Financial stability at a cost: Countercyclical capital buffers in South Korea

Countercyclical capital buffers (CCyBs) are now a core Basel III international banking standards and crisis regulatory framework instrument. However, evidence on their macroeconomic effectiveness, particularly across shock types and in emerging markets, remains limited. This paper provides a structural assessment for Korea using Bayesian estimation of a New Keynesian dynamic stochastic general equilibrium (DSGE) model with an explicit banking sector and time-varying regulatory capital requirements, estimated on quarterly data from 2003Q1 to 2024Q1. We show that credit-sector disturbances account for a substantial share of Korea’s macroeconomic fluctuations, consistent with its bank-dependent financial structure. The estimated transmission mechanism implies that tighter buffers significantly tighten credit conditions and contract aggregate demand, while the systematic CCyB response to credit conditions appears cautious. Counterfactual policy experiments reveal a clear trade-off: a more responsive CCyB rule stabilizes the credit cycle but increases output and inflation volatility. Moreover, CCyB effectiveness is shock-dependent: strong under credit disturbances and limited when fluctuations originate primarily from non-credit demand shocks. These findings support a state-contingent approach to CCyB design in bank-dominated emerging economies, emphasizing credit-risk stabilization while recognizing the associated macroeconomic costs.