European Central Bank working paper finds banks’ regulatory risk tolerance doubled post-crisis as management buffer targets fell

The European Central Bank published a working paper that analyses how large US and euro-area banks manage the headroom above regulatory capital requirements and introduces a new metric, “regulatory risk tolerance” (RRT), to capture the trade-off between the risk of breaching requirements and the cost of holding and restoring “management” buffers. Using 68 quarters of data, including non-public supervisory sources for euro-area banks, the authors find that management buffer targets declined and banks’ RRT increased after the Great Financial Crisis under the Basel III regime. The study covers 17 US and 17 euro-area banking groups over 34 quarters pre-crisis and 34 quarters post-crisis, estimating steady-state buffer targets, speeds of reversion and shock volatility to derive RRT. On average, RRT roughly doubled between regimes, driven mainly by a 2 percentage point decline in buffer targets that cushioned the impact of higher regulatory requirements on capital ratios. The rise in RRT was stronger at banks facing larger post-crisis increases in capital requirements, while banks with more volatile buffer shocks tended to set higher buffer targets and reversion speeds, consistent with an active capital management choice. The paper also links RRT to how banks adjust their balance sheets when buffers are depleted. High-RRT banks tend to restore buffers by cutting lending, with a one standard deviation negative management buffer shock associated with a 0.75% reduction in net lending over a two-quarter horizon, whereas low-RRT banks reduce asset riskiness without materially shrinking asset volumes. The paper includes a disclaimer that it does not represent the views of the ECB.