Operationalising the Countercyclical Capital Buffer: Indicator Selection, Threshold Identification and Calibration Options

By C. Detken, Olaf Weeken, Lucia Alessi, Diana Bonfim, Miguel Boucinha, Christian E. Castro, Sebastian Frontczak, G. Giordana, J. Giese, N. Jahn and 5 more. Social Science Research Network, 2014

140 citations recorded by the source corpus.

This paper presents the analysis underpinning the ESRB Recommendation on guidance on setting countercyclical buffer rates (ESRB 2014/1). The Recommendation is designed to help authorities tasked with setting the countercyclical capital buffer (CCB) to operationalise this new macroprudential instrument. It follows on from the EU prudential rules for the banking system that came into effect on 1 January 2014. The analysis underpinning the Recommendation was conducted by a dedicated ESRB Expert Group working under the auspices of the ESRB Instruments Working Group. The Expert Group was made up of representatives from over 30 ESRB member institutions (see Annex G). Its analysis focused on early warning models in order to identify indicators that signal the types of crises that the CCB is designed to mitigate. This includes identifying leading indicators and associated thresholds that signal that the CCB might need to be built up as well as indicators and associated thresholds that suggest that the CCB should be reduced or fully released. For one particular variable, the deviation of the ratio of credit to gross domestic product (GDP) from its long-term trend (credit-to-GDP gap), the analysis also focused on how to map specific levels of the credit-to-GDP gap into indicative settings of the CCB – a so-called benchmark buffer rate. Consistent with the literature, this paper finds that, in univariate signalling, credit-to-GDP gaps (using bank, household and total credit) are the best single leading indicators for systemic banking crises associated with excessive credit growth. This finding is established here for the European Union as a whole. While the specification suggested by the Basel Committee on Banking Supervision (BCBS) performs well for the large majority of countries for which it can be analysed, the credit-to-GDP gap does not perform well in all cases. In particular, some specifications suggest implausibly persistent gaps for a number of countries. In addition, the results are based on little information from central and eastern European transition economies owing to a lack of data. The main results for credit-to-GDP gaps are robust across a range of different specifications for the gap. The specification suggested by the BCBS is based on total credit to the domestic private nonfinancial sector and is among the best performing indicators. Few specifications of the credit-to-GDP gap perform better. Those that do are often based on narrower credit aggregates (e.g. bank credit and credit to households) that may be less robust to financial innovation than a broad measure based on total credit. A number of other variables performed well in univariate signalling, and thus offer a good indication that the CCB may need to be built up. These variables include the residential property price-toincome ratio, residential and commercial property price gaps, the debt service-to-income ratio for households, real bank and household credit growth and the deviation of the (deflated) broad monetary aggregate M3 from its trend. Multivariate analysis shows that when the credit-to-GDP gap is combined with other variables either in a multivariate signalling approach, a discrete choice model or a decision tree approach, the overall signalling performance improves. In addition to the above-mentioned variables, the overall debt service-to-income ratio, the current account-to-GDP ratio and real equity price growth are useful variables in a multivariate setting. In particular, this reduces the incidence of false alarms. Market-based indicators have been found to be the best coincident or near-crisis indicators which can be used to signal that the CCB should be reduced or released. The LIBOR-OIS (overnight index swaps) spread, covered bond spreads and the ECB’s composite indicator of systemic stress (CISS) perform particularly well. Moreover, these indicators not only perform well for the pooled sample, but also for most individual EU Member States. An important caveat is the short time series availability for many of these data series. This means that the results are largely driven by the recent global financial crisis and the possibility for generalising the results for the release phase is limited. Moreover, there may be circumstances other than stress, e.g. when cyclical systemic risks recede, where the buffer might be reduced, but which may not be captured by this analysis. Judgement may thus need to play an even greater role in the release phase than in the build-up phase. The analysis in this paper suggests thresholds for each indicator and multivariate model. Policymakers could view the breaching of such thresholds as a trigger for discussions on the implementation and release of the CCB. Of course, the results are based on an in-sample analysis and therefore the usual caveats for policy use apply. This paper finds that mapping the credit-to-GDP gap into a benchmark buffer rate poses conceptual challenges. Since the way that the BCBS calibrates the benchmark buffer rate is ad hoc, the Expert Group investigated a number of alternative approaches. Some of the alternatives described in this paper may serve as cross-checks for calibration decisions, but would need to be further developed before becoming operational. In addition to describing the analysis underpinning the ESRB Recommendation on the CCB, this paper contributes to the literature. First, to the best of our knowledge, this is the first comprehensive study covering all 28 Member Countries of the European Union to the extent possible with the data available. The paper establishes a reference dataset on systemic banking crises associated with domestic credit cycles, which will be useful for further research on CCBs. Second, this paper includes a conceptually more appealing measure of (broad) total credit than most of the existing empirical cross-country studies, which are often based on narrower aggregates. Third, a novel evaluation approach has been used, combining different criteria, i.e. AUROCs (and partial AUROCs), with a loss function approach for specific policy-makers’ preferences, as well as taking into consideration the robustness of results across different countries. Fourth, while the analytical findings focus on the CCB, this paper provides a methodology for indicator selection, threshold identification and calibration options that can be adapted to help operationalise other macro-prudential instruments. JEL Classification: G21, G18, E58

Subfields: Finance

View Paper: https://www.semanticscholar.org/paper/4c04c4735fb3ea16d8955610ac48a325af795513

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