4  Tier 1 capital is taken to be capital intended to ensure operational continuity. This capital enables a bank to pursue its activities and maintain its solvency. The highest-quality tier 1 capital is called common equity tier 1 (CET1). Tier 2 capital is considered to be capital intended to absorb losses in the event of liquidation. This capital allows a bank to reimburse depositors and preferential creditors in the event of its insolvency. 7  In short, when a macroprudential capital buffer is activated or increased, banks5 might consider the following options to comply with these new requirements: a) increase the net interest income arising on customer charges, generate more profits and retain a portion of them; b) maintain profits, but reduce dividend payments; c) issue new shares and raise additional funds, or d) reduce risk-weighted assets. The first three alternatives would tend to exert upward pressure on the interest rates on loans granted by banks. These higher interest rates mean that fund-seekers will resort to a lesser extent to financing in their spending decisions, whereby the volume of lending and, therefore, the risks borne by the financial system will diminish. Moreover, this increase in interest rates will reduce household consumption, and firms will also invest less, which will further reduce the demand for credit. In parallel, real and financial asset prices will adjust downwards, reducing the value of the collateral for credit transactions.
Although TALF is off to a relatively slow start – hurt, in part, by the reluctance of some investors to participate because of worries about the potential implications for them of the TARP funding that is involved in the TALF program, it has helped to restart the securitization markets in the consumer asset-backed securities area and has brought down funding costs for consumer ABS issuers. The third goal of these policy interventions has been to improve market function. By dramatically reducing rollover risk, the Federal Reserve’s willingness to serve as the lender or investor of last resort has helped improve market function in a broad number of areas. Rollover risk is the risk that a borrower may not be able to obtain new funding in order to repay an investor when the investor needs the funds for other uses. If rollover risk is high, the investor is going to be concerned about getting its funds back and, thus, may be unwilling to make the investment in the first place. The impact of the Fed’s intervention on rollover risk has been especially important in the triparty repo market and in the commercial paper market. The triparty repo market is a market in which investors such as money market mutual funds lend funds, mostly on an overnight basis, to securities dealers, with the loans collateralized by high-quality securities. During the crisis, this market became less stable.