Submission

Advice on the countercyclical capital buffer, 2014 Q1

Norges Bank's letter of 26 March 2014 to the Ministry of Finance.

Norges Bank shall draw up a decision basis and advise the Ministry of Finance on the level of banks' countercyclical capital buffer four times a year. In a letter of 4 December 2013, the Bank recommended a rate of 1 percent from 1 January 2015. The buffer rate was set at 1 percent from 30 June 2015.

The decision basis for the first advice in 2014 will be published in Monetary Policy Report with financial stability assessment 1/14. As part of its work in preparing the advice, Norges Bank has exchanged information and 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 rate will be assessed in the light of other requirements applying to banks. The buffer rate can be reduced 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. Since the financial crisis, credit growth has slowed somewhat, but the ratio of total credit to mainland GDP is nonetheless at a historically high level. This level is little changed since the previous advice was given in December. Household debt ratios are high, and debt is still rising somewhat faster than disposable income.

The European Systemic Risk Board (ESRB) issued preliminary recommendations for setting the buffer on 3 March 2014, including methodologies for calculating a buffer guide. Norges Bank was a participant in this effort. The ESRB cites a proposal by the Basel Committee for a simple rule for calculating a reference rate on the basis of the credit-to-GDP ratio. Applied to Norwegian data, the rule prescribes a reference rate of 0 percent at the end of 2013 Q4. Norges Bank attaches weight to an alternative calculation method, which has been shown to provide a better leading indicator of crises. This method yields a reference rate of ¾ percent.

House price inflation has long outstripped the pace of growth in household disposable income. Over the past year, house prices have stopped rising, and in February, they were 1.1 percent lower than at the same time in 2013. Low house price inflation may slow the growth of household debt and eventually reduce financial imbalances.

Norwegian banks' corporate loan exposure is highest in the commercial property market. The increase in prices for office space in some market segments over several years has likely made banks more vulnerable to an economic downturn. The commercial property price indicator, which is based on estimated market prices for high-standard office space in Oslo, fell slightly in the past year.

The wholesale funding ratio for banks, which rose markedly in the years prior to the financial crisis, has stabilised. The wholesale funding ratio is approximately unchanged since Norges Bank issued its latest advice.

Norges Bank's assessment of financial systemic risk is little changed since December. The indicators of financial imbalances are at historically high levels. They are also higher than most of the estimated long-term trends. This indicates that there has been a build-up of financial imbalances that may trigger or amplify an economic downturn. Recent developments suggest that imbalances are no longer building up at present. Banks' adjustments to stricter capital requirements may have been a contributing factor.

At end-2013, the Common Equity Tier 1 (CET1) capital ratios of the largest banks were 1–2 percentage points above the requirement as from 1 July of this year. Norges Bank gives weight to the fact that a large number of regulatory changes are being implemented simultaneously. Uncertainty regarding the effect of banks' response to the requirements on the Norwegian economy ahead suggests that total capital requirements should not be raised too quickly.

Norges Bank is of the view that the decision basis does not support a change in the buffer requirement at this time.

If there are signs that financial imbalances continue to build up, Norges Bank will issue advice to increase the buffer rate. It will also be relevant to recommend an increase in the buffer rate if the other requirements applying to banks in the coming years prove to be less stringent than Norges Bank has assumed.

The countercyclical capital buffer is not an instrument for fine-tuning the economy. In the interest of robustness, the buffer rate should not necessarily be reduced even if there are signs that financial imbalances are receding. In long periods of low loan losses, rising asset prices and credit growth, banks should normally hold a countercyclical capital buffer.

Any future advice to reduce the buffer rate 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.

 

Sincerely,

Øystein Olsen

Amund Holmsen

Published 4 April 2014 08:00