Why Financial Regulations Might Fail to Produce Their Desired Outcome: The Case of the Capital Conservation Buffer

The capital conservation buffer (CCB) was created after the 2008 financial crisis, instructing banks to retain their dividends in an escrow account and create a buffer as a precaution for future crises. Although the presence of the CCB is important for liquidity needs, its value during crises remains unclear due to regulators’ failure to lead.

Following the onset of the 2007–2009 global financial crisis, bank regulations and supervision were strengthened to make them more resilient. With the start of the coronavirus pandemic in 2020, financial firms faced significant uncertainty about their viability and many governments around the world provided broad financial support for their country’s economy.

Given the reform and the broad financial support during the pandemic, financial authorities in the US and the Europe were expecting financial firms to extend support for their economies. But concerns have arisen as to whether the conduct of financial firms were in line with those expectations. Specifically, bank regulators in the US and Europe were expecting banks to not only manage their operations during crises, but also to keep lending to support the economy during downturns. 

Although there is little evidence, regulators suspect that financial firms underutilized their resources and that banks did not access their capital conservation buffer (CCB) for additional lending. The CCB is constructed from funds that can be distributed to bank owners in the form of payouts, dividends, or share repurchases. Banks were expected to disburse the funds for lending. The process then requires banks to reduce (or forgo) their future dividends (and perhaps annual bonuses) until they are again able to maintain sufficient funds in the CCB under the regulatory guidelines. Thus, failure to access funds in the CCB lends support to the narrative that the leaders of financial firms considered their owners’ interest, as well as high ranking executives’ interest, over that of the public in yet another crisis situation. 

However, even if the decline in lending was due to supply side considerations (resulting from banking firms’ reluctance to lend), the concerns are not justified when considering bank operations in the broader context of the market.

The seed for the idea of the CCB originated from a dividend retention scheme introduced in March 2008 in the Research Group of the Federal Reserve Bank of New York. Presumably, in a turbulent financial market, as the United States was then, banks would have difficulty raising significant amount of funds by equity issuance, particularly all at once, in order to have the capital needed to absorb potentially large future losses. At the time, not knowing the depth of the ongoing financial crisis and the amount of funds needed, regulators focused on the idea of dividend cuts as a potential way to conserve capital. But instructing some (but not all) banks to cut dividends was not a viable option due to the adverse impact that would have on bank equity prices, which were already suffering. Also, regulators and supervisors did not know with certainty which banks were risky and could fail. Thus, to the avoid the stigma of labeling a bank “unhealthy” and potentially inducing a run on the bank, it was then prudent to treat all banks the same ( the same concept was later applied to financial firms in the Troubled Asset Relief Program, or TARP).  

Therefore, the sound economic decision was not a dividend cut, but rather to instruct all banks to retain their dividends in an escrow account and create a buffer as a precaution. Shareholders, in effect, had a claim on retained dividends. At year-end, regulators would revisit financial condition of banks and allowing them payout if they were healthy and economy was strong. Otherwise, banks would not be allowed to distribute. The dynamic of dividend retention could be repeated annually to create a larger buffer (and the scheme was outlined in a June 2008 draft). 

In October 2009, the concept of Capital Conservation, similar to dividend cut in the context of financial crisis, was introduced at the Bank for International Settlements by then-Federal Reserve Bank of New York president William Dudley. Academics also voiced concern about bank payout in the wake of the bailouts. Other academics underscored the impact of dividend payout on bank capital depletion and emphasized the role of externality in dividend payout—that is, payment of dividend by one bank could make other banks more vulnerable. The economic role of the CCB in financial stability was introduced by researchers in late 2009 and was circulated in early 2010. 

A key departure of the CCB innovation was the construction of a buffer with banks’ earnings in  stable economic environment to support the banking system in the event of another shock. The regulators’ subsequent focus turned to how much liquidity buffer was prudent for large banks to avoid another crisis without government assistance.  

By 2019, the evolution of the CCB was finalized and it became part of the financial reform package under the Basel III. What was not considered in its formal adoption was the influence of economics on bank decisions and the role of incentives for bank owners and their proxies—that is, the management teams of institutions as decision makers. Thus, as is often the case in financial reforms and regulation, the CCB design in its final form failed to benefit from incentive-compatibility.  

In the absence of a coherent framework that takes into account the role of incentives, the expectation of regulators in the US and Europe that banks would effectively utilize the CCB seems unrealistic. Given the original motivation behind the CCB, bank regulators erred in asking banks to cut dividends following the health crisis. Their decision, although made with some hesitation, could have been influenced by pressure from former regulators and activists early in 2020, advising regulators to ask banks to cut their payouts. In effect, having gone through the financial crisis and experiencing the effect of regulators’ slow and late response, citizens (and former officials familiar with the reform) did not have confidence that regulators would protect them.

In the US, regulators asking financial firms to stop payouts generated a few behavioral consequences for bankers. They became skeptical of regulators’ judgment. That is, regulators did not trust the instrument that they adopted following the financial crisis— the CCB— to work. Moreover, the view of financial firms was that accessing the CCB might carry a great stigma in the market in which they operate. Although accessing the funds in the CCB for lending might have been perceived as a positive move by regulators, without a coherent and transparent regulatory strategy, banks worried that they would be punished for being undercapitalized; for example, losing their discretion in future acquisitions or tight oversight of their activities. Further, banks were aware of the role of rating agencies and investors. With no transparent regulator, rating agencies could view CCB usage as a sign of weakness, not strength.

Nevertheless, many governments, including the US government, were able to save their economies and their banking sector. Not knowing how rules work in uncertain times and with conflicting expectations from banking firms and the public, and in the absence of incentive-compatible regulations, regulators and policymakers will most likely intervene in a future crisis. Thus, the value of the CCB in bank operation (for example, in lending) during crises remains unclear, although the presence of the CCB for liquidity needs is important for financial stability. In its absence, banks may face the risk of the fire-sale of assets.

What is the way going forward? At least in the United States, business decisions are left to banking firms and the task of oversight to regulators. It is fair to say that, in the context of the CCB, banks executed their duty. Future research could shed light on the concern that the leaders of financial firms forsaking their obligations to the public. Assuming that the concerns raised by financial regulators on lending are in effect justified, then another dynamic is needed if regulators want banks to operate differently during a crisis. One option for regulators is to provide better guidance and work with bankers as partners—a coordinated effort is more likely to offer an effective response to the economic problems. A transparent regulator with a clear expectation and effective communication channel is less likely to have to question the conduct of banks and the industry ex-post.

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