Countercyclical Capital Buffer

Credit booms often end in heavy losses and a sharp pullback in lending that deepens a downturn. The buffer is meant to lean against this. National authorities set a rate, in Basel III between zero and 2.5% of risk-weighted assets, for exposures in their country, based on indicators such as the gap between credit and economic output. Banks with international lending apply a weighted average of the rates in the countries where they lend. Increases are normally announced up to a year ahead so banks can prepare. When stress arrives, the rate can be cut, and the freed capital can absorb losses or support new loans. Failing to meet it brings the same payout limits as the conservation buffer. Watching the announced rate tells a banker how worried the authority is about credit growth, and in calm periods it often sits at zero.

A regulator sees mortgage lending growing at twice the pace of the economy and house prices rising fast. It announces a buffer of 1% effective in twelve months, and banks start retaining profit to meet it. Two years later a downturn hits, the regulator cuts the rate to zero, and banks keep lending to businesses instead of shrinking their balance sheets.