) has been given until 1 november of this year to assess criteria for identifying systemically important financial institutions. these assessments are being done in collaboration with norges bank. 1 the countercyclical capital buffer is designed to act as a buffer against systemic risk that varies over time. the size of the buffer is to be assessed each quarter, and will normally be between 0 and 2. 5 percent of risk - weighted assets. on 4 october, a regulation relating to the countercyclical capital buffer was issued by the government. norges bank has been tasked with preparing a basis for the buffer decision and providing advice to the ministry of finance regarding the buffer four times a year. in preparing its advice, norges bank will exchange relevant information and assessments with finanstilsynet. since march of this year, norges bank has published an assessment of the need for a countercyclical capital buffer in the monetary policy report in addition to its monetary policy assessment. norges bank will give its first advice on the level of the buffer to the ministry of finance in connection with the next monetary policy report, to be published at the beginning of december. in line with the purpose of the countercyclical capital buffer, norges bank has formulated three criteria for setting an appropriate countercyclical capital buffer. the buffer should ensure that the resilience of banks is strengthened during an upturn. the buffer requirement ( size of the buffer ) should be viewed in the light of other requirements applying to banks, particularly when new requirements are introduced. one of the most important purposes of the capital buffer is to alleviate stress in the financial system. history shows that the groundwork for banking crises is laid during upturns. when financial imbalances build up, this increases the likelihood of substantial losses in the entire banking system. in an environment characterised by large losses, insufficient equity capital may force banks to curtail lending to households and enterprises, amplifying a downturn. banks should therefore hold larger capital buffers when financial imbalances are building up or have built up. norges bank ’ s advice regarding the buffer will primarily be based on four key indicators : total credit as a percentage of mainland gdp, the wholesale funding ratio of norwegian credit institutions, the ratio of house prices to disposable income and commercial property prices. both economic theory and historical experience from a number of countries provide support for the view that these indicators capture systemic risk. the chart shows the indicators along with

, they will have to tighten lending. this may serve to amplify the downturn, as is currently the case in a number of european countries. compared with other enterprises, banks have limited equity capital. it is often more costly for banks to fund lending with equity capital than with deposits and borrowing from the market. as deposits are readily available to depositors and many deposits are covered by a deposit guarantee, depositors accept a relatively low interest rate. the insurance premium banks pay for the deposit guarantee bears little relation to the risk the bank takes. in addition, since investors can expect that the authorities will come to the aid of banks in distress, they may be satisfied with a lower return. the result is an underpricing of risk, potentially leading to excessive risk - taking. bis central bankers ’ speeches low equity ratios reduce loss - absorbing capacity and, at the same time, strengthen the incentive to take risks. while owners cannot lose more than their equity stake, there is a potential for high returns on the equity capital they have invested. banks ’ owners lack incentives to take full account of the risk imposed on creditors. to avoid a situation where banks hold inadequate equity capital, banks are subject to capital requirements. each bank should hold capital in proportion to its risk exposure. this is the basis of microprudential bank regulation. but even if each individual bank appears to be solid on its own, the banking system as a whole may be vulnerable. risk in the system has several sources. externalities between banks are one important source. banks are exposed to one another and can inflict losses on one another directly. banks can also inflict substantial losses on one another if they have shared exposures outside of the banking system. this was clearly evident during the financial crisis. when a bank is forced to sell off assets, these assets fall in value. 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