Capital Buffer

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DEFINITION of 'Capital Buffer'

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.

INVESTOPEDIA EXPLAINS 'Capital Buffer'

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 unavailable at all. 

The 2007-2008 financial crisis exposed weaknesses in the balance sheets of many financial institutions across the globe. Bank lending practices were risky, 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 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 twelve months in advance. If economic conditions allow a decrease in required capital buffers those reductions take place immediately.

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