A financial crisis is systemic when all or part of the financial system can no longer provide financial services, putting the economy under pressure.
The economic costs of systemic financial crises are considerable, partly because downturns resulting from a financial crisis are deeper and longer than downturns in economic crises. Problems within the banks could mean that companies and households are unable to obtain loans to finance house purchases or investments, which could reinforce the downturn.
Systemic risks are complex
Systemic risks are defined as imbalances or vulnerabilities of households, companies, credit institutions and other participants/counterparties in the financial system that could, in the event of a negative shock, lead to problems in all or part of the financial sector and have consequences for the economy.
Even if an individual bank or company appears robust, viewed in isolation, risks could still exist in the financial system as a whole that could lead to a financial crisis.
Systemic risks can be difficult to identify and measure. They build up in complex interaction between the financial system and the economy.
For example, in periods of economic growth, great optimism and risk willingness may prevail among lenders and borrowers, such as households and companies. As a consequence banks might become more willing to lend, even to companies and households without sufficiently sound finances. At the same time, households may choose to raise large amounts of debt relative to their income or the value of their home.
Danmarks Nationalbank prevents and reduces the effect of financial crises
Note:
Activity in society and the financial sector naturally moves up and down. In periods of growth, risks may build up in the financial system and materialise at the onset of the downturn.
The housing market – and the commercial real estate market – has played a considerable role in previous financial crises. Therefore, both Denmark and other countries have, since the financial crisis, implemented measures to limit risks related to the housing market and borrowers – called macroprudential measures.
Macroprudential policy is aimed at mitigating systemic risks
Macroprudential policy refers to measures to mitigate systemic risks in the financial system as a whole. The purpose is to reduce the risk of periods of financial instability when the financial system fails to provide key financial services to the economy.
Macroprudential measures focus on the overall financial system and its interaction with the economy – not on individual credit institutions.
Various types of macroprudential measures can be used to limit the risk of a crisis and to reduce the damage to the economy at the onset of a crisis.
Measures that can help mitigate the risk of crises can be borrower-based measures, for instance. Such measures might be a requirement for borrowers to make a certain down payment when buying a home or rules for the size of a loan relative to the borrower’s income.
An example of measures to reduce the harmful effects of a possible crisis are capital requirements. Capital requirements ensure that banks have the capacity to withstand loan losses while continuing to provide new lending.
Thus, the two types of macroprudential measures complement each other.
What is the countercyclical capital buffer?
The countercyclical capital buffer is an example of a macroprudential measure. Its purpose is quite simple: It is to ensure that credit institutions save up in good times to have capital reserves for bad times.
The buffer must be built up when the economy is booming and risks are building up, e.g. due to growing optimism and risk willingness in the financial sector. If risks materialise after a negative shock to the financial system, the buffer must be released. Credit institutions can then use the released capital to e.g. absorb losses.
The purpose of the buffer is to prevent credit institutions from excessive tightening of credit provision to households and companies in the event of turmoil or stress in the financial system.
The Systemic Risk Council
The Systemic Risk Council was established in 2013 in the wake of the financial crisis. The task of the Systemic Risk Council is to monitor, identify and mitigate systemic risks.
Danmarks Nationalbank participates in the Systemic Risk Council together with a number of other authorities. The chairman of Danmarks Nationalbank’s Board of Governors chairs the Council.