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.

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.

  1. Basel Accord

    A set of agreements set by the Basel Committee on Bank Supervision ...
  2. Basel I

    A set of international banking regulations put forth by the Basel ...
  3. Bank Capital

    The difference between the value of a bank's assets and its liabilities. ...
  4. Tier 1 Capital

    Tier 1 capital is a term used to describe the capital adequacy ...
  5. Capital Reserve

    A type of account on a municipality's or company's balance sheet ...
  6. Capital Requirement

    The standardized requirements in place for banks and other depository ...
Related Articles
  1. Insights

    The New Global Banking Regulations To Avert Future Crisis

    These are the types of policies that are being developed to minimize the risks posed to the global financial system by banks which are too big to fail.
  2. 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.
  3. Investing

    Using Economic Capital To Determine Risk

    Discover how banks and financial institutions use economic capital to enhance risk management.
  4. 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.
  5. Insights

    Bank of England Keeps Interest Rates Unchanged

    The decision is sure to disappoint markets which rallied before the announcement.
  6. Investing

    Regulators Accept Morgan Stanley's Capital Plan

    The Fed gives a thumbs up to Morgan Stanley's plans for its profits.
  7. Investing

    Financial markets: Capital vs. Money Markets

    There are several key differences between capital markets and money markets as components of financial markets. Check out the similarities and differences between the two markets.
  8. Personal Finance

    Peer-To-Peer Lending - Determining The Future Of Banking Across The World

    The peer-to-peer lending industry continues to flourish. What does this mean for the future of loans from banks?
  1. What is the minimum capital adequacy ratio that must be attained under Basel III?

    Find out more about the capital adequacy ratio, or CAR, and the minimum capital adequacy ratio that banks must attain under ... Read Answer >>
  2. How are international investment banking practices regulated?

    See which international organizations are responsible for overseeing and regulating global investment banks, including the ... Read Answer >>
  3. 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 >>
  4. What percent of capital should banks hold relative to its risk weighted assets?

    Learn what percentage of capital banks must hold under the capital adequacy ratio as set forth in Basel III, and understand ... Read Answer >>
  5. What average annual growth rate is typical for the banking sector?

    Learn the typical average annual growth rate for the banking sector and why regulatory requirements have a profound effect ... Read Answer >>
  6. What is the minimum liquidity coverage ratio that a bank must have from 2016 to 2 ...

    Learn the purpose of the new liquidity coverage ratio requirements under the Basel III standards, and see the phase-in of ... Read Answer >>
Trading Center