The key policy rate is set with a view to keeping inflation close to 2.5 percent over time without triggering excessive fluctuations in output and employment. Monetary policy also seeks to be robust and take into account the risk that financial imbalances in the economy build up. Even though the objectives differ, both of these instruments work through banks’ responses. The level of the countercyclical buffer may therefore affect the conduct of monetary policy. Increased buffer requirements may induce banks to increase their lending margins or restrict access to credit in other ways. More restrained lending growth will dampen economic activity. This will in turn contribute to lower inflation. Thus, an increase in capital requirements resulting in rising lending margins suggests, in isolation, a lower key policy rate. Other developments in the economy may amplify or dampen this effect. Allow me to refer to a recently developed version of our model for the Norwegian economy, NEMO, to illustrate this point. In this version of NEMO, the credit market is modelled explicitly. 6 Households and enterprises can borrow from banks, but only against equity. For a household, the value of their dwelling is important as collateral. A rise in house prices can thereby allow households to borrow more, increasing their debt. This mechanism is an example of what is referred to in the literature as a financial accelerator. 7 In the model, banks also face capital requirements that affect their capital costs.

This weakens the balance sheets of other banks holding the same type of assets. Systemic risk also arises from externalities in the interaction between the financial system and the real economy. Financial crises generally occur following a period of mutually reinforcing increases in credit, property prices and demand for goods and services, culminating in a bubble that reaches bursting point. Each individual loan makes a scant contribution to overall risk, but gradually, as debt burdens increase, the economy becomes more vulnerable to shocks. Chart 1 shows that Norway has also experienced periods of especially strong credit growth that have been interrupted by financial crises. The subsequent losses in the real economy have been substantial. Ahead of both the banking crisis of the 1990s and the financial crisis, lending growth far outpaced growth in deposits. Banks relied increasingly on short-term wholesale funding, exacerbating the vulnerability of the banking system itself. Wholesale funding often dries up or becomes considerably more expensive in turbulent times. Banking regulation must therefore include a macroprudential perspective. The purpose is to dampen the build-up of systemic risk and ensure that the banking system as a whole is resilient to shocks. In a number of countries, frameworks are now being established for macroprudential regulation, along with efforts to put policy instruments in place. In Norway, the Financial Institutions Act has recently been amended, with effect from July 2013. The amendments have been harmonised with new EU regulations. The amended act sets higher capital requirements for Norwegian banks and includes a countercyclical capital buffer.