Macroprudential policies for bank capital 

There are specific features of the Irish economy and financial system, which inform the Central Bank’s strategy around the operation of the macroprudential capital buffer framework.

Ireland is a small and highly-globalised economy, within a monetary union. This has implications for the nature and magnitude of macroeconomic ‘tail risks’ facing the banking system. The small and open nature of the Irish economy means that it is inherently more susceptible to shocks relative to larger, more diversified economies. Historically, the Irish economy has been considerably more volatile than its peers across a range of macro-financial variables. In part, though not entirely, this higher volatility stems from the small and highly-globalised nature of the Irish economy. Indeed, small countries tend to experience more adverse macro-economic outcomes than larger, more diversified economies. Given its openness, the Irish economy is also particularly sensitive to global financial or economic shocks, whether cyclical or structural in nature. Overall, small countries such as Ireland face a greater degree of macroeconomic ‘tail risk’. To safeguard resilience, capital levels need to reflect this higher level of macroeconomic ‘tail risk’.

The banking system in Ireland has two distinct groups. First, retail banks, which predominantly provide financial services to the domestic real economy and by nature of the size of the Irish economy tend to be small in an international context. Second, international banks, which, while located in Ireland, tend to have more limited interaction with the domestic real economy. In recent years, including as a result of the UK’s departure from the EU, a number of institutions in this latter group have substantially grown in size. Further, the retail banking sector in Ireland continues to experience structural changes in terms of the number and type of institutions operating in the market. This has implications for the distribution of systemic risk across the banking system.

The Central Bank’s primary objective for the CCyB is to promote resilience in the banking sector to future adverse shocks – in a manner proportionate to the risk environment - with a view to facilitating a sustainable flow of credit to the economy through the macro-financial cycle. The CCyB looks to ensure that banking sector capital requirements take account of the cyclical variations in the macro-financial risk environment. As a small, open economy, the Irish economy is more susceptible to shocks relative to larger, more diversified economies. Setting a positive buffer rate early in the cycle acknowledges this fact as well as the inherent uncertainty in measuring cyclical systemic risk, looking to ensure that an appropriate buffer is available to release as and when required. In addition, by moving early in the cycle, the Central Bank has the scope to implement policy changes in a gradual manner, where necessary and appropriate, with a view to minimising unwanted impacts on the real economy.

There were a number of inputs informing the Central Bank’s chosen approach whereby it would build the CCyB rate to 1.5 per cent when risk conditions are neither elevated not subdued, including:

• An assessment of the macroeconomic benefits and costs of different levels of bank capital for the Irish banking system, at a point in the cycle when risks are neither elevated, nor subdued.
• A macroprudential stress test of the banking system. The positive CCyB rate is not calibrated to ensure the banking sector is resilient to all possible shocks, but rather to a scenario that is appropriate based on the current risk environment. Higher CCyB rates would be implied by the stress testing framework when risk conditions are elevated.
• Lessons-learned from the operation of the macro-prudential capital framework over the past decade, including during the COVID-19 shock, which demonstrated the value of releasable capital buffers to better enable the banking system to support the economy in times of stress.
• Approaches to the setting of the CCyB taken by other jurisdictions, a number of which have adopted a strategy of setting a positive CCyB rate when risks are neither elevated, nor subdued.

The range outlined serves as a guide for considering what levels of banking system capital maximise the net benefits to the economy, when risks are neither elevated, nor subdued. This has been one of the inputs informing the Central Bank’s updated macroprudential strategy and the calibration of the 1.5 per cent CCyB rate in a standard risk environment. The width of the range is a reflection of the fundamental uncertainty in assessing levels of bank capital that maximise net benefits to the economy.

There is no mechanical approach to arriving at the 14-18 per cent range. That is ultimately a judgement, incorporating a range of considerations. The starting point are estimates that – for a typical advanced economy, and in an environment where risks are neither elevated nor subdued – the range of T1 capital levels at which the net benefits to the economy are maximised could be between 12 and 20 per cent, depending on underlying assumptions. This range is broadly in line with other studies in this area.

Additional considerations include evidence that the effects of banking crises tend to be persistent and that the costs of higher capital are to some degree offset in overall funding costs; evidence that small, open economies are subject to greater macro-financial risks; the interactions between risk weighting and macroprudential capital buffers; the enhancement of bank resolvability, which should lower the cost of banking crises; as well as the presence of the mortgage measures. Some of these factors are difficult to quantify, given the available evidence. The Central Bank has sought to outline its thinking on how it considers these.

The outcome of the capital review has been the calibration of a 1.5 per cent CCyB rate when risks are neither elevated, nor subdued. This leans towards the lower part of the 14-18 per cent Tier 1 range. Among others, this acknowledges the other elements of the prudential regime, including the offsetting factors outlined above

Regulatory capital demand’ refers to minimum Pillar 1 requirements, the system-wide average Pillar 2 requirements, the capital conservation buffer, the system-wide average O-SII buffers, the CCyB, as well as an estimate of a system-wide average P2G. Given that P2G is not disclosed on an individual institution basis, the published SSM system-wide average is used instead. As set out in the updated framework, in considering its strategy around macroprudential capital buffers, the Central Bank has sought to take into account other elements of the capital regime for banks, rather than consider macroprudential buffers in isolation.

The macroprudential stress test is an internal exercise, reflecting the focus of using the stress test as an input to inform the setting of macroprudential buffers. This particular exercise is not used to assess individual institution risks.

The banking system in Ireland has long had two broad but distinct groupings of institutions. Retail banks, which predominantly provide financial services to the domestic real economy and by nature of the size of the Irish economy tend to be small in an international context. International institutions, while located in Ireland, tend to have more limited interaction with the domestic real economy and mainly provide services into the rest of the EU.

This heterogeneous make-up of the banking sector has implications for the Central Bank’s strategy around the identification of, and setting of buffers for, systemically important institutions, as the channels through which these different types of institutions can affect systemic risk vary.

In particular, for banking sectors like Ireland, the EBA scoring methodology (which is relative to the national banking system) can lead to situations where the use of certain indicators within the framework can result in an over or under estimation of systemic importance. It is due to these limitations that the Central Bank views the role for judgement within the framework, on top of the more mechanical elements, as an important element of the assessment.

Broadly speaking there are two elements to the assessment. The first looks to identify those institutions which are systemically important, the second relates to the setting of capital buffers commensurate with the level of systemic importance.

The Central Bank’s identification assessment is carried out in line with the relevant EBA guidelines. These guidelines set out a two stage process:

1. a mandatory scoring methodology based on quantitative indicators relating to an institution’s size, importance, complexity and interconnectedness. The scoring methodology results in each institutions receiving an O-SII “score”. An institution receiving a score in excess of a threshold level should be identified as an O-SII.
2. (ii) a supervisory overlay where additional institutions can be designated as O-SIIs if deemed appropriate based on (prescribed) additional qualitative and quantitative indicators.

Buffer setting for institutions identified as systemically important is based on guided discretion. Beyond complying with the “floor methodology” developed by the ECB – where buffer floors for institutions are directly linked to the O-SII score – the Central Bank does not employ a mechanical link between an institution’s O-SII score and its O-SII buffer. In reaching a judgement on the setting of O-SII buffer rates, the Central Bank considers measures of systemic importance relating to institutions’ linkages with the domestic economy as well as broader measures that would be relevant from the perspective of European financial stability. Buffers are set within the range set out in CRD.

The Central Bank no longer intends to introduce a SyRB to mitigate the risks relating to Ireland’s small, highly-globalised economy. Rather these risks are now captured through the Central Bank’s strategy for the CCyB where a 1.5 per cent CCyB rate would be built up when risk conditions are deemed to be neither elevated nor subdued.

The SyRB remains part of the Central Bank’s macroprudential toolkit and is available should additional risks be identified as warranting mitigation via this instrument in the future.