1.1: What is the countercyclical capital buffer? The countercyclical capital buffer (CCyB) was introduced following the GFC (as part of the Basel III agreement in 2010) as a tool to address the systemic risks that financial cycles pose. The UK CCyB is a key macroprudential policy tool used by the FPC to deliver on its statutory responsibility of protecting and enhancing the resilience of the UK financial system. The UK CCyB rate allows the FPC to adjust the resilience of the banking system to the level of risk – at the system level – that banks will make losses on their UK exposures that could result in an undue restriction in the provision of essential services to the real economy. By aligning resilience with risk, the CCyB therefore reduces the extent to which economic shocks will be amplified by the banking system.

Although in principle this resilience could be achieved by very high baseline capital requirements, the FPC judges that this would be inefficient and inconsistent with its objective not to harm the capacity of the financial sector to contribute to the growth of the UK economy in the medium or long term. Varying capital requirements over time allows the required resilience to be achieved in a more efficient way.

1.2: Who does the countercyclical capital buffer apply to? The CCyB applies to all banks, building societies and investment firms (other than those exempted by the FCA) incorporated in the United Kingdom (henceforth referred to as ‘banks’). The CCyB is applied at both individual entity and consolidated group levels. Over time, lending activity may migrate to institutions not covered by the CCyB. If this creates risks to financial stability, the FPC can make Recommendations designed to address these risks.

1.3: Calculating the institution-specific countercyclical capital buffer rate Each bank must calculate its ‘institution-specific’ CCyB rate, defined as the weighted average of the CCyB rates in effect across the jurisdictions in which it has credit exposures.footnote[2] The institution-specific CCyB rate is then applied to the firm’s total risk weighted assets.

Table A provides a stylised example of how this operates. Bank A has only UK credit exposures so its institution-specific CCyB rate is equal to the UK CCyB rate of 2%; Bank B’s credit exposures are distributed equally between the United Kingdom and the foreign jurisdiction, so its institution-specific CCyB rate is 1.5%, the average of the UK CCyB rate of 2% and the foreign CCyB rate of 1%; Bank C has only foreign credit exposures, so its institution-specific CCyB rate is equal to the foreign rate of 1%. These institution-specific CCyB rates are applied to each firm’s total risk-weighted assets to calculate the amount of capital it has to have to meet its CCyB.

The FPC’s strategy for setting the UK CCyB rate is based on six core principles:

1. The FPC’s principal aim in setting the UK CCyB rate is to help ensure that the UK banking system is better able to absorb shocks without an unwarranted restriction in essential services, such as the supply of credit, to the UK real economy.

2. In setting the CCyB, the FPC takes into account the extent of financial vulnerabilitiesfootnote[4] and the risk that the banking system could experience losses on its UK exposures arising from those vulnerabilities that may result in an unwarranted restriction in credit supply.

The UK CCyB rate applies to UK credit exposures. Other instruments may be more appropriate and efficient to deal with potential losses on other exposures.

One example of this is risks from non-bank financial institutions. The CCyB only applies to banks so it would not be an effective tool to build resilience against vulnerabilities in the non-bank financial sector.

3. When financial vulnerabilities are building up, the FPC expects to increase the UK CCyB rate. The pace of adjustment will be determined with reference to the level and growth of financial vulnerabilities, and the economic cost of building resilience.

Typically, banks will have 12 months to meet any increase in the UK CCyB rate. Small increases that banks can meet, for example, through retained earnings should have a relatively small effect on the cost of capital to the real economy.

However, in some cases the FPC may need to build the CCyB at a faster rate to reach the necessary level of resilience. This could include a need to build capital at a faster rate than banks can meet through retaining earnings. This could be when risks from the financial cycle are elevated, costs to the economy of banks having inadequate levels of capital are high and/or the cost to banks of meeting a higher UK CCyB rate is low (for example, if they had surplus capital available).

4. Building resilience by increasing the UK CCyB rate may also restrain credit growth and reduce the future build-up of financial cycle vulnerabilities, but this is not the primary objective of any rise in the CCyB.

Other macroprudential tools, such as those aimed directly at lending standards or sectoral capital requirements, may be better placed to address excessive growth of credit or other heightened vulnerabilities.

5. In the current context of its overall capital strategy, the FPC judges that the neutral rate for the UK CCyB is around 2%.

The FPC expects to set a positive neutral rate for the UK CCyB of around 2% when indicators of underlying cyclical financial vulnerabilities are at or around their long-term historical average and an assessment of banks’ resilience to potential and actual shocks suggests they are likely to be able to absorb a shock rather than amplify it.

This is important as it takes time for banks to increase their capital buffers. If the FPC only started to build the CCyB to the level it might need at the top of the financial cycle banks might have to build capital very quickly, increasing the economic cost, and there might not be enough capital in place in time.

A positive neutral CCyB rate means that the FPC would be able to release the buffer in the event of a shock that emerged with little warning. The speed and unpredictability of adverse developments within the financial system make being prepared particularly important, as does the inherent uncertainty involved in the measurement of cyclical and other systemic risks.

In the December 2019 Financial Stability Report, when updating its capital strategy, the FPC noted that many of its indicators ahead of the GFC did not point to financial vulnerabilities being elevated until 2004 or later. Given that any decision to increase the UK CCyB rate normally takes 12 months to become effective, the FPC judged that it was unlikely the Committee would have been able to identify risks sufficiently early to build the CCyB from a rate of 1% and ensure the banking system was appropriately capitalised for its risks at the peak of the cycle. Starting from a higher neutral rate for the UK CCyB would allow the FPC time to observe evidence of building financial vulnerabilities and respond in a way that did not require banks to raise capital quickly which could cause them to cut lending and so risk creating a downturn in credit growth or the economy.

6. Should vulnerabilities abate, or crystallise, the FPC would consider reducing the UK CCyB rate. The FPC expects to reduce the UK CCyB rate – if necessary to zero - if it anticipates that the banking system may face losses that could otherwise cause it to restrict lending by more than was warranted by the macroeconomic environment, thereby amplifying potential damage to the economy.

The FPC expects to reduce the CCyB if there is a heightened risk of large losses that might make banks restrict the provision of essential financial services to defend capital positions in a way that was not warranted by the macroeconomic environment. Cutting the CCyB should help reduce the risk that the banking system prevents creditworthy businesses and households from accessing funding, which would be counterproductive, harming both the wider economy and ultimately the banks themselves. More details on how the FPC considers and assesses these issues are set out in Box B: Bank lending decisions following a deterioration in the macroeconomic outlook.

Following a cut in the CCyB, the FPC provides an indicative period in which no increase is expected, to aid usability of the CCyB. The FPC then monitors a number of factors including the expected evolution of the economic recovery, prevailing financial conditions and the outlook for banks’ capital. The pace of return to the neutral CCyB rate would depend on banks’ ability to rebuild capital while continuing to lend to creditworthy UK households and businesses.

In contrast, many business cycle downturns will not lead to losses that constrain banks’ balance sheets and warrant a CCyB cut. Similarly, shocks elsewhere within the financial system (for example, to non-bank financial institutions) are only likely to warrant a UK CCyB cut if they indirectly pose significant threats to the banking system and the provision of essential services, such as the supply of credit, that banks provide to the real economy.

These principles support the FPC in setting the CCyB in the way it judges most appropriate given its primary and secondary objectives. The FPC would of course take into account any other considerations relevant at the time of its decision.