# LO 59.5: Describe the motivations for and calculate the capital conservation buffer

LO 59.5: Describe the motivations for and calculate the capital conservation buffer and the countercyclical buffer introduced in Basel III.
The capital conservation buffer is meant to protect banks in times of financial distress. Banks are required to build up a buffer of Tier 1 equity capital equal to 2.5% of risk- weighted assets in normal times, which will then be used to cover losses in stress periods. This means that in normal times a bank should have a minimum 7% Tier 1 equity capital ratio (i.e., 4.5% + 2.5% = 7.0%). Total Tier 1 capital must be 8.5% of risk-weighted assets and Tier 1 plus Tier 2 capital must be 10.5% of risk-weighted assets in normal periods. Banks need an extra cushion against loss during stress periods. The idea behind the buffer is that it is easier for banks to raise equity capital in normal periods than in periods of financial stress. The buffer will be phased in between January 1, 2016, and January 1, 2019.
Dividend payments are constrained when the buffer is wholly or partially used up. For example, if a banks Tier 1 equity capital ratio is 6%, the bank must retain a minimum of 60% earnings, thus dividends cannot exceed 40% of earnings. See Figure 3 for the restrictions on dividend payments as they relate to the capital conservation buffer.
Figure 3: Dividend Restrictions Resulting from the Capital Conservation Buffer
Tier 1 Equity Capital Ratio
Minimum Percentage o f Retained Earnings 7.0% 4.000% to 5.125% 5.125% to 5.750% 5.75% to 6.375% 6.375% to 7.000% > 7.0%
100% 80% 60% 40% 0%
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Topic 59 Cross Reference to GARP Assigned Reading – Hull, Chapter 16
Professors Note: While the buffer requires the ratios to be 7% (Tier 1 equity), 8.5% (Total Tier 1 capital), and 10.5% (total capital) o f risk-weighted assets, the ratios are expected to decline in times o f market stress due to losses. At that point, the ratio requirements described in LO 59.4 are in force (i. e., 4.5%, 6.0%, and 8.0%, respectively). However, once fin an cial markets stabilize, banks w ill fa ce pressure to increase the ratios again. Given the higher equity requirements under Basel III, it w ill likely be difficult fo r banks to achieve the high returns on equity (ROE) that they enjoyed in the 15 years leading up to the fin an cial crisis (i. e., 1990 2006).
While left to the discretion of individual country supervisors, Basel III also recommends that banks have a capital buffer to protect against the cyclicality of bank earnings, called the countercyclical buffer. The countercyclical buffer can range from 0% to 2.5% of risk- weighted assets. Like the capital conservation buffer, it must be met with Tier 1 equity capital. The buffer will be phased in between January 1, 2016, and January 1, 2019.
For countries that require the countercyclical buffer, dividend restrictions may apply. See Figure 4 for the restrictions on dividend payments as they relate to the countercyclical buffer (when set to the maximum 2.5% of risk-weigh ted assets), keeping in mind that the ratios are higher because the capital conservation buffer is also included. In other words, Figure 4 is a revised Figure 3, taking the additional buffer into account.
Figure 4: Dividend Restrictions Resulting from the Capital Conservation Buffer and a
2.5% Countercyclical Buffer
Tier 1 Equity Capital Ratio
M inimum Percentage o f Retained Earnings 9.5% 4.50% to 5.75% 5.75% to 7.00% 7.00% to 8.25% 8.25% to 9.50% > 9.5%
100% 80% 60% 40% 0%
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