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IAI Actuarial Core Principles · Business Economics · Role, structure and stability of the financial system

Before a financial crisis, banks are observed to extend large amounts of credit to risky borrowers and rely on rising asset prices to justify this. Which policy tool is designed specifically to counter this build-up of system-wide risk in the upswing?

A countercyclical capital buffer is the macroprudential tool aimed at this problem. It makes banks hold extra capital when credit growth is excessive, strengthening their loss-absorbing capacity and dampening the boom, unlike rate cuts or spending which do not target systemic risk directly.

  1. AA countercyclical capital buffer that requires banks to hold more capital when credit growth is excessiveCorrect
  2. BA cut in the policy interest rate to stimulate more lending
  3. CA reduction in deposit insurance coverage to zero
  4. DRemoval of all reserve requirements
  5. A rise in government spending on infrastructure

Explanation

Macroprudential policy targets procyclicality. A countercyclical buffer raises capital requirements during credit booms, increasing resilience and tempering lending. Rate cuts would add to the boom; the other options do not address build-up of systemic risk.

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