WASHINGTON — The Federal Reserve issued a proposal Monday outlining a framework to implement a countercyclical capital buffer for the largest and most internationally active banks, the Fed's first detailed explanation of how it will implement the key Basel III provision.
The intent of the buffer is to give the Fed an additional tool to cool down credit markets if they see worrisome levels of risk building up. When those risks are diminished, the Fed can release those capital requirements. Under the plan, banks with more than $250 billion of assets or more than $10 billion of on-balance-sheet foreign assets would have to hold a buffer of 0% to 2.5% of risk-weighted assets. The Fed said the initial buffer should be set at 0%.
Any future increase would be announced a year in advance "unless the board establishes an earlier effective date." The countercyclical buffer could be lowered, however, either the day after the Board votes to do so or on the earliest permissible date thereafter, whichever is later.
"The CCyB [countercyclical capital buffer] is designed to increase the resilience of large banking organizations when the Board sees an elevated risk of above-normal losses," the Fed said in its Federal Register notice. "By requiring advanced approaches institutions to hold a larger capital buffer during periods of increased systemic risk and removing the buffer requirement when the vulnerabilities have diminished, the CCyB has the potential to moderate fluctuations in the supply of credit over time."
The buffer would apply based on a bank's exposures — requirements will be equivalent to the weighted average of countercyclical amounts established by the agency for the national jurisdictions where the bank has private-sector exposures.
During a phase-in period, the maximum buffer level given to U.S.-based private-sector exposures in 2016 would be 0.625%; in 2017, 1.25%; in 2018, 1.875%, and in 2019, 2.5%. The Fed says that it expects to set levels for U.S. credit exposures jointly with the Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency, which will retain jurisdiction to set buffer levels for banks they oversee. The Fed said that the purpose of the countercyclical buffer and the guiding principal for setting it is to internalize the risks in the market equally across covered institutions, not to penalize one kind of banks versus another.
"The CCyB is designed to take into account the broad macroeconomic and financial environment in which banking organizations function and the degree to which that environment impacts the resilience of the group of advanced approaches institutions," Fed said. "Therefore, the board's determination of the appropriate level of the CCyB for U.S.-based credit exposures would be most directly linked to the condition of the overall financial environment rather than the condition of any individual banking organization. But, the overall CCyB requirement for a banking organization will vary based on the organization's particular composition of private sector credit exposures located across national jurisdictions."
The framework would base a decision of whether and when to raise or lower the buffer on various financial-system vulnerabilities or inputs, including the relative level of leverage in the financial sector, leverage in the nonfinancial sector, maturity and liquidity transformation in the financial sector, asset valuation pressures and other indicators, models and risk indicators. The Fed said that because "economic and financial risks are constantly evolving, then range of indicators and models that the board would consider could change over time."
Fed officials did not seem especially concerned that, should the agency choose to raise the buffer suddenly, the markets would overreact and create the kind of instability that the capital rules are meant to help the banks absorb.
A Fed official said that the purpose of the buffer is to initiate it far ahead of any kind of stress event, and noted that other countries have been able to utilize countercyclical buffers without substantial financial pains.
The Fed is taking comment on the proposal through Feb. 19, 2016.