This is because mounting losses mean write-downs on banks’ capital, and shrinking capital ratios. How banks respond depends on their capital buffers (chart 8). If banks use their buffers, this stabilises lending. If they try to maintain their capital ratios, loans would decline more sharply.
Although no form of testing can ever fully simulate a real crisis and the tensions that go with it, we think that periodic crisis simulation exercises involving home and host supervisors, central banks and finance ministries will become an important mechanism in testing coordination arrangements.