Triggers for countercyclical capital buffers

Abstract

Banking is said to be inherently procyclical; during good times banks loosen their credit standards, fuelling the boom. During recessions banks become reluctant to grant loans, which slows down economic activity and may turn a recession into a depression. The so-called countercyclical capital buffer system will be introduced in different parts of the world, for instance in the EU as a part of CRD IV. When the credit market seems over-heated, regulators could impose additional capital requirements on banks. This additional requirement would be country specific and depend on the home country of the borrowers, not on the location of bank headquarters. The buffer would protect banks against excessive accumulation of risks and make them more resilient during recessions. This paper presents two alternative ways to derive a suitable trigger indicator from data on the loan stock and the GDP. The ability of these two indicators to predict major problems in the banking sector seems to outperform the predictive power of the original proposal by Drehmann et al. in at least the recent international financial crisis. This paper does not discuss any other aspects of the countercyclical capital buffer as a macroprudential tool. For instance, the efficiency of additional capital requirements as a policy tool and related legal and organisational issues are beyond the scope of this paper.