CP-3. Concept paper on capital buffer requirements under Basel III

Transcription

1 CP-3 Concept paper on capital buffer requirements under Basel III

2 Table of Contents Subject Page Section 1: Introduction 2 Section 2: Framework of the capital conservation Buffer 2 Capital conservation range table 4 Section 3: Countercyclical buffer 6 Relevant parameters and indicators 7 Capital conservation (including countercyclical buffer) range table 8 Release of buffer 10 Section 4: Jurisdictional reciprocity 11 Section 5: Frequency of buffer decisions and communications 13 Treatment of surplus when buffer returns to zero 14 Interaction with Pillar 1 and 2 14 Section 6: Calculation of the countercyclical buffer 15 Step by step guide for calculating the buffer requirement 16 Calibration of thresholds 18 Thresholds for Oman 19 Performance of variables for signaling release of buffer 23 Section 7: Prompt Corrective Action and Capital conservation buffer 24 Annex 1: Oman Data for calculation of Gap 26 Annex 2 : Computing range for capital conservation table 29 1

3 Concept paper on Capital buffers under Basel III SECTION 1 1. Introduction 1.1 The Basel III guidelines issued by the Basel Committee on Banking Supervision (BCBS) in December 2010 and revised in June 2011 had indicated that outside of periods of stress, banks should hold buffers of capital above the regulatory minimum. Two such buffers had been mentioned therein, viz., Capital Conservation buffer and Countercyclical buffer. 1.2 The final roadmap for implementation of Basel III in the Sultanate was issued to all banks in August It was indicated therein that a concept paper on Capital buffers would be issued by the Central Bank of Oman. 1.3 The guidelines on regulatory capital under Basel III were issued to all banks in November As mentioned therein, the Capital Conservation buffer would be comprised of Common Equity Tier 1 and the first installment of 0.625% was implemented from January 1, Subsequent installments due in 2015 and 2016 were deferred, so that the full level of the buffer would be achieved by January 1, The Capital Conservation buffer will be comprised of Common Equity Tier 1 and will be established above the regulatory minimum capital requirement. 1.4 Common Equity Tier 1 (CET1) must first be applied to meet the minimum capital requirements, (including the 9% of Tier 1 capital and 12% of Total capital requirements, if necessary), before the remainder can contribute to the Capital Conservation buffer. SECTION 2 2. Framework of the Capital Conservation buffer 2.1 The Capital Conservation Buffer is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses occur. 2.2 The Basel Committee noted that at the onset of the financial crisis, a number of banks continued to make large payouts in the form of dividends, share buybacks and generous compensation payments even though their individual financial condition and the outlook of the sector was deteriorating. Many banks returned to profitability but did not do enough to rebuild 2

4 their capital buffers to support new lending activity. Taken together, this dynamic increased procyclicality of the system. 2.3 The framework that has been proposed in the Basel guidelines is based on simple capital conservation rules designed to avoid breaches of minimum capital requirements. When buffers have been drawn down, one way banks should look to rebuild them is through reducing discretionary distributions of earnings. This could include reducing dividend payments, share buybacks and staff bonus payments. Banks may also plan to raise new capital. 2.4 Other key aspects of the requirements are as follows:- a) Items considered to be distributions include dividends and share buybacks, discretionary payments on other Tier 1 capital instruments and discretionary bonus payments to staff. Payments that do not result in a depletion of Common Equity Tier 1 are not considered distributions. b) Earnings are defined as distributable profits calculated prior to the deduction of elements subject to the restriction on distributions. Earnings are calculated after the tax which would have been reported had none of the distributable items been paid. c) The framework would be applied at consolidated level i.e. restrictions would be imposed on distributions out of the consolidated group. CBO may also apply it at solo level to conserve resources in specific parts of the group. d) Although the buffer must be capable of being drawn down, banks should not choose in normal times to operate in the buffer range simply to compete with other banks and win market share. CBO may impose time limits on banks operating within the buffer range to rebuild the buffer and restore it to prescribed level. In any case, banks should ensure that the Internal Capital Adequacy Assessment Process appropriately factors in the projected levels of capital conservation buffers and plans to rebuild the same to required levels, if needed, over an appropriate time frame. 2.5 It would not be proper for the banks which have depleted their capital buffers, to use predictions about future recovery as justification for generous distributions to shareholders, other capital providers and employees. Nor would it be proper to use distribution of capital as a way to signal financial strength, which is irresponsible and puts shareholders interests above depositors and may also encourage other banks to follow suit. 3

5 2.6 The framework thus reduces the discretion of banks which have depleted their capital buffers, to further reduce them through generous distributions of earnings. In doing so, the framework will strengthen the ability of the banks to withstand adverse environments. Implementation of the framework through internationally agreed capital conservation rules will help increase sector resilience going into a downturn and provide the mechanism for rebuilding capital during the early stages of economic recovery. 2.7 Capital conservation range table As banks are well aware, the draft audited annual financial statements are submitted to Central Bank of Oman (CBO) for approval. During this exercise, the CBO also approves the amount of dividend proposed by the banks. The extent of the Capital Conservation Buffer and the distribution constraints in the form of conservation of its earnings would be one of the factors that will be considered by CBO, while approving the proposed dividend payouts. Banks should ensure that the other payouts in the form of discretionary bonus, share buyback proposals etc. do not breach the minimum capital conservation ratios as indicated in the tables given below:- Common Equity Tier 1 Minimum Capital Conservation ratio * 7% % 100% >7.625% % 80% >8.25% % 60% >8.875% - 9.5% 40% > 9.5% 0% * Expressed as a % of Upper end points in the intervals are included. 2.8 The Common Equity Tier 1 ratio indicated in the above table includes amounts used to meet the minimum CET1 requirement but excludes any additional CET1 needed to meet the Tier 1 and Total capital requirements. For example, if a bank has CET1 of 12% and no 4

6 Additional Tier 1 capital or Tier 2 capital, it meets all minimum capital requirements but would have a zero capital conservation buffer. It would therefore fall in the first slab of the table given above and be subject to 100% constraint on capital distributions. Illustrations of calculating the range in which a bank may fall are given in Annex 2. Banks are urged to proactively exercise prudence in distribution of capital, as they near the outer limits of capital conservation buffer. 2.9 The capital conservation buffer will be phased in as per the following time line: January 1 Capital Conservation Buffer % % % % A table indicating the CET1 requirements during all the years of the transition period is given below. Range of Common Equity Tier 1 ratio (%) in following Minimum capital Upto & conservation including ratio % > > > > > > > % > % > > > > % >7.625 >8.25 >8.875 >9.5 0% 5

7 SECTION 3 3. Countercyclical buffer 3.1 The primary objective of the countercyclical capital buffer regime is to use a buffer of capital to achieve the broader macro-prudential goal of protecting the banking sector from periods of excess aggregate credit growth that have often been associated with the build- up of systemwide risk. This should help to reduce the risk of the supply of credit being constrained by regulatory capital requirements that could undermine the performance of the real economy and result in additional credit losses in the banking system. 3.2 Losses incurred in the banking sector can be extremely large, when a downturn is preceded by a period of excessive credit growth. These losses can destabilize the banking sector and spark a vicious cycle, whereby problems in the financial system can contribute to a downturn in the real economy that then feeds back on to the banking sector. These interactions highlight the particular importance of the banking sector in building up additional capital defences in periods where the risks of system wide stress are growing rapidly. 3.3 The Countercyclical buffer aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. It will be deployed when excess aggregate credit growth is judged to be associated with a build-up of system-wide risk to ensure that the banking system has a buffer of capital to protect it against future potential losses. 3.4 Protecting the banking sector in this context is not simply ensuring that individual banks remain solvent through a period of stress, as the minimum capital requirement and Capital Conservation buffer are together designed to fulfill this objective. Rather, the aim is to ensure that the banking sector in aggregate has the capital on hand to help maintain the flow of credit in the economy without its solvency being questioned, when the broader financial system experiences stress after a period of excess credit growth. In addressing the aim of protecting the banking sector from the credit cycle, the countercyclical capital buffer regime may also help to lean against the build-up phase of the cycle in the first place. This would occur through the capital buffer acting to raise the cost of credit, and therefore dampen its demand, when there is evidence that the stock of credit has grown to excessive levels relative to the benchmarks of past experience. 6

8 3.5 The Countercyclical capital buffer is meant to provide the banking system with an additional buffer of capital to protect it against potential future losses, when excess credit growth in the financial system as a whole is associated with an increase in system-wide risk. The Countercyclical buffer can be released when the credit cycle turns so that the released capital can be used to help absorb losses and reduce the risk of the supply of credit being constrained by regulatory capital requirements. A side benefit of operating the buffer in this fashion is that it may lean against the build-up of excess credit in the first place. The buffer is not meant to be used as an instrument to manage economic cycles or asset prices. Where appropriate those may be best addressed through fiscal, monetary and other public policy actions. 3.6 The internationally consistent credit/gdp guide is considered as a useful starting reference point to take into account in formulating and explaining buffer decisions. However, CBO would be free to emphasise any other variables and qualitative information for purposes of assessing the sustainability of credit growth and the level of system-wide risk, as well as in taking and explaining buffer decisions. This includes constructing additional credit/gdp or other guides that are more closely aligned to the behaviour of Oman s financial systems. 3.7 Relevant parameters and indicators In assessing a broad set of information to take buffer decisions in both the build-up and release phases, CBO would look at all relevant parameters and indicators suitable for the domestic economy for evidence as to whether the inferences from the credit/gdp guide are consistent with other variables. Some examples of other variables that may be studied in both phases include: various asset prices; funding spreads; credit condition/economic surveys; real GDP growth and inflation; profitability of banks; gross non-performing loans growth; credit-deposit ratio ; capital adequacy ratios; data on the ability of non-financial entities to meet their debt obligations on a timely basis private sector credit to Non-Oil GDP growth private sector real credit growth 7

9 real GDP growth and real output gap deviation from trend in MSM 30 index (and its sub indices) and real estate price index M2 to GDP ratio Indebtedness of corporate sector and household etc. 3.8 In using the credit/gdp guide it is important to consider whether the behaviour of the GDP denominator reflects the build-up of system-wide risks. For example, it may not be appropriate to adhere to the guide if the ratio had risen purely due to a cyclical slowdown or outright decline in GDP resulting in a lower value of the denominator. 3.9 As the calculated long-term trend of the credit/gdp ratio is a purely statistical measure that does not capture turning points well, CBO would form its own judgments about the sustainable level of credit in the economy and use the calculated long-term trend as a starting point in its analysis When imposed, the maximum counter cyclical buffer will also follow the same timeline as the capital conservation buffer, and the maximum requirements during the transition period will as under:- January 1 Countercyclical Capital Buffer phase in* Before % % % % % * As % of risk weighted assets, if imposed Capital conservation (including CCyB) range table Once the Countercyclical buffer is in force, it will be implemented through an extension of the Capital Conservation buffer. Assuming that the banks are subjected to a Counter cyclical buffer of 2.5%, the bank s minimum capital conservation standards will be as follows:- 8

10 Common Equity Tier 1 Ratio (including other fully Minimum Capital Conservation loss absorbing capital ratio * 7% % 100% >8.25% - 9.5% 80% >9.5% % 60% >10.75% - 12% 40% > 12% Intervals include upper end-points. * Expressed as % of earnings Until further guidance from BCBS, the countercyclical buffer is to be met only with CET1. For further clarity, the corresponding tables for each year of the transition period are also given below:- Range of Common Equity Tier 1 ratio (%) in following years: With full countercyclical buffer, as applicable Upto & including Minimum capital conservation ratio % > > > > % > > > > % > > > > % >8.25 >9.5 >10.75 > % Consistent with the Capital Conservation buffer, the CET1 ratio includes amounts needed to meet the 7% Common Equity Tier 1 requirement, but excludes any additional CET1 needed 9

11 to meet the 9% Tier 1 and 12% Total Capital requirements. As banks are aware, the dividend payout proposed by them is subject to the discretion and approval of CBO When excess aggregate credit growth is judged to be associated with a build up of system-wide risks, CBO would deploy the buffer, possibly in tandem with other macro prudential tools such as the lending ratio and reserve requirements, in order to ensure that the banking system is resilient enough to protect it against future potential losses. Alternative tools such as loan-to-value limits, income gearing limits or sectoral capital buffers may be deployed in situations where excess credit growth is concentrated in specific sectors but aggregate credit growth is judged not to be excessive or accompanied by increased systemwide risks. 4 Release of buffer 4.1 CBO would take an informed decision to release the buffer gradually in situations where credit growth slows and system-wide risks recede in a benign fashion. In other situations, given that credit growth can be a lagging indicator of stress, it may at its discretion, decide to promptly release the buffer to reduce the risk of the supply of credit being constrained by regulatory capital requirements. In some cases this can be done by timing and pacing the release of the buffer with the publication of banking system financial results so that the buffer is reduced in tandem with the banking sector s use of capital to absorb losses or its need to absorb an increase in risk weighted assets. In other cases, more prompt action may be called for based on relevant market indicators of financial stress to help ensure that the flow of credit in the economy is not jeopardised by uncertainty about when the buffer will be released. 4.2 When a decision is taken to release the buffer in a prompt fashion, CBO may, to the extent possible, also indicate how long they expect the release to last. This will help to reduce uncertainty about future bank capital requirements and give comfort to banks that capital released can be used to absorb losses and avoid constraining asset growth. Any pronouncements in this regard would be reviewed and updated on a regular basis so that any changes in the CBO s outlook can be publicly disseminated on a timely basis. 10

12 SECTION 4 5. Jurisdictional reciprocity 5.1 Jurisdictional reciprocity will be applied when it comes to internationally active banks, i.e. banks which have branches overseas. The host authorities take the lead in setting buffer requirement that would apply to credit exposures held by local entities located in their jurisdiction. They would also be expected to promptly inform their foreign counterparts of buffer decisions so that authorities in other jurisdictions can require their banks to respect them. Meanwhile, the home authority will be responsible for ensuring that the banks they supervise calculate their buffer requirements correctly based on the geographic location of their exposures. Such reciprocity is necessary to ensure that the application of the countercyclical buffer in a given jurisdiction does not distort the level playing field between domestic banks and foreign banks lending to counterparties in that jurisdiction. This reciprocity does not entail any transfer of power between jurisdictions; the power to set and enforce the regime will ultimately rest with the home authority of the legal entity carrying the credit exposures. 5.2 The home authority will always be able to require that the banks they supervise maintain higher buffers if they judge the host authorities s buffer to be insufficient. However, the home authority should not implement a lower buffer add-on in respect of their bank s credit exposures to the host jurisdiction. This will help to ensure that concerns about a competitive equity disadvantage to domestic banks (from foreign bank competition) do not discourage the implementation of the buffer add-on. Also, without such a level playing field on the minimum buffer add-on, the impact of foreign banks (not subject to buffer) increasing their lending in response to lower competition from domestic banks (subject to buffer) could undermine the buffer regime s potential side benefit of reducing excessive credit in a jurisdiction. 5.3 In cases where banks have exposures to jurisdictions that do not operate and publish buffer add-ons, the home authority will be free to set their own buffer add-ons for exposures to those jurisdictions. This can be done using credit and GDP data and other information on economic and financial conditions for those jurisdictions available from the BIS and IMF and other sources. 11

13 5.4 Internationally active banks will look at the geographic location of their private sector credit exposures (including non-bank financial sector exposures) and calculate their countercyclical capital buffer requirement as a weighted average of the buffers that are being applied in jurisdictions to which they have an exposure. Credit exposures in this case include all private sector credit exposures that attract a credit risk capital charge or the risk weighted equivalent trading book capital charges for specific risk, Incremental Risk Charge and securitisation. 5.5 The weighting applied to the buffer in place in each jurisdiction will be the bank s total credit risk charge that relates to private sector credit exposures in that jurisdiction, divided by the bank s total credit risk charge that relates to private sector credit exposures across all jurisdictions. The countercyclical buffer is required to be held at a consolidated level. In addition, CBO may apply the buffer at solo level to conserve resources in specific parts of the group. Example Consider that a bank is having operations in 2 other countries, apart from its home country, viz., Oman. These countries have imposed different CCyBs depending on local conditions. The risk weighted assets (total) would be multiplied by the weighted CCyB requirement to arrive at the CCyB amount at a consolidated level, as follows:- Country 1 Country 2 Home country Total Credit risk charge relating to private sector credit 100, ,000 2,900,000 3,150,000 CCyB imposed (%) CCyB at consolidated level@@ (%)= % * of total risk weighted assets 12

14 It may be added that for levels in excess of the relevant maximum buffer add-on rate, home authorities may, but are not required to, reciprocate host authorities buffer requirements. SECTION 5 6. Frequency of buffer decisions and communications 6.1 Explaining the information used and how it is synthesised to arrive at buffer decisions should help build understanding and credibility in the buffer decisions taken by CBO among the banks that are required to hold the buffer, institutions in other jurisdictions, and other stakeholders. 6.2 As macroeconomic, financial and prudential information are usually updated on at least a quarterly basis, CBO would endeavour to review the information at its disposal and take countercyclical capital buffer decisions on a quarterly or more frequent basis. CBO also recognises the need to preannounce prospective buffer requirements and would, to the extent possible, provide sufficient lead time to give banks a reasonable amount of time to adjust their capital plans. 6.3 CBO would also consider appropriate communications strategy for providing regular updates on the assessment of the macro financial situation and the prospects for potential buffer actions in a useful way for preparing banks and their stakeholders for likely buffer decisions. In turn, that should help to smooth the adjustment of financial markets to those actions, as well as give banks as much time as possible to adjust their capital planning accordingly. But that does not mean that CBO should be expected to make quarterly statements on their buffer stance on an on- going basis. Given that the buffer in each jurisdiction is likely to be used infrequently, once CBO has implemented the communication strategies, it would be appropriate for it to comment on at least an annual basis using whichever communication vehicles are appropriate for Oman. More frequent communications may be conducted, however, to explain buffer actions when they are taken and to advise banks and other 13

15 stakeholders promptly when there are significant changes to the CBO s outlook for the prospect of changes to buffer settings. 6.4 All announced changes to the prevailing buffer requirement would be reported to the BIS on a timely basis. This will enable a list of prevailing buffers, and pre-announced buffers, to be published on a dedicated page at the BIS website. This will provide banks with the information they need to calculate their specific buffer requirements. 7. Treatment of surplus when buffer returns to zero The capital surplus created when the countercyclical buffer is returned to zero would be unfettered, subject however, to the approval of dividend payouts by CBO, as hitherto. When the buffer is turned off, banks are likely to wish to use the released capital to absorb losses or protect themselves against the impact of problems elsewhere in the financial system. However, if banks do seek to distribute the released capital when the buffer has been turned off, and such an action is considered to be imprudent given the prevailing circumstances, CBO could prohibit these distributions. 8. Interaction with Pillar 1 and The countercyclical capital buffer incorporates elements of both Pillar 1 and 2. It is like a Pillar 1 approach in that it is a framework consisting of a set of mandatory rules and disclosure requirements. However, its use of jurisdictional judgement in setting buffer levels and the discretion provided in terms of how authorities explain buffer actions are more akin to a Pillar 2 approach. Irrespective of whether it is considered to be a Pillar 1 or a Pillar 2 approach, it is essentially a disclosed requirement that sits on top of the capital conservation buffer and minimum capital requirement, with a pre-determined set of consequences for banks that do not meet this requirement. 8.2 Pillar 2 would need to adapt to accommodate the existence of the countercyclical buffer regime. Specifically, it would make sense that a bank s Pillar 2 requirements do not require capital to be held twice for financial system-wide issues, if they are already captured by the countercyclical buffer when the latter is above zero. However, as Pillar 2 may capture additional risks that are not related to system-wide issues (e.g. concentration risk), capital 14

16 meeting the countercyclical buffer should not be permitted to be simultaneously used to meet these non-system-wide elements of any Pillar 2 requirement. SECTION 6 9. Calculation of the Countercyclical buffer 9.1 After a detailed study, the Bank for International Settlements concluded that credit-to-gdp gap was the best performing of the range of variables considered as a guide for taking buffer decisions. A broad definition of credit is used that will capture all sources of debt funds for the private sector (including funds raised abroad) to calculate a starting buffer guide. This should not be viewed as penalising the banking sector for credit that has been supplied via the nonbank financial sector. Rather it simply recognises the reality that banks can suffer the consequences of a period of excess credit, even if they have not directly driven its growth. This is also the reason why the buffer add-on will apply equally to all banks with credit exposures to a given jurisdiction, irrespective of whether or not they are viewed as being a primary contributor to the credit boom. 9.2 Using a broad definition of credit may also limit the scope for unintended consequences such as providing incentives for banks to divert the supply of credit to other parts of the financial system, since the aggregates and resulting buffer would be immune to changes over time in what kinds of entities are supplying funds to private sector. Aside from the reasons above, the empirical analysis suggests that a broad definition of credit performs considerably better as a predictor of banking sector stress than a narrow definition. 9.3 Available credit data varies across jurisdictions and so this complicates the specification of a single series which should be used by all jurisdictions. Ideally the definition of credit should include all credit extended to households and other non-financial private entities in an economy independent of its form and the identity of the supplier of funds. This means that it should include credit extended by domestic and international banks as well as non-bank financial institutions either domestically or directly from abroad, and should also include all debt securities issued domestically or internationally to fund households and other nonfinancial private entities (including securitisations), regardless of who holds the securities. 15

17 This would by definition also include securities held by banks and other financial institutions in their trading portfolios and banking books as well as securities held by other residents and non-residents. Jurisdictions which do not have credit aggregates this broad will have to initially rely on the broadest aggregates at their disposal. Over time jurisdictions could aim to establish broader measures of credit as their financial systems evolve. 9.4 Such a broad definition of credit will capture all sources of debt funds for the private sector. This limits the scope for unintended consequences (such as providing incentives for credit to be supplied outside of the banking sector), since the aggregates and hence buffer would be immune to changes over time in what kinds of entities are supplying funds to private sector. It also recognises that banks can suffer the consequences of a period of excess credit, even if they have not directly driven it. In principle, there is a case for using an even wider definition of credit that includes gross credit flows between financial institutions (including between banks and non-banks). Rapid growth in intra-financial system flows can be a source of systemic risk by increasing the potential for financial contagion through counterparty credit losses, for instance. However, it should be noted that the countercyclical buffer regime does not account for this dimension of systemic risk to avoid overlap with other work streams. 10. Step-by-step guide for calculating the buffer requirement 1 As a starting point for determining the buffer add-on, CBO will first calculate the guide buffer add-on (expressed in the regime as a percentage of risk weighted assets). There are 3 steps in this process: Step 1: Calculate the aggregate private sector credit-to-gdp ratio Step 2: Calculate the credit-to-gdp gap (the gap between the ratio and its trend) Step 3: Transform the credit-to-gdp gap into the guide buffer add-on 1 Please refer to Guidance for national authorities operating the countercyclical buffer BCBS( December 2010) & Frequently asked questions on the Basel III Countercyclical capital buffer (October 2015). 16

18 Each step is described in detail below. Step 1: calculating the credit-to-gdp ratio The credit-to-gdp ratio in period t is calculated as: RATIO t =CREDIT t / GDP t Х 100% GDP t is domestic GDP and CREDIT t is a broad measure of credit to the private, non-financial sector in period t. Both GDP and CREDIT are in nominal terms and on a quarterly frequency. Step 2: calculating the credit-to-gdp gap The credit-to-gdp ratio is compared to its long term trend. If the credit-to-gdp ratio is significantly above its trend (i.e. there is a large positive gap) then this is an indication that credit may have grown to excessive levels relative to GDP. The gap (GAP) in period t is calculated as the actual credit-to-gdp ratio minus its long-term trend (TREND): GAP t =RATIO t TREND t. TREND is a simple way of approximating something that can be seen as a sustainable average of ratio of credit-to-gdp based on the historical experience of the given economy. While a simple moving average or a linear time trend could be used to establish the trend, a filter (such as the Hodrick-Prescott filter) can be used as it has the advantage that it tends to give higher weights to more recent observations. This is useful as such a feature is likely to be able to deal more effectively with structural breaks. Step 3: transforming the credit-to-gdp gap into the guide buffer add-on The size of the buffer add-on (VB t ) (in percent of risk-weighted assets) is zero when GAP t is below a certain threshold (L). It then increases with the GAP t until the buffer reaches its maximum level (VBmax) when the GAP exceeds an upper threshold H. The lower and upper thresholds L and H are key factors in determining the timing and the speed of the adjustment of the guide buffer add-on to underlying conditions. BCBS analysis has found 17

19 that an adjustment factor based on L=2 and H=10 provides a reasonable and robust specification based on historical banking crises. 11. Calibration of thresholds at which the guide indicates a buffer requirement may be appropriate Previous academic work has shown that the credit-to-gdp gap can be a powerful predictor for banking crises. Building on the general principle that the objective of the countercyclical buffer is to protect banks from periods of excess credit growth, the criteria to determine threshold GAP level L, when the rule should start building up capital buffers, and a GAP level H, at which the maximum buffer should be reached have been indicated. Given the current state of knowledge, the rule simply provides a starting guide to the relevant authorities responsible for deciding the buffer add-on. CBO retains the right to implement a different buffer add-on than indicated by this simple guide, after providing a public and transparent explanation of this decision. Criteria for the minimum threshold (L) when the guide would start to indicate a need to build up capital (1) L should be low enough, so that banks are able to build up capital in a gradual fashion before a potential crisis. If banks are given one year to raise additional capital, this means that the indicator should breach the minimum at least 2-3 years prior to a crisis. (2) L should be high enough, so that no additional capital is required during normal times. Criteria for the maximum (H) at which point no additional capital would be required, even if the gap would continue to increase (3) H should be low enough, so that the buffer would be at its maximum prior to major banking crises (such as the current episode in the US or the Japanese crises in the 90s). Empirical evidence suggests that H has to be set to 10 to meet Criterion 3 above. To ensure that Criteria 3 is met, L has to be set at 2 so that the rule would have required the build up of capital for all major banking crises 2-3 years in advance. L=2 and H=10 would also imply that the rule would have worked very well for other domestic crises and even in the case of some 18

20 international crises. Study conducted by BCBS also has showed that L=2 and H=10 provide a very robust trade-off between type 1 errors (a crisis occurs but the gap does not breach the threshold) and type 2 errors (the threshold is breached but no crisis occurs). 12. Thresholds for Oman 12.1 Based on the methodology given in the BIS paper, credit to GDP Gap for Oman was estimated using quarterly GDP and credit data from first quarter of 1997 (Q1-1997) to second quarter of 2015 (Q2-2015) to calculate Credit-to-GDP ratio, trend and gap. The position is given in Annex 1.The GDP data is annualized using four-quarter moving sum. In a later refinement, three-year moving average of GDP is used. For each quarter t, Credit-to-GDP ratio (RATIO t ) is calculated as: RATIO t = 100 x CREDIT t / GDP t where, CREDIT t is the outstanding credit at the end of quarter t, and GDP t is four-quarter moving sum of quarterly GDP from quarter t-3 to quarter t (or 3 year moving average GDP in alternative treatment) About half of the time series (8 years or 32 quarters) is used to estimate the trend Credit-to- GDP (TREND t ) using one-sided HP filter with smoothing parameter (lambda) of 400,000 as suggested by BCBS. For each subsequent quarter t, the trend TREND t up to that quarter is estimated by using additional credit and GDP data available up to that quarter. The Credit-to-GDP Gap is then calculated for each quarter t from Q onwards as: GAP t = RATIO t TREND t The results of calculations of Credit-to-GDP gap using backward looking data and annualized GDP for Oman are presented in Graph 1 below. The results show that the Credit-to-GDP gap does not have extreme negative and positive values and fluctuates in a reasonable range of - 3 and 15 percent, which is close to the thresholds proposed by BCBS. 19

21 Graph 1 CCyCB Guide (4-Qtr GDP and backward looking Data) 35,000 RO, million per cent , ,000 20, , ,000 5, Credit 4Q-GDP Credit Growth Gap L:2 H: Three-year Moving Average GDP: To correct for the large number of false positive signals, following Kauko 2 the Gap is recalculated using three-year moving average of GDP. The results are presented in Graph 2 below. The results show that the three-year moving average of GDP smoothens out sudden short-term fluctuations from the GDP series and thus lends more credibility to the Credit-to- GDP ratio as a guide to trigger countercyclical capital buffers. The Credit-to-GDP gap moves more in sync with the credit growth. At present, using private sector credit or total credit gives similar results as seen from the following graphs: 2 Kauko, K (2012): Triggers for countercyclical capital buffers, Bank of Finland Online,no 7. 20

22 Graph 2 CCyCB Guide (3-year Moving Average GDP) 35,000 RO, million 30,000 25,000 20,000 15,000 10,000 5,000 0 per cent Credit GDP(3Y Moving Average) Credit Growth Gap L:2 L : 4 H : 10 Graph 3 CCyCB Guide (Private Credit and 3-year Moving Average GDP) 35,000 RO, million 30,000 25,000 20,000 15,000 10,000 5,000 0 per cent Pvt. Credit GDP(3Y Moving Average) Credit Growth Gap L:4 H:10 21

23 12.4 The minimum threshold (L = 2 also plotted in the Graph 2) proposed by BCBS appears to be too low for Oman. With this threshold, the guide still emits many false positive signals even when credit growth is fairly muted. A minimum threshold of L = 4 (and maximum threshold of H = 10) seems to perform better in terms of balance between correct signals and noise. This minimizes the risk of misleading signals and ascertains that the credit growth is excessive in Oman s context when build-up of countercyclical capital is triggered. The historical data suggests that unlike in advanced countries, in Oman the minimum threshold is not breached 2-3 years before the (global financial) crisis, this was expected as the crisis did not set off because of internal imbalances within Omani economy/ financial sector and this guide (the Gap) alone is not expected to pre-warn (much ahead of the time) about the developing instabilities elsewhere in the world. Relatively late breach of the minimum threshold (L) implies that the countercyclical capital buffer will need to be built up quickly (before a full blown crisis hits), hence a smaller difference between minimum and maximum threshold levels (L : 4; H : 10) is not off the mark. Setting L=4 means that when: ((CREDIT t / GDP t ) Х 100% ) (TREND t ) <=4%, the buffer add-on is zero. Setting H=10 means that when: ((CREDIT t / GDP t ) Х 100% ) (TREND t ) >=10%, the buffer add-on is at its maximum As an example, we could assume for illustrative purposes that the maximum buffer add-on (VBmax) is 2.5% of risk weighted assets (i.e. the full level of Countercyclical buffer). When the credit-to-gdp ratio is 4 percentage points or less above its long term trend, the buffer add-on (VB t ) will be 0%. When the credit-to-gdp ratio exceeds its long term trend by 10 percentage points or more, the buffer add-on will be 2.5% of risk weighted assets. When the credit-to- GDP ratio is between 4 and 10 percentage points of its trend, the buffer add-on will vary linearly between 0% and 2.5%. This will imply for example, a buffer of 1.25% when the creditto-gdp gap is 7 (i.e. half way between 4 and 10). Similarly, if the gap is 8.5, (i.e. 3/4 th between 4 and 10), the buffer requirement would be 1.875%. 22

24 13. Performance of variables for signaling release of the buffer 13.1 As mentioned in the Basel Committee s guidelines, to judge the performance of different indicator variables for the release phase, it is important to revisit the rationale for releasing the buffer. As set out in principles underpinning the role of judgment, the release guidance highlights that release should be contemplated in two scenarios. The first is when there are losses in the banking system that pose a risk to financial stability. In that case it makes sense to release the buffer in accordance with those losses so that this buffer is depleted first before banks begin depleting their normal capital conservation buffers. The second is when there are problems elsewhere in the financial system, which have the potential to disrupt the flow of credit that could undermine the performance of the real economy and generate additional losses in the banking system. In that case it could be important to release the buffer on a timely basis. It is therefore essential that variables guiding the release phase react sufficiently promptly Research indicated that macro variables may not be ideal indicator variables for signalling the release phase. While credit and GDP often contract around crises, this is not always the case. For example, during the recent crises real credit growth even increased initially in several countries, such as for example the United Kingdom and Spain. Equally, real GDP continued to grow for over a year after the recent crisis materialized in several countries like Germany, Switzerland, the United Kingdom and the United States. Indicators of credit conditions may, on the other hand, provide useful information to identify bad times. But they are survey based and therefore potentially vulnerable to manipulation. Indicators of banking sector conditions provide mixed signals for the release phase. Aggregate profits capture the current crisis but not necessarily other episodes. Nonperforming loans, on the other hand, seem to perform reasonable well. However, in some instance they grow too slowly and then remain high for quite some time Asset prices can be an important source of information. A key advantage is that they are available at a much higher frequency than quarterly macro data or information from bank 23

25 balance sheets (which may only be available annually in some cases). Analysis under taken by the Bank for International Settlements shows that deviations of property and equity prices from trend can help to identify the build-up phase. However, these series would start releasing the buffer too early. Nevertheless, their past performance could be useful in helping authorities assess and explain the need to release the buffer after the financial system comes under stress Spreads can be an alternative market based indicator. For the current crisis, CDS spreads and funding costs (e.g. 3 month interbank rates minus 3 month overnight index swaps) captured the onset of the recent crisis perfectly and no particularly wrong signals were issued beforehand. However, no other crises are covered, so the evidence is not robust enough to use these variables in a prescriptive fashion. Furthermore, only a few countries have CDS series available. The same is true for corporate credit spreads. For those countries where data are available, they show that corporate credit spreads increased rapidly during the recent crisis. But, they also reached very high levels after the dot-com boom, even though no systemic banking crises materialized. More importantly, they did not indicate any particular vulnerability in the United States in the 1988 crisis. This is even more apparent from long run corporate bond spreads, which narrowed during the same crisis. CBO would look at all relevant parameters and indicators suited to the domestic economy, before making any decisions regarding release of the buffer. SECTION Prompt Corrective Action and Capital conservation Buffer 14.1 The Prompt Corrective Action (PCA) framework was advised to all banks in terms of our circular BM The PCA framework is an integral part of supervisory oversight, based on pre- determined, rule based and structured early intervention. The PCA framework is based on two important indicators-asset Quality and Capital adequacy. For every trigger point a set of mandatory as well as discretionary corrective actions are provided. The actions are designed to address both the symptoms and causes of weaknesses. The degree of the package of actions would be corresponding to the severity of the problem. 24

26 14.2 As regards the capital conservation buffer, a reference is drawn to paras 129 & 130 of the document Basel III: A global regulatory framework for more resilient banks and banking systems (December 2010 revised June 2011) issued by the Basel Committee on Banking Supervision, which state that Banks will be able to conduct business as normal when their capital levels fall into the conservation range as they experience losses. The constraints imposed only relate to distributions, not the operation of the bank. The distribution constraints imposed on banks when their capital levels fall into the range increase as the banks capital levels approach the minimum requirements. The Basel committee does not wish to impose constraints for entering the range that would be so restrictive as to result in the range being viewed as establishing a new minimum capital requirement Thus, as per the Basel III guidelines, falling into the range of Capital Conservation Buffer would only result in constraints that will be imposed on the bank as regards payouts in the form of cash dividends, share buybacks and discretionary bonus payments It is therefore clear that the PCA framework has a larger scope in terms of trigger points as well as mandatory and discretionary early actions. The Capital Conservation Buffer is thus complementary to and not a substitute for PCA Prompt Corrective Action framework (PCA) is operationalised based on a capital adequacy trigger of 13% and below. Taking note of BCBS s comments regarding Capital Conservation Buffer, it is clarified that the trigger point for PCA requirements would not be adjusted to include the buffers. For example, suppose the full CCB of 2.5% is in place(and assuming CCyB is not in force). The PCA capital adequacy trigger point will remain at 13% and not become 15.5%.So, if a bank has CET1 of 9%, Additional Tier 1 of 2% and Tier 2 capital of 4.4%, the total capital is 15.4%. The bank will not be placed under PCA, but would face capital conservation requirements as indicated in table 4. PCA will be triggered if total capital adequacy ratio falls below 13%. ************************ 25

27 Oman Data for calculation of gap Annex 1 Period 4-Quarter Moving Sum GDP and Backward Looking Data (Graph 1) Credit 4Q- HP -to- Gap GDP Trend GDP 3 Yr Moving Avg. GDP (Graph 2) Cred 3Y HP it-to- Gap GDP Trend GDP Private Credit and 3 Yr Moving Avg. GDP (Graph 3) Credi 3Y HP t-to- Gap GDP Trend GDP 1997Q4 6, Q1 5, Q2 5, Q3 5, Q4 5, Q1 5, Q2 5, Q3 5, Q4 5, ,822 5, Q1 6, ,920 5, Q2 6, ,045 6, Q3 7, ,199 6, Q4 7, ,293 6, Q1 7, ,478 6, Q2 7, ,675 6, Q3 7, ,848 6, Q4 7, ,992 6, Q1 7, ,165 7, Q2 7, ,329 7, Q3 7, ,469 7, Q4 7, ,575 7, Q1 8, ,684 7, Q2 8, ,719 7,

28 2003Q3 8, ,759 7, Q4 8, ,847 7, Q1 8, ,959 7, Q2 8, ,101 8, Q3 9, ,266 8, Q4 9, ,528 8, Q1 9, ,806 8, Q2 10, ,103 9, Q3 11, ,477 9, Q4 11, (3.09) 9, , Q1 12, (2.97) 10, , Q2 13, (2.79) 10, , Q3 13, (0.94) 11, , Q4 14, (0.27) 11, , Q1 14, , , Q2 14, , , Q3 15, , , Q4 16, , , Q1 17, , , Q2 19, , , Q3 22, , , Q4 23, , , Q1 22, , , Q2 20, , , Q3 18, , , Q4 18, , , Q1 19, , ,

29 2010Q2 21, , , Q3 22, , , Q4 22, , , Q1 23, , , Q2 24, , , Q3 25, , , Q4 26, , , Q1 27, , , Q2 28, , , Q3 29, , , Q4 29, , , Q1 29, , , Q2 28, , , Q3 29, , , Q4 30, , , Q1 30, , , Q2 30, , , Q3 31, , , Q4 31, , , Q1 30, , , Q2 29, , ,