Designing Countercyclical Capital Buffers

This essay explores the new countercyclical capital buffer requirement that is a part of both the Basel III and Dodd-Frank rulemaking efforts following the financial crisis. The new buffer will require banks to hold higher levels of capital reserves during times that regulators determine capital markets have created excessive levels of debt. This essay briefly explores why financial regulation tends to be procyclical, how the new capital buffer attempts to address that tendency, and how well the attempt is likely to work. The verdict is mixed. The new countercyclical buffer may do some good. However, some features in its design may lead to it not being triggered when it should, and to weakening its effect even when it is triggered. The essay suggests some design tweaks which may help