Dangerous bubbles are those in which a market experiences not only rising prices, but also the use of the underlying assets as collateral. This leads to the unsustainable long-term development of the price of these assets, parallel to unsustainable long-term credit growth. As these prices increase, so too does the value of the underlying assets, enabling them to be used as collateral for further loans. At the same time, increased credits provide increased purchasing power, allowing prices to rise even more. This can turn into a feedback loop that is hard to break. The development of housing markets in the United States and a number of other countries in the period leading up to the present crisis are examples of such bubbles. The Swedish commercial property market at the start of our crisis in the 1990s is another illustrative example. A current illustration was provided in last week’s Financial Times by the well-known economist Frederic Mishkin, who, among other research, carried out an assessment of Swedish monetary policy a couple of years ago. Mishkin emphasised the importance of making a distinction between different types of bubble. Bubbles are dangerous when the underlying assets are used as collateral and fuel an excessive credit boom. However, this is not the situation in the world today. On the contrary, the banks are shrinking their balance sheets and tightening their credit conditions. Thus the asset price increases that we are currently seeing in a number of countries hardly constitute a serious problem.
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. Financial imbalances, or systemic risk, are difficult to measure. However, there is both empirical and theoretical support for using the credit-to-GDP ratio as one indicator of risk in the financial system. In the first chart I showed today, we saw that financial crises have followed periods of strong credit growth. Chart: Key indicators Also indicators other than the credit-to-GDP ratio provide signals regarding systemic risk. We have emphasised in particular developments in house and commercial property prices and the share of banks’ wholesale funding. The chart shows the indicators along with both an estimated trend and a mean.1 The greater the positive gap above trend and historical mean, the stronger is the signal of vulnerability and imbalances. Text slide: Section 3 of the Regulation relating to a countercyclical capital buffer The countercyclical capital buffer is a part of the EU’s Capital Requirements Directive (CRD IV).