The buffer requirement (size of the buffer) should be viewed in the light of other requirements applying to banks, particularly when new requirements are introduced. One of the most important purposes of the capital buffer is to alleviate stress in the financial system. History shows that the groundwork for banking crises is laid during upturns. When financial imbalances build up, this increases the likelihood of substantial losses in the entire banking system. In an environment characterised by large losses, insufficient equity capital may force banks to curtail lending to households and enterprises, amplifying a downturn. Banks should therefore hold larger capital buffers when financial imbalances are building up or have built up. Norges Bank’s advice regarding the buffer will primarily be based on four key indicators: Total credit as a percentage of mainland GDP, the wholesale funding ratio of Norwegian credit institutions, the ratio of house prices to disposable income and commercial property prices. Both economic theory and historical experience from a number of countries provide support for the view that these indicators capture systemic risk. The chart shows the indicators along with an estimated trend and a mean. 2 The greater the positive gap above trend, the stronger is the signal of vulnerability and imbalances. In line with the recommendations from the Basel Committee on Banking Supervision and from the European Commission, there should not be a mechanical relationship between developments in the indicators and Norges Bank’s advice on the buffer.
The key policy rate is set with a view to keeping inflation close to 2.5 percent over time without triggering excessive fluctuations in output and employment. Monetary policy also seeks to be robust and take into account the risk that financial imbalances in the economy build up. Even though the objectives differ, both of these instruments work through banks’ responses. The level of the countercyclical buffer may therefore affect the conduct of monetary policy. Increased buffer requirements may induce banks to increase their lending margins or restrict access to credit in other ways. More restrained lending growth will dampen economic activity. This will in turn contribute to lower inflation. Thus, an increase in capital requirements resulting in rising lending margins suggests, in isolation, a lower key policy rate. Other developments in the economy may amplify or dampen this effect. Allow me to refer to a recently developed version of our model for the Norwegian economy, NEMO, to illustrate this point. In this version of NEMO, the credit market is modelled explicitly. 6 Households and enterprises can borrow from banks, but only against equity. For a household, the value of their dwelling is important as collateral. A rise in house prices can thereby allow households to borrow more, increasing their debt. This mechanism is an example of what is referred to in the literature as a financial accelerator. 7 In the model, banks also face capital requirements that affect their capital costs.