International regulation of financial institutions changed considerably in the aftermath of the 2008 financial crash. Banks are now required to meet certain ratios in terms of liquid assets as well as holding more capital in the form of equity in order to better absorb unexpected losses. Some institutions are also deemed to be systemically important, be it by virtue of global size or their significance in the domestic economy, and therefore required to hold additional equity in order to ameliorate the ‘too big to fail’ issue.
Banking tends to be very pro-cyclical and regulators have introduced an additional capital requirement which is adjustable over the economic cycle. This counter-cyclical buffer (CCyB) can be increased in an economc upswing when credit growth is strong, in order to act as additional support when credit losses start to appear, and released in a downturn in order to prevent a rapid contraction in bank lending.In the euro area the local regulator, in our case the Central Bank, is designated to determine the size and timing of the buffer, which can range from zero up to 2.5% and is set quarterly ( a bank would then have twelve months to meet the CCyB)
What determines whether the buffer is triggered? In effect the Central Bank has ‘guided discretion’ with emphasis placed on the stock of existing credit to GDP ratio relative to its long term trend (the’Credit Gap’). In Ireland’s case the ratio exceeded 400% at the peak but has fallen sharply of late, down to 260% at the end of 2017, reflecting deleveraging by the private sector and the surge in nominal GDP. Consequently the ratio is low relative to the trend and as such would argue for a zero capital buffer, which has indeed been the case since it was first introduced in 2016.
Indeed, the negative credit gap in Ireland is very large ( the current ratio is 75% below trend) which implies it would take years before it closes even with a resumption of positive credit growth, and therefore years before that measure would trigger a rise in the counter cyclical buffer, However, the Central Bank has recently drawn attention to the rise in new lending and noted in its most recent review of the buffer (in March) that ‘it could … be the case that the Bank sets a positive CCyB rate prior to the credit gap measures indicating the need to do so‘.
In that context it was interesting that the Bank has just published research here on the ratio of new mortgage lending to household disposable income. That ratio exceeded 30% at the peak of the boom and then collapsed to a low of 2.5% in 2011 before recovering in recent years and is currently at 6.7%. Is this too high? The average ratio going back to 1998 is over 13 so that would not indicate a problem but of course the average includes periods where credit standards were very loose. The research piece attempts to answer the problem by estimating a model based ratio, driven by structural factors such as long term interest rates, demographics and an index designed to measure the effectiveness of the financial and regulatory system( the latter two prove to be the key drivers).
In fact the model throws up a current figure close to the existing ratio, and although the growth of new lending is slowing it still exceeds income growth, with the implication that the ratio will continue to rise, albeit at a slower pace. So this new emphasis by the Bank on the flow of new lending as opposed to the stock of existing private sector debt may in time be used to justify a rise in the CCyB even though the standard Credit Gap would argue against.