The time has come to admit the countercyclical capital buffer can't work

WASHINGTON — Armies are always fighting their last war — that is, preparing for problems encountered in the past rather than anticipating problems that could occur in the future — and this is also true of bank regulation. In the Global Financial Crisis (as we're now calling it) quite a few things went wrong, and it took the next several years of national and international negotiation to develop a regulatory framework that would keep another GFC from happening in the same way again.

There are a lot of ins, outs and what-have-yous to the bank capital framework post-2008, but it can be described briefly like so: more capital, more liquidity, more supervision. But those things are operationalized through an alphabet soup of rules promulgated over the course of a decade by one or more bank regulators, and all of these things were developed a priori — that is, while they were designed based on the experience of what went wrong in 2008, many of these concepts had not been tested in the field. 

Some have proven highly effective. Stress testing, which banks had done internally on a small scale before the crisis, was perhaps the most consequential supervisory innovation to emerge from the GFC. The G-SIB surcharge, Liquidity Coverage Ratio and Stress Capital Buffer seem to have been meaningful contributions to the safety and soundness of the banking system as well.

But there is at least one innovation that I think regulators should consider jettisoning, and that is the Countercyclical Capital Buffer, or the CCyB. The rule essentially allows the Fed to tack on an additional capital requirement of up to 2.5% on banks with more than $250 billion of assets (or banks with more than $10 billion of on-balance-sheet foreign exposures). The Fed says that the buffer "will be activated when systemic vulnerabilities are meaningfully above normal," and while any number of metrics may be taken into account when deciding whether to raise the buffer and by how much, it is fundamentally designed to counteract credit losses.

So the rule is broad in that it gives the Fed the authority and a framework for raising capital requirements to counteract abnormally large credit vulnerabilities in the financial system — that makes sense. But the rule only applies to the biggest banks — which is where a systemic vulnerability may or may not lie, as we have recently learned. That's not necessarily a problem because the Fed's supervisory authority allows it to tell banks of any size under its jurisdiction to do whatever whenever for any reason — but you don't need a CCyB to get there.

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A bigger issue with the CCyB is that there really is no point in the business cycle when it could be raised without causing harm. Regulators have said before that the CCyB isn't meant to be a countermeasure to hot economic markets — bank resiliency and market froth are different things, after all. But in reality there isn't a way for the Fed to raise the CCyB without precipitating market fallout precisely because the CCyB is an explicit sign of heightened risk in the financial system, and markets tend not to like that.

Other countries use the CCyB — most notably in Europe — and have done so for at least a decade, so maybe there is a way for Fed officials to raise it without making them wish they hadn't. But the CCyB regimes differ pretty dramatically from jurisdiction to jurisdiction where they have been used — some countries explicitly say the buffer is meant to be imposed in good times because times are good, not because there is heightened risk, while others explicitly say the opposite.   

Former Fed Vice Chair for Supervision Randal Quarles seemed to anticipate this problem some years back when he suggested that the agency could choose to raise the minimum threshold of the Stress Capital Buffer — that is, the capital floor for all stress-tested institutions, regardless of their portfolio — instead of relying on the CCyB to be the catchall risk variable in the bank capital stack. 

If regulators are looking to raise bank capital — particularly for firms that have shown their capital to be inadequate — tinkering with the SCB seems like a better choice, since it would affect more banks on the one hand and can actually be used in practice on the other.