Acquired systemic cushion

What Is Acquired Systemic Cushion?

An Acquired Systemic Cushion refers to the capital reserves and other loss-absorbing capacities that financial institutions, particularly banks, are required or encouraged to build up to safeguard the broader financial system against shocks. This concept falls under the umbrella of financial regulation and [prudential supervision], aiming to enhance [financial stability]. Unlike a naturally occurring buffer, an Acquired Systemic Cushion is often a deliberate accumulation or a regulatory mandate designed to absorb unexpected losses without jeopardizing the solvency of individual institutions or triggering widespread contagion across markets. It serves as a critical protective layer, allowing institutions to weather adverse economic conditions, such as [financial crises], while continuing to provide essential financial services.

History and Origin

The concept of building substantial capital buffers to protect the financial system gained significant traction following the global financial crisis of 2007-2009. Prior to this period, while individual bank capital requirements existed, the emphasis on systemic resilience was less pronounced. The crisis highlighted how the failure of one large, interconnected institution could cascade throughout the entire system, leading to widespread instability and economic disruption. Policymakers recognized the need for a collective "cushion" to prevent such systemic events.

The development of the Basel III framework by the Bank for International Settlements: The countercyclical capital buffer and G-SIB surcharge (BCBS) was a pivotal moment. Basel III introduced higher minimum [Common Equity Tier 1 (CET1)] capital requirements, a [capital conservation buffer], and, crucially, specific surcharges for [Global Systemically Important Banks (G-SIBs)]. These measures were designed to compel the largest and most interconnected financial institutions to hold more capital, thereby creating an Acquired Systemic Cushion that directly addressed the "too big to fail" problem. Subsequent regulatory reforms in various jurisdictions, such as those implemented by the Federal Reserve Board: Annual Large Bank Capital Requirements in the United States, further solidified the implementation of such cushions. The very idea of an "acquired" cushion gained prominence as a departure from a laissez-faire approach, with regulators actively intervening to mandate and oversee its accumulation.

Key Takeaways

• An Acquired Systemic Cushion represents intentionally built-up capital reserves and loss-absorbing capacity within the financial system.
• It is a core component of [macroprudential policy] aimed at enhancing overall financial stability and mitigating [systemic risk].
• Key mechanisms include higher capital requirements, [stress capital buffers], and surcharges for systemically important institutions.
• The concept emerged strongly after the 2007-2009 global financial crisis to prevent cascading failures.
• Despite its importance, the usability and optimal calibration of such cushions remain ongoing areas of discussion among regulators and economists.

Formula and Calculation

While there isn't a single universal formula for a generic "Acquired Systemic Cushion," its components are derived from specific regulatory calculations for [capital buffers] and surcharges. For example, the capital surcharge for Global Systemically Important Banks (G-SIBs) is determined by a methodology that assesses their systemic importance based on factors like size, interconnectedness, cross-jurisdictional activity, and substitutability.

The G-SIB Surcharge (Method 1, as defined by the Basel Committee) is calculated based on a bank's systemic importance score, derived from a set of indicators. Each indicator contributes to the overall score, which then maps to a specific capital surcharge bucket.

Example of G-SIB Surcharge calculation for Method 1:

where:

• (\text{Indicator}_i \text{ Value}) represents the value of a specific systemic indicator for the bank.
• (\text{Aggregate Global Indicator}_i \text{ Value}) represents the aggregate global value of that specific indicator across all banks in the G-SIB assessment sample.
• The sum is over 12 indicators covering size, interconnectedness, complexity, cross-jurisdictional activity, and substitutability.

The calculated G-SIB score then determines the specific capital surcharge (e.g., 1.0%, 1.5%, 2.0%, etc.) that must be held as additional [CET1] capital.

Interpreting the Acquired Systemic Cushion

An Acquired Systemic Cushion is interpreted as a measure of the financial system's collective resilience. A larger, robust Acquired Systemic Cushion generally indicates a greater capacity for the financial system to absorb shocks originating from various sources, such as widespread [credit risk] defaults, significant market volatility, or large-scale operational disruptions.

For an individual institution, maintaining an adequate Acquired Systemic Cushion means it holds capital well above minimum regulatory requirements. This extra capital acts as a buffer against unforeseen losses, allowing the institution to continue lending and supporting the economy even during times of stress. Regulators interpret the collective levels of these cushions across the financial sector as a key indicator of systemic health. When these cushions are deemed insufficient, regulators may implement policies to compel banks to build them up further, for instance, by restricting [dividend payments] or share buybacks. Conversely, in times of severe stress, the usability of these buffers becomes critical, allowing banks to draw them down to support the economy.

Hypothetical Example

Consider a hypothetical global bank, "GlobalConnect Bank," that operates across numerous jurisdictions and has significant interbank exposures. Due to its size and interconnectedness, regulators classify it as a G-SIB. As part of its Acquired Systemic Cushion, GlobalConnect Bank is required to hold an additional G-SIB capital surcharge on top of its baseline [regulatory capital] requirements.

Let's assume the bank's systemic importance score places it in a bucket that mandates a 2.0% G-SIB surcharge on its risk-weighted assets (RWAs). If GlobalConnect Bank has $1 trillion in RWAs, its required G-SIB surcharge translates to $20 billion in additional [Tier 1 capital]. This $20 billion acts as a specific component of its Acquired Systemic Cushion.

During an unexpected severe economic downturn, GlobalConnect Bank experiences substantial loan losses and a decline in asset values. Instead of immediately falling below minimum capital requirements, the bank first draws down on this $20 billion G-SIB surcharge. This allows it to absorb a significant portion of its losses without needing external bailouts or drastically cutting lending, thus preserving its own stability and preventing a wider ripple effect through the financial system. The Acquired Systemic Cushion effectively serves its purpose by providing a protective layer against the adverse event.

Practical Applications

The concept of an Acquired Systemic Cushion is primarily applied within the realm of [financial stability] and [risk management] by regulatory bodies and financial institutions.

• Bank Supervision: Regulators use frameworks like Basel III to impose and monitor the Acquired Systemic Cushion levels for individual banks, especially [systemically important financial institutions]. This involves regular [stress tests] to ensure banks can withstand severe economic scenarios.
• Macroprudential Policy: Central banks and other financial authorities implement macroprudential policies aimed at building up or releasing the Acquired Systemic Cushion across the entire financial system. For instance, the countercyclical capital buffer (CCyB) is a tool that requires banks to build up capital during periods of excessive credit growth, creating an Acquired Systemic Cushion that can be released during downturns.
• Investor Due Diligence: Investors analyze a bank's capital structure and its adherence to Acquired Systemic Cushion requirements as part of their due diligence. Strong capital positions indicate a more resilient institution, potentially leading to lower [cost of capital] and better credit ratings.
• Resolution Planning: The existence of an Acquired Systemic Cushion is crucial for [resolution planning], which outlines how large, complex financial institutions can be wound down in an orderly manner without triggering a broader crisis or requiring taxpayer bailouts. Financial institutions must demonstrate they have sufficient loss-absorbing capacity, much of which constitutes this cushion. A significant critique has been the reluctance of banks to actually use their IMF: Usability of Bank Capital Buffers: The Role of Market Expectations when faced with crises, fearing negative market perception.

Limitations and Criticisms

While the concept of an Acquired Systemic Cushion is fundamental to modern financial regulation, it is not without limitations or criticisms. One primary concern is the potential for these cushions to become procyclical. If capital requirements are too rigid or increase excessively during economic downturns, banks may cut back on lending to meet capital ratios, exacerbating the economic contraction. Conversely, during boom times, the build-up of the cushion might not fully prevent excessive risk-taking, as discussed in the context of [moral hazard].

Another critique revolves around the "usability" of these buffers. Despite regulatory encouragement, banks may be reluctant to draw down their Acquired Systemic Cushion during a crisis for fear of signaling weakness to markets, which could trigger a negative response from investors and counterparties. This reluctance can undermine the very purpose of the cushion. Additionally, setting the optimal level of an Acquired Systemic Cushion is challenging; too little might be ineffective in a severe crisis, while too much could unduly restrict lending and economic growth. The debate on these optimal levels and the effectiveness of current [capital adequacy] frameworks is ongoing within policy circles, as highlighted by discussions on CEPR: Reinventing financial regulation: A blueprint for overcoming systemic risk and the implementation of international standards.

Acquired Systemic Cushion vs. Capital Adequacy Ratio (CAR)

The Acquired Systemic Cushion and the [Capital Adequacy Ratio (CAR)] are related but distinct concepts within financial supervision.

While the CAR measures a bank's general financial strength and its ability to absorb losses, the Acquired Systemic Cushion represents specific, often extra, capital requirements designed to fortify the entire financial system against widespread shocks. The components of an Acquired Systemic Cushion (like G-SIB surcharges or countercyclical buffers) are calculated and added on top of the minimum CAR requirements, effectively increasing the overall capital demanded from banks for systemic protection.

FAQs

Why is an Acquired Systemic Cushion important for the economy?

An Acquired Systemic Cushion is crucial for the economy because it enhances the resilience of the financial system. By requiring banks to hold extra capital, it helps prevent bank failures from spiraling into broader economic crises, ensuring that credit continues to flow to businesses and households even during challenging times. This promotes overall [economic stability].

How does regulation contribute to building an Acquired Systemic Cushion?

Regulation plays a direct role by setting mandatory minimum [capital requirements] and introducing additional buffers for specific risks or institutions. For instance, regulations compel [too-big-to-fail banks] to hold G-SIB surcharges, which directly contribute to the overall Acquired Systemic Cushion of the financial system.

Can an Acquired Systemic Cushion be too large?

Theoretically, yes. While a larger cushion provides more safety, an excessively large Acquired Systemic Cushion could potentially tie up too much capital, making it less available for productive lending and investment. This could increase the [cost of capital] for banks and potentially slow down economic growth by limiting the supply of credit. Regulators aim to strike a balance between safety and economic efficiency.