Strategic Importance of Countercyclical Capital Buffer

The global financial crisis of 2007-2008 triggered a significant overhaul of regulatory frameworks across the banking sector, with a key focus on mitigating systemic risks and enhancing financial stability. One such regulatory tool developed as a response is the Countercyclical Capital Buffer (CCyB), introduced under the Basel III framework. The CCyB is a capital reserve that banks must accumulate during periods of economic growth and prosperity, which they can draw upon during times of financial stress or economic downturns.

In the context of Nepal, Nepal Rastra Bank (NRB), the central bank, adopted this tool in 2015 to ensure the stability of the country's financial system, given its growing credit market and the economy's exposure to both domestic and external risks.

The Concept of the Countercyclical Capital Buffer

The Countercyclical Capital Buffer (CCyB) is a macroprudential regulatory tool designed to counter the pro-cyclicality of credit growth in the banking system. Pro-cyclicality refers to the tendency of credit markets to expand rapidly during economic booms and contract sharply during downturns. This can create asset bubbles during good times and exacerbate recessions when the economy slows down.

The Countercyclical Capital Buffer (CCyB) is designed to enhance the resilience of the banking system by requiring banks to accumulate additional capital during periods of excessive credit growth, often signaled by a rising credit-to-GDP ratio. This extra capital reserve serves as a protective buffer that can be drawn down during times of financial stress, allowing banks to absorb losses and continue lending without resorting to sudden credit cutbacks or raising emergency capital. By having this buffer in place, the broader financial system is shielded from potential shocks, reducing the likelihood of systemic crises and minimizing the need for government bailouts, thus supporting economic stability.

The Basel Committee on Banking Supervision (BCBS) introduced the CCyB under the Basel III regulatory framework, and it has since been adopted by many countries around the world, including Nepal.

Global Implementation of the Countercyclical Capital Buffer

Globally, the implementation of the CCyB has been gradual. Countries apply the buffer differently depending on their specific economic conditions and credit trends. The framework allows national regulators to set the buffer rate anywhere from 0% to 2.5% of Common Equity Tier 1 (CET1) capital (refers to a bank's core capital, consisting of common shares, retained earnings, and reserves, which are the strongest buffer against financial losses. It is the most reliable form of capital to absorb losses and protect the bank during financial stress, depending on the level of systemic risk in the economy.

Countries like the United Kingdom and Sweden have been proactive in using the CCyB, increasing the buffer rate during periods of economic growth to reduce the risks associated with rising household debt and overheated real estate markets. In contrast, the United States has been more conservative in applying the buffer, largely keeping it at 0% since the 2008 crisis.

The CCyB has proven effective in many jurisdictions as a tool to curb excessive credit growth and maintain financial stability. For example, in Sweden, the CCyB was raised to 2.5% during periods of strong credit growth to prevent an unsustainable increase in household debt.

Countercyclical Capital Buffer in Nepal

Nepal implemented the CCyB as part of its macroprudential policy under the guidance of the Nepal Rastra Bank (NRB) in 2015. The NRB introduced the buffer to promote financial stability and ensure that the country's banking sector remains resilient during periods of economic downturn.

The credit-to-GDP ratio is a critical indicator used by the NRB to determine when the buffer should be activated. According to data from recent fiscal years, the credit-to-GDP ratio in Nepal fluctuated significantly, peaking at 95.87% in 2077/78 (2020/21) before gradually declining to 90.58% in 2080/81 (2023/24 P).

The NRB sets the buffer requirement based on the credit-to-GDP gap, which is the difference between the actual credit-to-GDP ratio and its long-term trend. The following table shows the buffer requirement in terms of Common Equity Tier 1 (CET1) capital:

Credit-to-GDP Gap	Buffer Requirement (% of CET1)
Up to 5 points	0%
5 to 6 points	0.5% Related story Bankers fear 2.5% countercyclical buffer will hit lending capac...
6 to 7 points	1%
7 to 8 points	1.5%
8 to 9 points	2.0%
above 9 points	2.5%

Source:Capital Adequacy Framework

Nepal's credit-to-GDP ratio for the fiscal year 2080/81 (2023/24 P) stands at 90.58%, reflecting a period of moderate credit growth following a peak during the COVID-19 pandemic in 2077/78 (2020/21). During this period, the NRB likely implemented a higher buffer requirement due to the sharp increase in credit flow.

Credit Flow and GDP Growth in Nepal

The credit-to-GDP gap is calculated as the difference between the credit-to-GDP ratio and its trend:
Credit to GDP Gap(t) = Credit to GDP Ratio(t) – Trend(t)

Trend defines the average credit-to-GDP ratio of the past five years.

The banks must increase the buffer level by up to 12 months, but they are free to lower it immediately afterward. The bank will not be permitted to disperse its profits if it cannot maintain the countercyclical buffer requirement.

The credit-to-GDP ratio in Nepal offers a clear picture of the country's economic health and financial stability over the past few years. The table below highlights the trends in credit flow, GDP, and credit-to-GDP ratio from fiscal year 2075/76 (2018/19) to 2080/81 (2023/24 P):

 (in million NPR)

Source: NRB monthly data

The Nepal Rastra Bank (NRB) initially introduced the Countercyclical Capital Buffer (CCyB) at 2% for the fiscal year 2076/77, intending to implement it. However, due to the fear of adverse economic impact of COVID-19, the implementation was postponed to provide financial relief to industries, businesses, and professionals affected by the pandemic, while ensuring the financial sector remained stable. This postponement eased loan disbursements by reducing the capital requirements for banks. If the CCyB had been implemented, banks would have needed to maintain a Capital Adequacy Ratio (CAR) of 13%, but without it, the CAR requirement remained at 11%. The buffer was temporarily removed to promote easier loan access and sustain economic activity.

In fiscal year 2080/81, the Countercyclical Capital Buffer (CCyB) was reintroduced in Nepal due to a credit-to-GDP gap of 6.09%, surpassing the 5% threshold necessary to activate it. Banks were directed to maintain 0.5% CCyB by the fiscal year end 2080/81. However, for the following year, 2081/82, the CCyB was not activated. The credit-to-GDP ratio stood at 90.58%, with a five-year average of 88.91%, yielding a gap of only 1.66%. Since this gap was below the 5% threshold, the CCyB remained inactive.

Implications for Financial Stability in Nepal

The NRB’s application of the CCyB ensures that banks maintain adequate capital buffers to weather periods of financial instability. By adjusting capital requirements based on the credit-to-GDP ratio, the NRB can mitigate the risk of a credit bubble or economic downturn.

The buffer also supports investor confidence by ensuring that banks have the necessary capital to absorb losses without threatening the overall financial system. This is particularly crucial in Nepal, where the banking sector plays a central role in economic development.

Global Comparisons and Lessons for Nepal

When compared with other countries, Nepal's implementation of the CCyB is relatively conservative, reflecting the country's developing economy and unique credit dynamics. While countries like the UK and Sweden have applied buffers as high as 2.5%, Nepal's buffer requirements have remained moderate, focused on preventing credit bubbles rather than addressing large-scale financial crises.

However, as the economy grows and credit expansion accelerates, Nepal may need to adopt a more aggressive stance, particularly in sectors like real estate and unproductive sectors, where credit growth could become unsustainable.