What is '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.

BREAKING DOWN 'Capital Buffer'

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 contracts. 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.

Capital Buffers and the Financial Crisis

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 in regards to the global economy.

Failure of these key institutions would be considered catastrophic. This was demonstrated during the bankruptcy of the Lehman Brothers firm, 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.

To give banks enough time to create adequate capital buffers, Basel Committee member jurisdictions announce planned increases 12 months in advance. If economic conditions allow a decrease in required capital buffers, those reductions take place immediately.

Countercyclical Capital Buffer Rates and International Lending

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 regards to the foreign exposures of domestic institutions.

RELATED TERMS
  1. Basel II

    A set of banking regulations put forth by the Basel Committee ...
  2. Basel III

    A comprehensive set of reform measures designed to improve the ...
  3. Capital Reserve

    A type of account on a municipality's or company's balance sheet ...
  4. Buffer Layer

    The difference between the primary limit of insurance and any ...
  5. Risk-Based Capital Requirement

    A rule that establishes minimum required liquid reserves for ...
  6. Tier 1 Leverage Ratio

    The relationship between a banking organization's core capital ...
Related Articles
  1. Investing

    Understanding The Basel III International Regulations

    The Basel III regulations mark a drastic reform in international banking. But how do they impact the future's investment landscape?
  2. Investing

    How Basel 1 Affected Banks

    This 1988 agreement sought to decrease the potential for bankruptcy among major international banks.
  3. Investing

    What is Basel III?

    The purpose of the Basel accords is to improve the worldwide bank regulatory framework.
  4. Retirement

    I Make $250K a Year: How Much Should I Invest?

    Learn how to determine the right level of monthly investments to make, how much to save for retirement and how big your emergency fund should be.
  5. Insights

    What's Economic Capital?

    While regulatory and economic capital use some of the same measurements of risk to determine how much capital a firm should hold in reserve, economic capital uses more realistic measures.
  6. Investing

    Structured Notes: Buyer Beware!

    At first glance, this product looks like the answer to investors' prayers. In reality, it's just too good to be true.
  7. Insights

    Free Up Lending, Halt Dividends: Bank of England

    The Bank of England has reduced capital requirements and halted any increase in dividend payments for U.K. banks.
  8. Financial Advisor

    Why Banks Don't Need Your Money to Make Loans

    Contrary to the story told in most economics textbooks, banks don't need your money to make loans, but they do want it to make those loans more profitable.
  9. Personal Finance

    Calculating the Tier 1 Capital Ratio

    The Tier 1 capital ratio is a measure of a depository financial institution’s financial health and capital adequacy.
RELATED FAQS
  1. What are the Basel III rules, and how does it impact my bank investments?

    Learn about Basel III rules and how they impact investors in the banking sector. They have made banks less procyclical, forcing ... Read Answer >>
  2. If my brother-in-law, who works at a pharmaceutical company, tells me about his research ...

    Discover what tier 1 capital measures about a bank. Tier 1 capital levels were mandated by Basel III following the financial ... Read Answer >>
  3. How does Basel III strengthen regulation and improve risk management of the global ...

    Learn about the banking regulations of Basel III, including provisions regarding capital, leverage ratios and liquidity requirements. Read Answer >>
  4. What is the Federal Reserve Board's market risk capital rule?

    Learn about the market risk capital rule enacted by the Federal Reserve, and understand how this rule reflects the Basel ... Read Answer >>
  5. Are a bank's current assets counted as liquidity?

    Find out how bank assets are defined and how the Federal Reserve controls the definitions of, requirements for, and availability ... Read Answer >>
Trading Center