This paper develops a multivariate filter based on an unobserved component trend-cycle model. It incorporates stochastic volatility and relies on specific formulations for the cycle component. We test the performance of this algorithm within a Monte-Carlo experiment and apply this decomposition tool to study the evolution of the financial cycle (estimated as the cycle of the credit-to-GDP ratio) for the United States, the United Kingdom and Ireland. We compare our credit cycle measure to the Basel III credit-to- GDP gap, prominent for its role informing the setting of countercyclical capital buffers. The Basel-gap employs the Hodrick-Prescott filter for trend extraction. Filtering methods reliant on similar-duration assumptions suffer from endpoint-bias or spurious cycles. These shortcomings might bias the shape of the credit cycle and thereby limit the precision of the policy assessment reliant on its evolution to target financial distress. Allowing for a flexible law of motion of the variance covariance matrix and informing the estimation of the cycle via economic fundamentals we are able to improve the statistical properties and to find a more economically meaningful measure of the build-up of cyclical systemic risks. Additionally, we find a large heterogeneity in the drivers of the credit cycles across time and countries. This result stresses the relevance in macro prudential policy of considering flexible approaches that can be tailored to country characteristics in contrast to standardized indicators.

The paper proposes a framework for assessing the impact of system-wide and bank-level capital buffers. The assessment rests on a factor-augmented vector autoregression (FAVAR) model that relates individual bank adjustments to macroeconomic dynamics. We estimate FAVAR models individually for eleven euro area economies and identify structural shocks, which allow us to diagnose key vulnerabilities of national banking systems and estimate short-run economic costs of increasing banks? capitalisation. On this basis, we run a fully-fledged cost-benefit assessment of an increase in capital buffers. The benefits are related to an increase in bank resilience to adverse shocks. Higher capitalisation allows banks to withstand negative shocks and moderates the reduction of credit to the real economy that ensues in adverse circumstances. The costs relate to transitory credit and output losses that are assessed both on an aggregate and bank level. An increase in capital ratios is shown to have a sharply different impact on credit and economic activity depending on the way banks adjust, i.e. via changes in assets or equity.