Banking capital in times of stress

Erik Thedéen: Banking capital in times of stress

• Date: 06/09/2017

• Speaker: Director General Erik Thedéen
• Place: UBS conference, Stockholm

"In times of stress, capital buffers need to be available, sufficient and usable. If a buffer is breached, the consequences will be material, but should not have self-reinforcing, stigmatic effects." "The calibration of the Basel output floor and leverage ratio to some extent challenges our principles to have capital requirements which are risk-based and with sufficient buffers. Hence, we can be very clear about one thing: we will not remove capital buffer requirements mechanically if minimum requirements increase. We will, however, comprehensively assess the need for sound overall capital levels contra the need for sufficient buffers to ensure resilience in the system." These words are from Erik Thedéen's speech today at the annual UBS conference about capital requirements and how FI might react during a financial crisis.

Erik Thedéen also commented on what might happen to capital requirements given the new global and European frameworks under discussion and that may be implemented in the next few years.

Banks must hold sufficient and usable capital buffers

Erik Thedéen pointed out that one of FI's main tasks is to promote the stability of the financial system. One way of achieving this is to use regulation and supervision to ensure that financial companies hold sufficient financial buffers to maintain market confidence and be able to absorb potential unexpected losses. For capital/buffers to be effective at absorbing losses, they must:

• Consist of high quality capital.
• Be designed to be used in practice, which means they should either be able to be adjusted by FI (through the buffer requirements) or used by the banks themselves (through the design of the buffers) without causing other creditors to abandon the bank or force authorities to view the bank as failing.

Capital requirements in crises

Erik Thedéen noted that buffers are important margins from the perspective of both the bank and the supervisor. However, even if both authorities and banks wish to avoid bank failures, the authorities and the banks are facing different incentives. The supervisory authority naturally has more of a systemic approach than one can expect from a bank. "For the regulator, bank capital is about resilience and warding off crises and costs for the economy at large, while the purpose of capital for individual banks is to act as a cushion to protect its debt holders from losses", commented Thedéen.

"This is one reason why FI proposes capital requirements that are higher than what the banking industry would prefer. And since FI's goals and perspectives differ slightly from the banks, there is a need for buffers that can be used by banks and that FI has the flexibility to continuously review", said Thedéen.

Erik Thedéen emphasized that during times of stress, FI needs to view capital requirements differently under different circumstances if it is to sustain a well-functioning banking system. For example, if a severe systemic crisis occurs, it is important to be able to use the capital held in systemic risk buffers. FI may even consider removing these buffers for the entire system, thus acting proactively and creating usable capital, with the intention to maintain financial stability. In an isolated event at a single large bank, however, FI would probably leave the systemic risk buffers in place. This means the bank in question might breach the combined buffer and be subject to the restrictions. "Another example is the additional Pillar 2 capital requirement, which in general consists of two components: a potential buffer for systemic events and a capital add on that is based more on individual risks in the bank and more along the lines of a minimum requirement", noted Thedéen.

FI needs to revise the requirements as new global rules enter into force

The efforts in recent years to reform and strengthen the international standards and capital requirements have taken large steps in the right direction to achieve the goal of resilient banks and financial stability. However, negotiations are continuing regarding the new EU Risk reduction package (review of CRR/CRD) and within the Basel Committee. For FI, capital buffers are a top priority and we see disadvantages with proposals that are mainly based on minimum requirements. "An appropriate capital buffer framework is when the consequences of a breach and subsequent restrictions are well-balanced. They should not have self-reinforcing, stigmatic effects. Some international discussions revolve around how to improve the "usability of buffers", which we welcome", said Thedéen.

"So, what happens to the Swedish capital requirement if the negotiations settle on Basel output floors and the leverage ratio? It is, of course, much too early to say. EU capital requirements are regulated at the union level, so for FI it will depend on how the Basel standards are eventually transposed into European law. And this outcome is far from decided", noted Thedéen.

"The proposed Basel output floors and minimum leverage ratio might raise the minimum capital requirements, but we also want banks to hold large, "usable" buffers to protect themselves from breaching these minimum requirements. Currently, FI is mandated with the right to require the large Swedish banks to hold large capital buffers for systemic risks. If this legal framework were to change, FI would need to re-assess how to secure a sufficient safety margin in the form of capital buffers based on the new legal grounds", commented Thedéen.

"We are strong proponents of international standards and robust common frameworks for banks. And, from this perspective, we believe the Basel output floors and leverage ratio have benefits. From a Swedish perspective, however, the proposals present some challenges. On these issues, FI normally bases its policy position regarding the core principles on what we want the design of capital requirements to achieve (a risk-based, buffer element, systemic risk perspective, transparency). The calibration of the Basel output floor and leverage ratio to some extent challenges our principles to have capital requirements which are risk-based and with sufficient buffers. Hence, we can be very clear about one thing: we will not remove capital buffer requirements mechanically if minimum requirements increase. We will, however, comprehensively assess the need for sound overall capital levels contra the need for sufficient buffers to ensure resilience in the system", concluded Erik Thedéen.