Assessing optimal credit growth for an emerging banking system

•The paper proposes a new approach for estimating the equilibrium level of credit growth.•The optimal credit growth is considered to be a non-accelerating credit risk, which implies a steady state for the flow of provisions.•The quadratic function was employed between credit growth and the one year after increase in the provision charge ratio to derive the optimal credit growth.

The paper sets forth a novel way to estimate the optimal level of credit growth for an emerging banking system. Contrary to the traditional credit-to-GDP gap indicator, credit growth is considered to be optimal when it does not accelerate credit risk measured by loan loss provisions. We provide empirical support for modelling the provision charge ratio dynamic by the quadratic function of the credit growth deviation from its optimal level. The operational framework consists of a simplified financial satellite with two equations representing credit growth and change in the provision charge ratio. Our empirical results show that a 3 percent (±1 pp margin) quarterly increase in credit to the private sector is, in nominal terms, optimal for financial stability and sustainable growth in Romania.