Norges Bank has been assigned the task of preparing a decision basis and providing advice to the Ministry of Finance regarding the level of banks' countercyclical capital buffer.¹ This decision basis will be published in Monetary Policy Report with financial stability assessment 4/13. As part of its work, Norges Bank has exchanged assessments with Finanstilsynet (Financial Supervisory Authority of Norway).

The premise for Norges Bank's assessment is that banks should build up and hold a countercyclical capital buffer when financial imbalances are building up or have built up over a period. The buffer will be assessed in the light of other requirements applying to banks. Banks would be allowed to draw on the buffer in the event of an economic downturn and large bank losses, with a view to mitigating the procyclical effects of tighter bank lending.

According to the Regulation, the decision basis shall "(...) contain an overview of the credit-to-GDP ratio and the extent to which it deviates from the long-term trend, as well as other indicators, and Norges Bank's assessment of systemic risk that is building up or has built up over time".

From the mid-1990s until 2008, total credit to households and mainland enterprises grew at a markedly faster pace than economic activity. Credit that rises faster than GDP may signal a build-up of imbalances. Since the financial crisis, credit growth has slowed somewhat and is more in line with mainland economic growth. The total credit-to-GDP ratio is nonetheless at a historically high level.

Norwegian enterprises as a whole are highly leveraged. Weaker corporate earnings could result in higher bank losses and amplify an economic downturn. Household debt is still rising faster than income and many households may find debt servicing more demanding in the event of a loss of income or higher borrowing rates.

As regards other systemic risk indicators, Norges Bank has taken note of developments in residential and commercial property prices and wholesale funding ratios for banks. Historically, these indicators have risen ahead of periods of financial instability.

After a brief decline during the financial crisis, house prices have risen sharply again in recent years, also relative to household disposable income. Interaction between household credit and house prices may lead to a build-up of imbalances. House price inflation slowed last winter and prices have fallen since summer. Lower house price inflation may over time contribute to lower household debt growth.

The commercial property market accounts for the highest share of Norwegian banks' corporate loan exposure. Price developments vary considerably across segments and regions, but price increases over several years in certain office segments have likely increased bank's vulnerability to a period of stress.

Rising wholesale funding ratios for banks may reinforce an increase in debt and asset prices. Owing to lower lending growth, the wholesale funding ratio, which had been rising for a long time, has now stabilised. This may indicate that banks are no longer increasing their risk in the same manner as in the years prior to the financial crisis.

The indicators are at historically high levels. They are also higher than estimated long-term trends. This indicates that there has been a build-up of financial imbalances that can trigger or amplify an economic downturn. Norges Bank's assessment is therefore that banks should now hold a countercyclical capital buffer. This will make them more resilient to future loan losses.

According to the regulation, Norges Bank shall take into account advice from the European Systemic Risk Board (ESRB). The ESRB is currently working to develop guidance for setting the buffer rate, and Norges Bank is participating in this work. In 2010, the Basel Committee proposed a mechanistic rule for calculating a buffer guide for the countercyclical capital buffer on the basis of the credit-to-GDP ratio. Applied to Norwegian data, the output of this rule is a buffer guide of ¼ percent at the end of the second quarter of 2013. There is considerable uncertainty attached to the estimate of the long-term trend in the credit-to-GDP ratio. An alternative calculation method, which provides a more robust leading indicator of crises, yields a buffer guide of 1¾ percent.

Norges Bank gives weight to the fact that a large number of regulatory changes are being implemented simultaneously. The level of the buffer must be considered in the light of other capital requirements. Recent developments suggest that imbalances are no longer building up at present. Banks' adjustment to tighter capital requirements, including expectations of a countercyclical capital buffer, may have been a contributing factor. Over the past year, growth in the Norwegian economy has slowed somewhat. Uncertainty regarding the effect of banks' response to the overall requirements on future developments in the Norwegian economy suggests that capital requirements should not be raised too quickly.

Norges Bank recommends that the countercyclical buffer should be set at 1 percent from 1 January 2015. If there are signs that financial imbalances continue to build up, Norges Bank may issue advice to increase the buffer. In the interest of robustness, the buffer should not be reduced automatically even if there are signs that financial imbalances are receding. Any future recommendation to reduce the buffer will be based on an assessment of market turbulence, loss prospects for the banking sector and the risk of a credit-driven downturn in the Norwegian economy.

Norges Bank recommends that the Norwegian buffer rate also apply to that portion of a bank's activities carried out in another state, except if that state's authorities have set their own buffer requirement. The home-country buffer should then apply to exposures in the state concerned.

Sincerely,

Øystein Olsen

Amund Holmsen

Footnotes

¹ Regulation on the Countercyclical Capital Buffer, laid down by Royal Decree of 4 October 2013