Capital buffers were first introduced in Iceland in 2016. Capital buffers are capital requirements that can be imposed on financial undertakings in excess of the required minimum capital base. The buffers are intended to enhance financial undertakings’ resilience and reduce the risk that there will be a shortage of credit when shocks strike the economy. When such shocks do occur, expected losses on financial undertakings’ assets can increase significantly. This can give rise to the risk that, in a bid to protect their own position, the undertakings will curtail their supply of credit too severely. Capital buffers are variable and flexible capital requirements. The repercussions of violating them and the penalties imposed as a result of violations are less onerous than for violations of minimum capital requirements.
In Special Publication no. 15/2021 (Icelandic), the Central Bank endeavours to explain the current regulatory framework for capital requirements and to reconcile differing perspectives on the application of capital buffers and other capital requirements, with an eye to macroeconomic efficiency.
Capital buffers are provided for in Chapter X of the Act on Financial Undertakings, no. 161/2002. The capital buffers that have been implemented in Iceland are as follows: systemic risk buffer, capital buffer for systemically important institutions (O-SII buffer), countercyclical capital buffer (CCyB), and capital conservation buffer. Below is a discussion of the current capital buffer rates, the combined buffer requirement, and each buffer individually.
Articles 83 and 83(e) of the Act on Financial Undertakings contain general provisions on capital buffers and the combined buffer requirement.
The combined buffer requirement refers to the sum of the following capital buffers, as applicable:
Capital conservation buffer
Countercyclical capital buffer (CCyB)
Capital buffer for systemically important institutions
Systemic risk buffer
The combined capital buffer requirement shall be satisfied with common equity Tier 1 capital (CET1) according to Part Two, Title I, Chapter 2 of Regulation (EU) No 575/2013 (the Capital Requirements Regulation, CRR); cf. Article 83(a) of the Act on Financial Undertakings. The combined capital buffer requirement is calculated from the total risk exposure amount according to Article 92(3) of the CRR. Financial undertakings shall maintain the combined capital buffer at consolidated, sub-consolidated, and institutional levels, as applicable; cf. Article 83(c) of the Act on Financial Undertakings.
Of the combined buffer requirement, undertakings must satisfy buffer requirements in this order: first, the systemic risk buffer; second, the capital buffer for systemically important institutions (O-SII buffer); third, the countercyclical capital buffer (CCyB), and finally, the capital conservation buffer; cf. Article 83 of the Act on Financial Undertakings. The priority assigned to the buffers reflects how seriously the matter is viewed if a financial undertakings does not satisfy them. It can therefore be said that the systemic risk buffer is the strictest and the capital conservation buffer the least strict. If a financial undertakings does not satisfy the combined buffer requirement, restrictions may be imposed, as applicable, on disposition of profit, payment of dividends, share buybacks, and bonus payments – cf. Articles 86(m)-86(o) of the Act on Financial Undertakings – and the undertaking must also prepare and submit a capital conservation plan; cf. Article 86(s) of the Act.
In general, the provisions of Chapter X of the Act on Financial Undertakings do not apply to investment firms. On the other hand, investment firms, which are required to have a paid-in initial capital contribution equivalent to at least 730,000 euros in Icelandic krónur, must maintain capital buffers unless they satisfy both of the following conditions:
Man-years do not exceed 250.
Annual turnover according to annual accounts does not exceed the equivalent of 50 million euros in Icelandic krónur, or assets according to annual accounts do not exceed the equivalent of 43 million euros in Icelandic krónur.
Types of capital buffers
The purpose of the statutory capital conservation buffer is to preserve the financial undertaking’s capital and bolster its resilience. With the buffer, the financial undertaking has additional capital that it can use to absorb loan losses without curtailing its ongoing operations, particularly its supply of credit.
The capital conservation buffer is provided for in Articles 84 and 84(a) of the Act on Financial Undertakings, which state that the capital conservation buffer shall equal 2.5% of the undertaking’s risk base. The requirement shall be met with common equity Tier 1 (CET1) capital. Financial undertakings shall maintain the buffer at consolidated, sub-consolidated, and institutional levels, as applicable.
The purpose of the countercyclical capital buffer (CCyB) is to shore up financial undertakings’ financial strength and attempt to ensure that access to credit is not severely curtailed during distressed periods, which could exacerbate the impact of economic shocks on the financial system and the economy. The CCyB rate shall be determined with an eye to cyclical systemic risk. The assessment of cyclical systemic risk shall take account of the debt cycle, particularly the credit-to-GDP gap, which depicts the risk stemming from excess credit growth in Iceland and other relevant factors. Particular consideration shall be given to the unique characteristics of the Icelandic economy.
The imposition of the CCyB is provided for in Articles 85-85(f) of the Act on Financial Undertakings, which authorise the Central Bank to set rules on the countercyclical capital buffer, upon prior approval from the Financial Stability Committee (FSN). The FSN has approved benchmarks for the determination of the CCyB, which state that all else being equal, the positive neutral buffer rate shall be 2-2.5% of the risk base due to domestic exposures.
The CCyB shall equal the financial undertaking’s risk base multiplied by the weighted average CCyB rate in other EEA Member States where the undertaking’s exposures are located. Information on active CCyB rates in the EEA can be found on the European Systemic Risk Board (ESRB) website.
In general, the CCyB for domestic exposures shall equal 0-2.5% of the relevant financial undertaking’s risk base, although it may be higher if risk factors underlying the assessment of the CCyB rate warrant it. The buffer rate shall be expressed as a multiple of 0.25 percentage points. The requirement shall be met with common equity Tier 1 (CET1) capital. Financial undertakings shall maintain the buffer at consolidated, sub-consolidated, and institutional levels, as applicable.
A decision to increase the CCyB rate shall take effect no later than twelve months after the decision date, unless extraordinary circumstances justify an earlier effective date. On the other hand, a decision to lower the CCyB shall take effect immediately.
The CCyB rate shall be reviewed on at least a quarterly basis.
Systemically important financial undertakings are those that, due to their size and the nature of their activities, could have a significant negative impact on financial stability and the real economy if they experience difficulties. Because of this, and because systemically important financial undertakings are generally important with respect to both financial market infrastructure operations and the public’s access to payment services and their own savings, the official safety net for such undertakings is tighter than it would be otherwise, and direct and indirect guarantees of their obligations are broader. This amplifies the moral hazard involved, as these entities could take on more risk than is beneficial for the financial system as a whole. A regulatory framework is therefore needed, particularly in the form of tighter capital requirements and more active supervision, which counteract this moral hazard.
The imposition of O-SII buffer is provided for in Articles 86(c)-86(f) of the Act on Financial Undertakings, which authorise the Central Bank to set rules on capital buffer for systemically important financial undertakings, upon prior approval from the Financial Stability Committee (FSN). The requirement shall be met with common equity Tier 1 (CET1) capital. Financial undertakings shall maintain the buffer at consolidated, sub-consolidated, and institutional levels, as applicable.
The O-SII buffer shall be equivalent to 0-3% of the risk base. The buffer rate may exceed 3%, however, subject to approval from the Standing Committee of the EFTA States.
With reference to Article 85(e) of the Act on Financial Undertakings, cf. Article 13, Item (d) of the Act on the Central Bank of Iceland, no. 92/2019, the Financial Stability Committee decides whether a financial undertaking shall be considered systemically important at the national level – on a consolidated, sub-consolidated, or institutional basis, as applicable – with respect to whether it is of such a nature that its activities could affect financial stability. The assessment shall take the following into consideration, at a minimum [3]:
Size
Importance for the EEA or Icelandic economy
Cross-border activities
Interconnections between the financial undertaking or its group and the financial system.
The designation of systemically important financial undertakings and the capital buffer rate shall be reviewed at least annually.
The sum of the O-SII buffer and the systemic risk buffer may not exceed 5% of the risk base without the approval of the Standing Committee of the EFTA States.
Arion Bank hf., Íslandsbanki hf., and Landsbankinn hf. have been designated by the Financial Stability Committee as systemically important financial undertakings in Iceland since 2016.
Capital buffer for global systemically important institutions (G-SII buffer)
Capital buffer on systemically important institutions at the global level (G-SII buffer) is provided for in Articles 86-86(f) of the Act on Financial Undertakings, These provisions authorise the Central Bank to set rules on capital buffers for financial conglomerates that are considered systemically important at the global level, pursuant to Article 86(b) of the Act and Regulation (EU) No 1222/2014, cf. the Rules on the Designation of Global Systemically Important Financial Undertakings, no. 886/2022, thereby requiring such undertakings to maintain a G-SII buffer. The G-SII buffer rate shall equal 1-3.5% of the risk base. No financial undertakings in Iceland have been designated as systemically important at the global level.
The systemic risk buffer is designed to prevent or limit the impact of systemic risk, which stems from the structure of the economy and remains broadly unchanged over time, on the activities of financial undertakings.
The imposition of systemic risk buffers is provided for in Articles 86(g)-86(l) of the Act on Financial Undertakings, which authorise the Central Bank to set rules on the systemic risk buffer, upon prior approval from the Financial Stability Committee (FSN). It is permissible to restrict the obligation to hold systemic risk buffers to one or more categories of financial undertakings.
The systemic risk buffer rate equals 0-3% of the financial undertaking’s risk base, or of one or more specific classes of exposures.[4] Under extraordinary circumstances, and subject to Ministerial approval, the buffer rate may exceed 3%. It may not exceed 5%, however, without the approval of the Standing Committee of the EFTA States as well. The buffer rate shall be expressed as a multiple of 0.5 percentage points. The requirement shall be met with common equity Tier 1 (CET1) capital. Financial undertakings shall maintain the buffer at consolidated, sub-consolidated, and institutional levels, as applicable. The interactions between the systemic risk buffer and the O-SII buffer are covered above, in the discussion of the O-SII buffer.
The systemic risk buffer rate shall be reviewed at least every other year.
[1] The systemic risk buffer shall be calculated on all domestic exposures.
[2] The countercyclical capital buffer (CCyB) shall equal the financial undertaking’s risk base multiplied by the weighted average CCyB rate in other EEA Member States where the undertaking’s exposures are located.