Predicting Financial Vulnerabilities to Guide the Set-Up of Counter-Cyclical Capital Buffers

The systemic dimension of the financial crisis has underscored the need for an expanded set of policies to contain systemic risk throughout the financial cycle. Counter-cyclical capital buffers (CCBs) form an integral part of the expanded European macro-prudential toolkit in this respect, with a “time series” focus in that they increase the resilience of the banking sector to shocks arising from financial and economic stress over the cycle and thereby provide a means to attenuate pro-cyclicality inherent in the financial system. To guide the setting of CCBs, the Basel Committee on Banking Supervision (BCBS) has proposed a focus on, inter alia, the deviation of the domestic credit-to-GDP ratio fromits backward-looking trend (also known as the domestic credit-to-GDP gap), given its track record of signalling financial stress well in advance. The Capital Requirements Directive (CRD) IV specifies that other variables should also be taken into consideration in addition to the credit gap. This special feature assesses the usefulness of private sector credit and other macro-financial and banking sector indicators in guiding the setting of CCBs in a multivariate early warning model framework. The analysis shows that in addition to credit variables, other domestic and global financial factors such as equity and house prices, as well as aggregate banking sector balance sheet indicators, help to predict historical periods of financial vulnerabilities in EU Member States. Consequently, policy-makers deciding on CCB measures could benefit from considering a wide range of indicators. JEL Classification: G00