Countercyclical capital buffer methodology

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The countercyclical capital buffer (CCyB) is intended to ensure that credit institutions accumulate a sufficient capital base during economic growth periods in order to absorb losses in stressed periods; it will serve as a safety cushion thus enabling credit institutions to continue lending in a more challenging economic environment.

The Financial and Capital Market Commission (FCMC) quarterly assess the intensity of cyclical systemic risk and set or adjust the CCyB rate, if necessary, based on the CCyB guide calculated for the respective quarter, other variables which the FCMC considers important for the assessment of the cyclical systemic risk and the applicable methodology described in the European Systemic Risk Board recommendations.

Calculation of the credit to GDP gap serves as a starting point in justification of the decision on the CCyB rate. In case of Latvia, the credit to GDP gap is calculated according to the “broad” and the “narrow” (which excludes the loans issued by non-banks) definition of credit, thereby obtaining two respective benchmark buffer rates. Benchmark buffer rate (as a percentage of risk weighed assets) is 0%, if the credit-to-GDP gap is equal to or less than 2 percentage points. In case the credit-to-GDP gap exceeds 2 percentage points, the benchmark buffer rate will increase linearly from zero to the upper threshold of risk-weighted assets at 2.5%. The benchmark buffer rate that best reflects the specificities of the national economy is selected as the CCyB guide. For Latvia, the results obtained from the calculations of the benchmark buffer rate under the narrow definition of credit are more justified than using the broad credit definition results. The data of the narrow credit time series are more stable (they are not retrospectively adjusted) and they become available sooner. Therefore, in Latvia the benchmark buffer rate that is calculated based on the narrow credit-to-GDP gap has been selected as the CCyB guide.

It should be noted that according to experience of other countries, the deviation of credit-to-GDP ratio from its long-term trend may not always be a reliable signal. In order to assess an increase in cyclical systemic risk and determine the CCyB rate, other quantitative indicators and constrained judgement should be considered as well, placing a great deal of emphasis on the qualitative assessment. Where necessary, the FCMC may set the CCyB rate that is higher than 2.5% of risk-weighted assets. Methodology involves the assessments of trends in the financial sector and real economy, including in the real estate market, by using a number of indicators, for example, lending growth, housing price dynamics, and others, which are considered important for the assessment of cyclical systemic risk.

In accordance with the Credit Institution Law Section 35.5, the FCMC is the authority responsible for assessing the intensity of cyclical systemic risk and setting or adjusting the CCyB rate (if necessary) in Latvia. Since 2015, the FCMC has been setting and publishing quarterly CCyB rate applicable to exposures to the residents of Latvia, but after 19 May 2021 when respective provisions of the Credit Institution Law came in force implementing capital requirements directive (CRD V)[1] that mends the procedure by which the EU Member States decide on setting the CCyB rate, the FCMC will continue as before to assess on a quarterly basis the intensity of cyclical systemic risk and the appropriateness of the applicable CCyB rate, but a decision on a new CCyB rate will be taken not quarterly (as up until now) – but only when the CCyB rate is changed. The decision is taken after consulting the Bank of Latvia and the Ministry of Finance. Where FCMC sets the CCyB rate above zero for the first time, it also states the date from which the banks must apply that increased buffer rate. This date (except in exceptional circumstances) is 12 months after the date when the increased buffer setting is announced.

In accordance with the ESRB Recommendation (ESRB/2014/1), FCMC’s decisions on the appropriate CCyB rate are guided by the objective of protecting the banking system against potential losses associated with a build-up of cyclical systemic risk, thereby supporting the sustainable provision of credit to the real economy throughout the financial cycle. The FCMC will decide about the necessity to set the CCyB rate above 0%, when a significant rise in cyclical systemic risks is recorded in Latvia’s financial sector.

Every credit institution calculates institution-specific CCyB rate, taking into account the geographic distribution of its exposures and the CCyB rates set in the respective countries (FCMC’s 25 August 2020 Regulations No 137 “Regulations on calculating the institution-specific countercyclical capital buffer rate”). A credit institution applies this institution-specific CCyB rate to its total exposures when calculating the CCyB.

[1] Directive (EU) 2019/878 of the European Parliament and of the Council of 20 May 2019 amending Directive 2013/36/EU as regards exempted entities, financial holding companies, mixed financial holding companies, remuneration, supervisory measures and powers and capital conservation measures.

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