Why is credit-to-GDP a good measure for setting countercyclical capital buffers?

• The Basel III suggests that the private credit to GDP ratio relative to its trend should be used as an indicator for regulators to set countercyclical capital requirements on banks.
• We provide European cross-country evidence that this indicator is well motivated because a high credit to GDP ratio significantly increases banks’ vulnerability to GDP shocks which would result in loan losses.
• A case in point is Finland where a high credit to GDP ratio preceded very high bank loan losses in the early 1990s crisis whereas a more moderate ratio, with the help of accommodative monetary policy, helped banks weather the dramatic GDP drop in 2009 without incurring major losses.

We examine banks’ loan losses in Europe in 1982–2012 using a nonlinear three-factor model that takes into account output growth, real interest rate, and the ratio of private credit to GDP relative to its trend (i.e., “excessive indebtedness”). We find that a drop in output has an intensified impact on loan losses if the private sector is excessively indebted. Because increased bank credit risk should be matched with higher bank capital, the result motivates the Basel III's countercyclical capital buffers as a function of private indebtedness relative to its trend. The result also helps to explain differences in the amount of loan losses in different recessions across time and across countries. The model also indicates that low interest rates during the recent recession have clearly mitigated loan losses.