range is sufficient to mitigate U.S. bank capital ratios cyclicality. Given an output gap drop of 6% during the 2007 Global Financial Crisis (GFC), when there was no bank liquidity regulation, our finding suggests that lowering the minimum Basel capital ratio requirement from 8% to 7%, would have been sufficiently accommodative during GFC. Following the COVID-19 outbreak in 2020, thanks to Basel III reforms, banks held higher levels of equity capital post-GFC than pre-GFC. This has enabled the USA, Canada and many countries around the world to cut their CCyB requirements, supplying the banking industry with useable capital not only to support lending but also to preserve and boost capital to weather banks robustly the pandemic crisis.

Keywords: Basel III, capital ratios, countercyclical capital buffer, liquidity coverage ratio, cyclical behavior

JEL Classification: E32; E44; G21; G28