Minimal stigma costs impede capital buffer usability

A new European Central Bank working paper reveals that even very low stigma costs prevent banks from fully utilizing regulatory capital buffers. Banks prefer to deleverage rather than breach buffer requirements when facing losses, undermining macro stabilization goals.

Stigma's subtle but strong grip

Researchers built a non-linear structural banking sector model, incorporating a minimum capital requirement and a capital buffer requirement (CBR) where breaching incurs stigma costs.

The model proves that even very low stigma costs, ranging from 0.5 to 3 basis points, are sufficient to induce banks to fulfill the CBR in "normal" times.

This leads to bank capital ratios that are 0.5-1.3 percentage points higher and bank liquidation probabilities that are 1.25-2.0 percentage points lower compared to a model without a CBR.

Aggregate loans are only marginally affected, decreasing by 1-13 basis points.

However, in "bad" times, when banks face losses and become equity constrained, these same minimal stigma costs are sufficient to prevent banks from using the CBR.

Instead, banks opt to deleverage significantly to avoid falling below the CBR, rather than absorbing losses with their buffers.

This behavior stems from foregone "excess profits" being extremely low under common assumptions, making deleveraging preferable to incurring stigma.

The buffer's dual nature

The Basel III framework introduced the CBR to enhance banking system resilience and reduce cyclicality by supporting aggregate loan supply during crises.

Unlike minimum capital requirements, banks are permitted to operate below the CBR, but doing so triggers increased supervisory scrutiny, mandates a capital conservation plan, and imposes payout restrictions on dividends and AT1 coupon payments.

The paper models these consequences as "stigma costs.

" While the macroprudential motivation for CBRs is clear, empirical evidence on their usability has been inconclusive.

Some studies suggest banks would rather reduce loan supply than breach the CBR when faced with adverse shocks, while others question the significance of such impediments.

The authors calibrate their model using euro area data to study the conditions under which these usability constraints emerge, focusing on structural non-releasable buffers, which currently form the majority of capital buffers in many European countries.

Rethinking crisis resilience

The study critically highlights a fundamental flaw in current capital buffer design.

By demonstrating that even minimal stigma prevents buffer usage, it questions the efficacy of non-releasable buffers in times of stress.

Policymakers should consider a greater share of truly releasable capital to ensure effective crisis response.