Making the counter-cyclical buffer more effective

One novel element in the toolbox of capital requirements after the Global Financial Crisis was the countercyclical capital buffer, which was introduced to strengthen the resilience of financial institutions across the credit cycle and (possibly) smooth the cycle. The buffer was to be built up when credit growth accelerated, and thus systemic risk increased, and to be released in times of downturns. The idea was somewhat similar to that of dynamic provisioning in Spain, which has been shown to have been somewhat successful at smoothing the credit cycle before 2008, although not sufficiently to avoid the crisis (Jimenez et al., 2017).

The idea of this countercyclical capital buffer was very much informed and motivated by the endogenous credit cycles seen in the run-up to the Global Financial Crisis in the US and many European countries. In March 2020, however, when the Covid-19 shock called for capital release, many European countries (especially in the euro area) could not release this buffer as it had not been built up. The pandemic shock was notably followed by another shock, the Russian invasion of Ukraine.

This strengthened a tendency to move towards a positive neutral countercyclical capital buffer, with a positive buffer rate being set early in the financial cycle when cyclical systemic risks are not yet elevated. Such a positive neutral counter-cyclical capital buffer is also consistent with a recent theory paper that shows that in bad times (as in the pandemic), when banks are not able to come up with sufficient equity to satisfy capital requirements, there is a “quantity channel” of such capital requirements for loan supply, which acts like a financial accelerator and can be very large: up to 10% higher loan volume for a capital requirement release of one percentage point (Lang and Menno, 2023)

The adoption of such a positive neutral approach is discussed in a recent ESRB report (ECB and ESRB, 2025), which describes the different approaches taken by regulators in the European Economic Area (EEA). The analysis shows that 17 EEA jurisdictions have implemented this approach with a positive neutral target rate anywhere between 0.5 and 2 percentage points. Outside the EU, the Bank of England’s FPC has also adopted this approach. It is important to note (unlike what some bankers might tell you) that this approach is not expected to yield higher CCyB requirements at the peak of the cycle. Instead, the objective is to build up the CCyB in a timely and more gradual manner

One challenge is the potential overlap with the systemic risk buffer, which also has the objective of increasing resilience against exogenous shocks. If one considers the original motivation for the countercyclical capital buffer, the systemic risk buffer might indeed be the more appropriate one to be released during downturns and crisis situations. However, given the severity of possible shocks and following the experience of 2020, having both instruments might not be a bad idea after all.

References

ECB and ESRB (2025): Using the countercyclical capital buffer to build resilience early in the cycle. Frankfurt a.M., Germany

Jiménez Gabriel, Steven Ongena, José Luis Peydró and Jesús Saurina, 2017, Macroprudential policy, countercyclical bank capital buffers and credit supply: Evidence from the Spanish dynamic provisioning experiments, Journal of Political Economy, 125 (6), 2126-2177.

Lang, Jan Hannes and Dominik Menno (2023): The state-dependent impact of changes in bank capital requirements, ECB Working Paper 2828.