Norges Bank’s framework for advice on the countercyclical capital buffer
The framework consists of the principles and the information basis for Norges Bank’s advice on the countercyclical capital buffer.
Principles for Norges Bank’s advice
Norges Bank provides advice on the countercyclical capital buffer in accordance with the following principles:
Banks should build and hold a countercyclical buffer when financial imbalances are building up or have built up. Higher levels of financial imbalances increase the risk of an abrupt decline in demand from households and enterprises and large bank losses. Higher capital buffers strengthen banks’ solvency and can mitigate the risk that banks amplify an economic downturn by tightening lending. Moreover a countercyclical capital buffer may curb high credit growth and mitigate the risk that financial imbalances build up further. During upturns, this may be a positive side-effect of the buffer.
The buffer should be activated early with signs of increasing financial imbalances. A build-up of financial imbalances usually becomes evident with a lag, and the regulation stipulates that buffer rate increases first enter into force after 12 months. In addition, the buffer can be built up in smaller increments over time when it is activated early. Banks should build capital buffers in good times.
The objective of the buffer is to increase banks’ resilience in downturns and should not be changed frequently in an attempt to manage credit growth or asset prices. The countercyclical buffer is not suitable as an instrument for fine-tuning the economy. In periods of persistently low loan losses and rising asset prices and credit growth, banks should normally hold a countercyclical buffer. The buffer rate should not be reduced automatically even if there are signs that financial imbalances are receding. The risk of a sharp downturn may remain elevated even if indicators for financial imbalances begin to recede. If financial imbalances recede significantly over time and the outlook for financial stability is good, a downward adjustment of the buffer rate may be considered. At the same time, banks should have sufficient capital buffers to withstand a severe downturn.
In the event of a severe downturn and clearly reduced access to credit, the buffer should be lowered to increase banks’ lending capacity. Reducing the buffer can counteract banks’ tightening of lending practices and therefore improve households’ and enterprises’ access to credit. This may dampen an economic downturn, for example, when there are prospects for substantial bank losses. The buffer can be reduced when other capital buffers in the banking system are assessed to be sufficient to weather the downturn. With a reduction in the buffer rate, the decision basis shall contain an estimate of when Norges Bank will provide advice to increase the buffer again to give banks as much predictability as possible.
The countercyclical capital buffer rate shall as a rule be between 0% and 2.5%, but can be set higher than 2.5% in exceptional circumstances. Exceptional circumstances are not described in detail in the regulation. A starting point for assessing the need for a countercyclical capital buffer above 2.5% is that the risk is assessed to be particularly high, for example, when many measures of financial imbalances are at high levels at the same time, and when stress tests and other analyses indicate that banks need higher capital buffers.
The buffer rate must be viewed in light of banks’ adjustment to the overall capital requirements. The usefulness of having a large buffer that can be used during a downturn must be weighed against any potential economic costs. Other capital requirements for banks and banks’ capacity to meet increased buffer requirements must be considered when setting the countercyclical capital buffer.
Information basis for Norges Bank’s advice
Advice on the level of the countercyclical capital buffer is based on a number of assessments – in line with the principles for the buffer. Chart 1 below provides an overview of these assessments.
Chart 1: Assessments in the advice on the countercyclical capital buffer
Financial imbalances are analysed to assess cyclical systemic risk that may trigger or amplify a pronounced downturn. The assessment of financial imbalances comprises three main elements: (a) pricing of risk and lending conditions; (b) real estate market vulnerabilities; and (c) vulnerabilities in the household and corporate sectors.
Access to credit is analysed to assess whether there is or could be a need to reduce the buffer rate because creditworthy enterprises and households cannot access credit. In this assessment, Norges Bank will use information on three main areas: (a) financial market stress; (b) developments in credit and credit practices; and (c) banks’ profitability.
Banks’ capacity to absorb losses is analysed to assess whether the level of the buffer is sufficient given the assessments of imbalances. An assessment of banks’ capacity to absorb losses will be based on banks’ capital adequacy, earnings and loss prospects in a cyclical downturn, for example through the use of stress tests.
Effects of a change in the buffer requirement on banks and the economy must also be assessed before providing advice to change the buffer rate. When the buffer is being raised, banks’ needs are assessed for raising capital, adjusting their dividend policy or increasing earnings by raising the pricing of loans. With a reduction in the buffer, it assessed whether the reduction can be expected to have the intended effect and increase banks’ willingness to lend to households and enterprises.
Assessments of the four areas are based on a broad range of indicators, models and market information. The set of indicators that constitute a starting point for Norges Bank’s assessments of financial imbalances and access to credit are described in greater detail in the Appendix of the Norges Bank Paper on “A framework for advice on the countercyclical capital buffer”. Indicator set will be published every quarter together with the decision basis, which can be found in Norges Bank’s Monetary Policy Report with financial stability assessment.
There will not be a mechanical relationship between developments in the indicators and Norges Bank’s advice on the buffer. In addition to indicators and quantitative analyses, advice on the countercyclical buffer is based on judgement. The set of indicators will be updated as access to data is expanded and new methods and indicators are developed.