Calibrating the magnitude of the countercyclical capital buffer using market-based stress tests

Banking regulation maintains the stability of the overall banking system. The countercyclical capital buffer helps to achieve this objective.

The banking system needs to be well-capitalized to support the flow of credit in the economy. The objective of the countercyclical capital buffer is to ensure the banking sector is sufficiently well-capitalized during the period of financial stress that could occur after a credit expansion. To achieve this, authorities can require the buildup of additional capital during periods of strong credit growth. The additional capital—called the countercyclical capital buffer—can then support credit growth when the economy faces challenging economic conditions.

How much bank capital would be enough to account for these cyclical variations is a difficult question. This paper proposes a new way to estimate the level of the countercyclical capital buffer required. The paper’s approach uses historical stock market data to carry out automated market-based stress tests on the banking system. These stress tests help estimate the size of capital buffers necessary to absorb severe but plausible shocks. They can be done retroactively to estimate the impact of severe shocks to the banking system during periods of strong and weak credit growth. The difference sheds light on the amount of capital required to offset the cyclical variations in risks.