The results also indicate that a low equity ratio in the banking sector can be an early warning of future instability. While indicators and empirical models can provide support in the assessment of financial imbalances, they can of course only go so far. Their ability to produce a precise estimate of systemic risk is limited. No two financial crises are alike, and the financial system is constantly evolving. In addition, the assessment of systemic risk must include an analysis of the consequence of a crisis. Assessments of systemic risk are therefore always based on judgement. The primary aim of the countercyclical capital buffer is to make banks more robust. The buffer may to some extent also dampen the build-up of financial imbalances. However, its impact on markets will depend on how banks increase capital ratios. Roughly speaking, banks have two options at their disposal: they can 1) increase equity capital or 2) reduce risk-weighted assets. Chart: Increased capital requirements in Norway Over the past few years, in order to meet the new requirements, the six largest Norwegian banks taken together have almost doubled their capital adequacy ratio, measured by Common Equity Tier 1 capital. This is primarily the result of a significant increase in capital. 4 Retained earnings contributed the most, and banks widened their lending spreads in 2013. Equity issues have been of minor importance. The second option I mentioned involves improving capital ratios by reducing risk-weighted assets.
This means that the central bank gives weight to fluctuations in output as well as to inflation. The expected future paths for inflation and output are included in the loss function. Let us now include a variable that captures the transmission of financial market instability to the wider economy. In this stylised model, the variable, called zt, enters the aggregate demand function. To simplify, we assume that there are only two states with respect to financial stability: either normal times with well-functioning financial markets or a situation of financial market stress (cf. the α parameter). If instability in financial markets emerges (i.e. α equals 1), the impact on the real economy will depend on the level of the financial imbalances. Within this framework, the risk of financial instability is endogenous, and monetary policy can influence this risk. A higher risk of instability can depress expected growth and inflation. When the central bank assesses the future path of inflation and output, it therefore has an incentive to dampen the build-up of financial imbalances. In this way, the central bank can contribute to a smoother expected path for inflation, output and employment over time. Let us now introduce an economic situation that is not unlike the one experienced in Norway in recent years: interest rates abroad decline and there are prospects that they will remain low for a long period. This results in a widening of the differential between interest rates at home and abroad, leading to an exchange rate appreciation.