The Bank of England said it may begin forcing banks to set aside capital as soon as March to support lending in a downturn.

The BOE's Financial Policy Committee intends gradually to increase the countercyclical-capital buffer to 1 per cent as the UK economy recovers from the crisis and risks to stability re- emerge. Officials published their thinking in London, alongside banking stress tests which all seven major lenders passed. The FPC left the buffer rate at zero percent for domestic exposures on Tuesday, and set out its policy for using the flexible tool in the future.

The central bank noted that financial conditions have shifted out of the post-crisis phase and said it will “carefully review” the rate at its next quarterly meeting. The regulator “intends to vary the buffer -- both up and down -- in line with the risk at the system level that banks will incur,” the FPC said. It sees the buffer “in the region of 1 per cent of risk-weighted assets when risks are judged to be neither subdued nor elevated.”

The countercyclical-capital buffer is intended to counteract banks’ tendency to boost lending in boom times, fueling the expansion, and slash it in the bust, exacerbating the slowdown. It’s designed to smooth peaks and troughs in lending by ensuring banks have the capital needed to support the economy in stressed periods because they have built it up when credit is growing.

‘Economic cost’

An increase this month had been predicted by analysts at firms including Nomura International Plc and Morgan Stanley. "By moving early, before risks are elevated, the FPC expects to be able to vary the countercyclical capital buffer gradually, and to reduce its economic cost," the bank said. The strategy for setting the buffer will be "to match the total equity buffer requirement of the banking system to the possible losses it could incur under stress," it said.

As risks in the system become elevated, the FPC will raise the buffer rate beyond 1 per cent, with no limit on how high it can go, the committee said. Under EU law and international agreements, “foreign authorities are mandated to reciprocate increases in the rate on UK exposures only up to 2.5 per cent of risk-weighted UK exposures.”

The BOE issued its guidance on the buffer along with the stress-test results, the semi-annual Financial Stability Report and the findings of its Systemic Risk Survey.

But-to-let lending

In the stability report, the BOE said the global economic environment “remains challenging.” Risks posed by Greece have decreased since its July meeting, as concerns shift from advanced to emerging economies. In the UK, the FPC said buy-to-let lending “may have implications for financial stability,” and that it was monitoring developments “closely.” Officials said they support the Prudential Regulation Authority’s initiative, announced Tuesday, to review lenders’ underwriting standards. While the report also reviewed cyber risk, household indebtedness, market liquidity, it made no new recommendations in these areas.