What can be done to make the world's financial markets more resilient and the 'real economy' more stable? Paul Tucker, Deputy Governor of the Bank of England, sets out his thinking on new macroprudential policies that are needed
There is a widespread agreement that we must all do our utmost to avoid a financial crisis like this again. And to do so we need a more resilient financial system that will be less prone to boom and bust. Part of the solution lies in the regimes that restrain the behaviour of banks and dealers so that they can withstand adversity. But another part lies in whether the authorities can lean against the boom phase of the credit cycle.
That's why in late November the Bank of England published a discussion paper on the possible role of macroprudential policy in helping to restrain the future build-up of risks within the financial system, and the threat these can pose to the economy generally. The aim would be to make the financial system more resilient and the real economy therefore more stable. With its focus on systemic risk, macroprudential policy sits between pure macroeconomic policy and the micro regulation of individual financial institutions. Along with regulators, central banks have a clear interest in helping to develop ideas in this area, not least to avoid an unrealistic burden being placed on monetary policy. The recent crisis has reminded everyone that the business cycle and the credit cycle are not always the same.
The key elements of this debate can be put under the following headings: policy aims and objectives; policy instruments; whether to deploy those instruments on the basis of rules or by using discretionary judgment; and international cooperation. Behind its technical detail, there lies the straightforward question of whether our economies can create regimes in which the authorities are ready and able, as the Federal Reserve's Chairman William McChesney Martin put it some 50 years ago, "to take away the punchbowl when the party threatens to get out of control." Having a body that meets regularly to consider precisely that issue might serve us well because it would mean that during the good times at least one body remains focused on how the good times might go sour. But that sort of body is feasible only if we can design the instruments and mechanisms needed to hold to account the relevant authorities.
To begin with the aims and objectives, in big picture terms these include quelling asset price booms, targeting credit growth and strengthening the resilience and performance of the banking system during credit booms and busts. The Bank of England discussion paper aired the possibility of focusing on the resilience of the banking system over the credit cycle because that would indirectly affect credit supply conditions and so help to lean against credit-fuelled booms.
So why not target asset prices? Essentially because we at the Bank of England feel that the threat to financial stability is greatest when exuberance in asset markets is accompanied by excess credit growth and indebtedness. It is the impact of falling asset prices on an over-levered and liquidity stretched financial system that imperils the provision of essential financial services to both businesses and households. But, in that case, why not cast the objective solely in terms of targets for credit growth? We doubt it would be feasible. Macroprudential instruments could be deployed to influence the terms on which credit is supplied by the banking sector, but the resulting growth of credit will also depend on demand conditions which lie beyond the direct reach of macroprudential instruments. Also, residents of industrialised countries are free to borrow abroad, so total credit growth cannot be controlled by constraining domestic lenders. But there is no good reason to turn our backs on the free flow of capital across borders, so we need a macroprudential regime that caters for that.
Focusing on the dynamic resilience of the domestic banking sector’ would be likely to act to some degree as a circuit-breaker on domestic credit supply. So there would be an effect on credit conditions, and so plausibly some indirect taming of the credit cycle during the upswing. And, crucially, during the subsequent downswing, the macroprudential dial could be relaxed where necessary to lean against the risks of a perverse downward spiral in the supply of credit, the economy and the strength of the banking system.
Turning to policy instruments, the obvious ones are capital and liquidity requirements for banks, and how much collateral they must take when lending to borrowers on a secured basis (often known as ‘haircuts’). Let’s take by way of illustration just one approach; that of applying a top-up or ‘surcharge’ over and above the usual regulatory minimum capital requirement. Those surcharges could be applied to headline capital requirements or at a more disaggregated level, through ‘risk weights’ on different classes of lending and exposure. To lean against accumulating risks to stability, they would need to vary counter-cyclically, increasing in a credit boom and perhaps falling during a cyclical contraction in the supply of credit.
The case for focusing on particular classes of lending is as follows; imagine that the authorities judge that a boom in lending to a particular sector of the economy had become overly exuberant and so threatens stability. Assume that this lending was to the shadow banking system (say conduits, special investment vehicles and so on). If the authorities were to raise the headline minimum capital ratio, banks could respond in a number of ways, including the perverse reaction of cutting lending to parts of the real economy that were showing no signs of exuberance, while continuing to lend on overly relaxed terms to the exuberant shadow banking system. In the real world this might well happen if lending of this sort seemed to offer terrific returns. A regime like that would not command support for long. Of course, the focus should sometimes be aggregate credit conditions, but if the relevant authority were always to delay its intervention until everything was booming, it might be harder to restore calm to the party.
To turn to the key question of whether clear-cut rules or the discretionary judgement of the authorities should determine the use of policy instruments, it’s worth saying that many commentators would ideally like policymakers to use simple rules. This helps people to understand what is going on, and makes it easier to hold policymakers to account. But accountability for a flawed rule helps nobody very much, and we at the Bank of England are doubtful that such a thing as a simple rule either exists or could be developed. If that view is correct, then judgment would always be needed to make reasonable policy choices. That in turn would call for an assessment of the resilience of the system, credit conditions, sectoral indebtedness and systemic spillovers. In short, all the available evidence would need to be weighed.
In very broad terms, this would be akin to applying Basel-Capital-Accord Pillar II-type judgments to banks in general. Doing so would share with the Pillar II element of micro prudential regulation a focus on the circumstances that warranted a capital charge different from the Pillar 1 minimum. But it would also differ in a number of important respects; first, any changes would have to be applied to all banks in the authorities’ jurisdiction, with individual banks being affected differently depending on their exposure to risk. Second, raising of capital requirements would depend on the problems facing the whole system, including how badly banks were exposed to each others’ risks. Third, although in the micro prudential setting Pillar II always adds to the Pillar I minimum, a macroprudential authority might actually reduce risk weights and therefore capital requirements during a credit cycle’s downswing. Fourth, application of a capital charge would need macroeconomic as well as financial system inputs, so to the extent that top-down stress tests were employed as one of these inputs, there could not be a standard battery of mechanical scenarios. They would need to be tailored to the risks confronting the financial system and the economy as a whole.
It would be important to constrain such a macroprudential regime so as to ensure transparency, accountability and a degree of predictability. That in turn would call for a very clear timetable for taking decisions, and for public explanations of those policy decisions. Even if the relevant authority had not actually used its policy instruments, a public explanation of the areas of banking it had examined might help to focus the minds of banks’ managements and the boards of directors.
What of the international dimension? There are big questions about whether a country could do any of this on its own, and whether tight co-ordination would be both needed and would be effective enough.
A useful illustration might be a case where the financial stability authorities in one country increased the risk weight on, say, domestic mortgage lending. The measure would apply only to banks headquartered domestically or operating out of a subsidiary, but could not apply to branches of foreign headquartered banks, still less to pure by cross-border activity. It is easy to imagine that, rather than borrowing from domestically-domiciled banks, mortgage brokers would arrange for households to borrow from a lender based abroad, or at least with the loan booked abroad. In terms of the accumulation of debt in the sector concerned – in this hypothetical case, households – there might be little or no effect. That would obviously not be great for the risk of default by the borrowing sector concerned, but domestically based banks would have been required to build their defences. If so, the damage to those domestic-based banks of any financial strain would be reduced, and the eventual economic costs might be lower, especially if they were able to take up some of the slack created by withdrawal of credit supply by foreign banks to sound borrowers.
One might even go further than that. In the first place, a domestic authority increasing capital or liquidity requirements on lending by its banks to a particular sector could act as a signal to international counterparts like to the home authorities of overseas banks. It would clearly be important to share this sort of analysis with peer organisations elsewhere, even if things went no further than that. More market transparency would of course strengthen that international dialogue and might usefully form part of a wider discussion on the use of macroprudential instruments. For putting in place a workable framework for macroprudential policy is now one of the great challenges facing our generation, and an active exchange of ideas is needed. The thoughts set out here draw on existing work by other regulators and central banks, but a lot more work is needed before policies of this sort could be put into practice. There are plenty of other elements to such a regime, but at least a debate is now under way.