Let us take as our starting point the following scenario, which has similarities to the economic situation over the past few years. Interest rates abroad have fallen and there are prospects that they will remain low for an extended period. At the same time, higher capital requirements for banks have seemed likely for some time and, in response, banks have increased their lending margins. In this chart, we have used the NEMO model to analyse how these factors affect the economy, including the interest rate. Low interest rates abroad widen the interest rate differential against other countries. This points towards a stronger exchange rate, which will result in lower inflation and output further ahead. At the same time, banks keep lending margins higher than normal for a period in order to build up capital. Higher bank lending margins and lending rates dampen growth and inflation. Both higher lending margins and lower interest rates abroad imply a lower key policy rate in Norway. In this scenario, the central bank reduces the key policy rate, but by less than the decrease in interest rates abroad. As a result, the krone appreciates. This leads in the short term to lower activity and inflation, but a lower key policy rate and slightly lower bank lending rates will gradually result in higher capacity utilisation and higher inflation. Borrowers, however, only experience a limited reduction in bank lending rates because of the assumed rise in bank lending margins. Somewhat lower interest rates and higher output nonetheless result in increased credit growth.
Since Norges Bank will be providing the Ministry of Finance with concrete advice regarding a countercyclical capital buffer, I would like to devote some time to stating the reasons why such a buffer is necessary, and why, more generally, regulation of the banking sector is necessary. Then I shall touch upon the interaction with monetary policy and will also add some brief comments about some of the challenges facing monetary policy in the wake of the financial crisis. Why capital regulation? A well functioning financial market is essential for virtually all other economic activity in a market economy. Banks are a key component of the financial system. Banks channel money from savers to investors. Banks determine who should be given credit and closely monitor borrowers and their projects. This is a task that would be difficult for small savers to undertake. Resilient banks and prudent banking are important for a solid and stable economy. If banks end up with insufficient equity capital following substantial losses in bad times, they will have to tighten lending. This may serve to amplify the downturn, as is currently the case in a number of European countries. Compared with other enterprises, banks have limited equity capital. It is often more costly for banks to fund lending with equity capital than with deposits and borrowing from the market. As deposits are readily available to depositors and many deposits are covered by a deposit guarantee, depositors accept a relatively low interest rate.