What Is a Capital Buffer? Definition, Requirements, and History

What Is a Capital Buffer?

A capital buffer is mandatory capital that financial institutions are required to hold in addition to other minimum capital requirements. Regulations targeting the creation of adequate capital buffers are designed to reduce the procyclical nature of lending by promoting the creation of countercyclical buffers as set forth in the Basel III regulatory reforms created by the Basel Committee on Banking Supervision.

Note that capital buffers differ from, and may exceed the reserve requirements set by the central bank.

How a Capital Buffer Works

In December 2010, the Basel Committee on Banking Supervision released official regulatory standards for the purpose of creating a more resilient global banking system, particularly when addressing issues of liquidity. Capital buffers identified in Basel III reforms include countercyclical capital buffers, which are determined by Basel Committee member jurisdictions and vary according to a percentage of risk-weighted assets, and capital conservation buffers, which are built up outside periods of financial stress.

Banks expand their lending activities during periods of economic growth and contract lending when the economy slows. When banks without adequate capital run into trouble, they can either raise more capital or cut back on lending. If they cut back on lending, businesses may find financing more expensive to obtain or not available.

History of Capital Buffers

The 2007-2008 financial crisis exposed weaknesses in the balance sheets of many financial institutions across the globe. Bank lending practices were risky, such as with the issue of subprime mortgage loans, while bank capital was not always enough to cover losses. Some financial institutions became known as too big to fail because they were systemically important to the global economy.

Failure of these key institutions would be considered catastrophic. This was demonstrated during the bankruptcy of Lehman Brothers, resulting in a 350-point drop in the Dow Jones industrial average (DJIA) by the Monday after the announcement. To reduce the likelihood of banks running into trouble during economic downturns, regulators began requiring banks to build up capital buffers outside periods of stress.

Special Considerations

The countercyclical capital buffer (CCyB) framework states that foreign institutions should match the CCyB rate of domestic institutions when lending occurs across international borders. This allows for a process referred to as recognition or reciprocation in regard to the foreign exposures of domestic institutions.