Macroprudential – Page 3 – Digital Finance Analytics (DFA) Blog

Business Lending Crunched – Investment Lending Apart

The final set of ABS data on finance for July 2016 includes all forms of lending, and does not tell a good story. Whilst investment housing lending grew, lending for productive business growth fell, again.

Here is the summary, having separated business lending for housing investment purposes, versus the rest. As normal we will focus on the trend data, which irons out some of the noise in the data, to see through to the underlying movements.

Lending for secured construction and purchase of dwellings fell 0.1%, or $20m, month on month, secured alterations rose just a little, personal finance rose 0.1% or $6m and overall commercial lending fell 1.75% or $671m compared with last month, and continues to fall.

Within the business or commercial flows, lending for investment property rose 1.1% or $127m, compared with last month, whilst lending for other commercial purposes fell 2% or $384m. Revolving commercial credit fell 5% down $416m.

So productive lending to business continues to fall, and overall lending is being supported by more investment housing. As a result, the proportion of business lending for investment housing rose again to 31% of commercial lending, whilst lending for other commercial purposes fell again to 48.2% of all commercial lending. These trends need to be reversed if we are to get real productive economic growth to kick in.

Finally, for completeness, here is the housing data, once again showing the ongoing rise in the proportion of investment housing lending, up 1.1% or $127m on last month, and up from 35.9% to 36.1% of total flows.

We think tighter macroprudential measures are overdue.

NZ Tightens Mortgage Lending Rules From 1 October

The NZ Reserve Bank today confirmed that new macroprudential rules tighten restrictions on bank lending to residential property buyers throughout New Zealand. Residential property investors will generally need a 40 percent deposit for a mortgage loan, and owner-occupiers will generally need a 20 percent deposit.

From 1 October, residential property investors will generally need a 40 percent deposit for a mortgage loan, and owner-occupiers will generally need a 20 percent deposit. In both cases, banks are still allowed to make a small proportion of their lending to borrowers with smaller deposits.

Confirmation of the new rules is in the Reserve Bank’s response to submissions to its public consultation about changes to Loan to Value Ratio (LVR) rules that was issued on 19 July.

The Reserve Bank is modifying its proposals in response to public consultation, and also through meetings and workshops with banks that are subject to the rules.

The new rules take effect on 1 October 2016, but banks have chosen to start following the new limits already.

Existing exemptions to LVR restrictions will continue to apply under the new rules and have been extended to include borrowing for a newly-built home, or to do work needed for a residence to comply with new building codes and rental-property standards.

BIS, FSB and IMF publish elements of effective macroprudential policies

The International Monetary Fund (IMF), Financial Stability Board (FSB) and Bank for International Settlements (BIS) released today a new publication on Elements of effective macroprudential policies. The document, which responds to a G20 request, takes stock of the international experience since the financial crisis in developing and implementing macroprudential policies and will be presented to the G20 Leaders’ Summit in Hangzhou.

Following the global financial crisis, many countries have introduced frameworks and tools aimed at limiting systemic risks that could otherwise disrupt the provision of financial services and damage the real economy. Such risks may build-up over time or arise from close linkages and the distribution of risk within the financial system.

Experience with macroprudential policy is growing, complemented by an increasing body of empirical research on the effectiveness of macroprudential tools. However, since the experience does not yet span a full financial cycle, the evidence remains tentative. “The wide range of institutional arrangements and policies being adopted across countries suggest that there is no ‘one-size-fits-all’. Nonetheless, accumulated experience highlights – and this paper documents – a number of elements that have been found useful for macroprudential policy making,” the publication says. These include:

A clear mandate that forms the basis for assigning responsibility for taking macroprudential policy decisions.

Adequate institutional foundations for macroprudential policy frameworks. Many of the observed designs give the main mandate to an influential body with a broad view of the entire financial system.

Well-defined objectives and powers that can foster the ability and willingness to act.

Transparency and accountability mechanisms to establish legitimacy and create commitment to take action.

Measures to promote cooperation and information-sharing between domestic authorities.

A comprehensive framework for analysing and monitoring systemic risk as well as efforts to close information gaps.

A broad range of policy tools to address systemic risk over time and from across the financial system.

The ability to calibrate policy responses to risks, including by considering the costs and benefits, addressing any leakages, and evaluating responses. In financially integrated economies, this includes assessing potential cross-border effects.

The document includes some data on the use of macroprudential tools; illustrative examples of institutional models for macroprudential policymaking; and a brief summary of some of the empirical literature on the effectiveness of macroprudential tools.

“Usage” counts the number of countries using the various instruments that comprise each group. Assuming that once a country introduces an instrument, it continues using it, the charts show usage of the various groups of instruments.

Institutional arrangements adopted by a country are shaped by country-specific circumstances, such as political and legal traditions, as well as prior choices on the regulatory architecture. While there can therefore be no “one size fits all” approach, in practice, there has been an increasing prevalence of models that assign the main macroprudential mandate to a well-identified authority, committee, or interagency body, generally with an important role of the central bank. While each of these models has pros and cons, any one model can be buttressed with additional safeguards and mechanisms.

Model 1: The main macroprudential mandate is assigned to the central bank, with its Board or Governor making macroprudential decisions (as in the Czech Republic, Ireland, New Zealand and Singapore). This model is the prevalent choice where the central bank already concentrates the relevant regulatory and supervisory powers. Where regulatory and supervisory authorities are established outside the central bank, the assignment of the mandate to the central bank can be complemented by coordination mechanisms, such as a committee chaired by the central bank (as in Estonia and Portugal), information sharing agreements, or explicit powers assigned to the central bank to make recommendations to other bodies (as in Norway and Switzerland).

Model 2: The main macroprudential mandate is assigned to a dedicated committee within the central bank structure (as in Malaysia and the UK). This setup creates dedicated objectives and decision-making structures for monetary and macroprudential policy where both policy functions are under the roof of the central bank, and can help counter the potential risks of dual mandates for the central bank (see further IMF 2013a). It also allows for separate regulatory and supervisory authorities and external experts to participate in the decision-making committee. This can foster an open discussion of trade-offs that brings to bear a range of perspectives and helps discipline the powers assigned to the central bank.

Model 3: The main macroprudential mandate is assigned to an interagency committee outside the central bank, in order to coordinate policy action and facilitate information sharing and discussion of system-wide risk, with the central bank participating on the committee (as in France, Germany, Mexico, and the US). This model can accommodate a stronger role of the Ministry of Finance (MoF). Participation of the MoF can be useful to create political legitimacy and enable decision makers to consider policy choices in other fields, e.g. when cooperation of the fiscal authority is needed to mitigate systemic risk.

Monetary versus macroprudential policies

Monetary policy, as currently being implemented, is failing to deal with the current raft of economic issues, including low inflation, stagnant wage growth, high asset prices and ultra low policy rates. When coupled with politicians taking a back seat and their inability to tackle the core issues, macroprudential measures are being tried, in a massive real-time experiment. This coupling of monetary and macroprudential action is largely untested. Can they work in tandem?

A Bank of England working paper “Monetary versus macroprudential policies causal impacts of interest rates and credit controls in the
era of the UK Radcliffe Report“, attempts to look at this issues, with some interesting results. They conclude that macroprudential policy is better suited to achieving financial stability goals than monetary policy.

The Global Financial Crisis and its disappointing aftermath are widely viewed as a major macroeconomic policy disaster from which lessons must be learned. Yet agreement on the precise failures and, thus, the necessary lessons, has been elusive in many areas, from mortgage regulation to fiscal policy, and from global imbalances to central banking. In the latter case, the role of macroprudential policies remains fraught, with doubts about whether they should exist, if they work, and how they should be designed and used.

Reflecting this range of skepticism, several countries have recently taken quite varied courses of action in retooling their policy regimes since 2008. For example, facing a heating up of their housing markets in 2010–12, Sweden and Norway took quite different policy actions. Sweden’s Riksbank tried to battle this development using monetary policy tools only, raising the policy rate, and tipping the economy into deflation, as had been predicted by the dissident Deputy Governor Lars Svensson, who subsequently resigned. Across the border, the Norges Bank implemented some cyclical macroprudential policies to crimp credit expansion and moderate mortgage and house-price booms, without relying as much on rate rises, and they managed to avoid such an out-turn. Elsewhere, other countries display differing degrees of readiness or willingness to use time-varying macroprudential policies. The Bank of England now has both a Financial Policy Committee and a Monetary Policy Committee, and the former has already taken macroprudential policy actions under Governor Mark Carney. As Governor of the Bank of Israel, Stanley Fischer utilized macroprudential policies against perceived housing and credit boom risks, but now as Vice-Chair at the Federal Reserve his speeches lament the lack of similarly strong and unified macroprudential powers at the U.S. central bank. Yet as one surveys these and other tacks taken by national and international policymakers, two features of the post-crisis reaction stand out: the extent to which these policy choices have proved contentious even given their limited scope and span of operation, and the way that the debate on this policy revolution has remained largely disconnected from any empirical evidence. And of course, the two features may be linked.

This paper seeks a scientific approach that might address both of these shortcomings, by bringing a new and vastly larger array of formal empirical evidence to the table. To that end, we turn to the last great era of central bank experimentation with the same types of macroprudential instruments: the postwar decades from the 1950s to the early 1980s when many types of credit controls were put in play. We go back and construct by hand new quantitative indicators on the application of such policies in the UK, including credit ceilings, hire purchase regulations, special deposits, and the “Corset.” To evaluate the impacts of these policies, and to compare them with the impacts of the standard monetary policy tool of Bank Rate, we then implement a state-of-art econometric estimation of impulse-response functions (IRFs) to the two policy shocks by developing a new approach to identification that is also original to this paper, one that we shall refer to as Factor-Augmented Local Projection (FALP). Our approach unites the flexible and parsimonious local projection (LP) method of estimating IRFs with the Romer and Romer approach of using forecasts to mitigate the selection bias arising from policymakers acting on their expectations of future macroeconomic developments. To ensure greater robustness, we also borrow from the factor augmentation approach that has been employed in the VAR literature as a means to control for other information correlated both with changes in policy and future macroeconomic developments. We subject our results to a range of robustness tests, most of which give us little reason to doubt our main results.

We report three main results. First, we find that monetary and credit policies had qualitatively distinct effects on headline macroeconomic indicators during this period. Increases in Bank Rate had robust negative effects on manufacturing output, and consumer prices especially, and positive effects on the trade balance. However, the estimated response of bank lending to an increase in Bank Rate is not statistically significant. By contrast, we find that credit controls — liquidity requirements on banks, credit growth limits, and constraints on the terms of consumer finance — had a strong negative impact on bank lending. We also find some evidence that credit policies may have depressed output, improved the trade balance, and led to an increase in consumer prices. But our evidence here is less strong than for corresponding shifts in Bank Rate. Overall, our estimates suggest that monetary and credit policies spanned different outcome spaces during this period. This result supports the notion that today’s macroprudential tools, which are close cousins of the credit policies studied in this paper, might provide the additional independent tools required to help central banks meet both their monetary and financial stability objectives.

Second, we find that our estimated monetary and credit policy shocks were major drivers of macroeconomic dynamics over the 1960s and 1970s. A significant fraction of lending and output dynamics can be explained by these shocks. Moreover, we find that a large fraction of the pick-up in inflation in the 1970s can be attributed to expansionary monetary policy shocks — that is, interest rates were substantially looser in the latter part of our sample than would have been expected given available econonomic forecasts and the information about the state of the economy contained in our estimated factors.

Third, our impulse responses indicate that credit policies had moderating effects on modern-day indicators of financial system vulnerabilities, while the effects of monetary policy actions were less clear cut. Contractionary credit policies had large and persistent negative effects on the credit-to-GDP ratio; they also reduced banks’ loan to deposit ratios (a measure of their resilience), and increased the spread between debentures i.e. term corporate debt instruments and gilts (a measure of investor risk appetite). In contrast, we find that contractionary monetary policy led to a persistent increase in the credit-to-GDP ratio, as the fall in GDP exceeded the fall in credit. Contractionary monetary policy actions also led to a small reduction in banks’ loan-to-deposit ratios, but led to a large persistent increase in the debenture spread. Our results therefore provide some support to the view that macroprudential policy is better suited to achieving financial stability goals than monetary policy.

Note: Staff Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Any views expressed are solely those of the author(s) and so cannot be taken to represent those of the Bank of England or to state Bank of England policy. This paper should therefore not be reported as representing the views of the Bank of England or members of the Monetary Policy Committee, Financial Policy Committee or Prudential Regulation Authority Board

Limiting the Effects of the Global Financial Cycle

Falling interest rates imposed on the Australian economy by the RBA have, so far at least, not been successful in driving the desired economic outcomes. Inflation is very low, alongside wage growth, household debt is sky-high, the dollar remains high, business investment is subdued, yet asset prices are inflated. Why might this be?

The phenomenon of national boom and bust cycles within countries is well known. The boom phase is associated with rising asset prices, easier access to finance, loose risk settings, and increased leverage. This may last for many years. But at some time, the worm will turn, leading to changed risk perceptions, a fall (often sudden) in asset prices and deleverage.

However, recent analysis has shown than national financial cycles are partly subsumed by global financial cycles. These cycles are driven by the policy settings of large countries, like the USA and China, in the context of global financial markets. We see the longer for lower interest rate settings leading to global players searching for yield. As a result, the price of risk falls. These forces collide with the local economies. So will central banks in smaller, open economies be able to make local monetary adjustments successfully when monetary policy transmission mechanism is affected by global risk factors and that these factors may move in the opposite direction to conventional monetary policy moves?

A timely Bank of Canada working paper “The Global Financial Cycle, Monetary Policies and Macroprudential Regulations in Small, Open Economies“, looks at this issue and draws some important conclusions.

Specifically, for small open economies, like Canada, and Australia, while there are large costs associated with financial crises, they suggest that the central banks’ leaning against the effects of the global financial cycle would typically be too costly. Central banks cannot rely on a combination of conventional and unconventional monetary policies alone to offset the effects of financial crises. Some form of micro- and macroprudential policies are also required to lower both the likelihood and severity of a crisis.

Here is their non-technical summary:

This paper offers an overview of the implications of the global financial cycle for conventional and unconventional monetary policies and macroprudential policy in small, open economies (SOEs) such as Canada. We start by reviewing the recent evidence on financial cycles. An important new finding is that national financial cycles may have been partly subsumed into a global financial cycle. The global financial cycle is driven, in part, by monetary policy decisions in the United States. Low-for-long U.S. policy rates cause global financial intermediaries to search for yield, which in turn leads to a decline in the cross-section of international risk premia. Risk premia form an important part of conventional and unconventional monetary policy transmission mechanisms in both large and small economies.

Next, we review the available policy actions that could be undertaken by SOE central banks and regulatory authorities to limit the effects of the global financial cycle. We show that conventional monetary policy actions in both large and small economies are affected by movements in global risk premia. The paper also examines the effectiveness of unconventional monetary policies originating in SOEs that are not coordinated with those in large countries.

If unconventional policies undertaken during financial crises are not completely effective in restoring output or inflation to their target levels, the question then arises as to whether central banks can use more aggressive conventional monetary actions to lean against the buildup of debt associated with the boom phase of the global financial cycle. We highlight new work that evaluates the potential for central banks to lean against the winds of the global financial cycle. This new work shows that the cost of leaning is quite high relative to the benefits of lowering the likelihood of either entering a house price correction episode or of triggering a new financial crisis.

We then assess to what extent macroprudential policy tools could be an alternative to curb increased risk-taking behaviour during the boom phase of the cycle. In large economies, a number of macroprudential policies are designed to break the chain that links asset allocation decisions by financial intermediaries with the resultant declines in risk premia. Such policies are likely to be less effective in SOEs, as global premia will likely not change in the face of portfolio switches by small institutions or by a relatively small number of households. At the end of the paper, we use our framework to provide suggestions for macroprudential policy reforms to improve the effectiveness of the current toolkit in SOEs.

They conclude:

New research illustrates the importance of accounting for the impact of the global financial cycle on both conventional and unconventional monetary policies as well as on macroprudential policies in small, open economies. The global financial cycle, driven in part by U.S. monetary policy decisions, affects the asset and liability allocation decisions of financial intermediaries and investors worldwide. Changes in these allocations cause time variation in global risk premia, which affects the domestic monetary policy transmission mechanism in SOEs. It also affects the conduct of macroprudential policies.

While the global financial cycle complicates the implementation of conventional and unconventional monetary policies, it does not imply that these policies are ineffective. The research does point out that the monetary policy transmission mechanism is affected by global risk factors and that these factors may move in the opposite direction to conventional monetary policy moves. This suggests that monetary policy may have to be more aggressive in the future, given the future lower level of the neutral rate. Unconventional policies may become much more conventional.
The buildup of debt during the boom phase of the global financial cycle raises the likelihood of a subsequent financial crisis. New research shows that the central banks can lean against the growth of the debt stock by keeping policy rates higher than warranted by current conditions. This is effective in lowering the likelihood of either a large house price correction or of a financial crisis over the long run. However, these effects are not large enough to overcome the negative consequences for borrowers who face a higher cost of debt. Thus the basic message of Svensson remains: In general, monetary policy should clean, not lean.

However, the costs of risk-taking behaviour induced by accommodative monetary policy should not be discussed in isolation from its benefits. The easing of monetary policy was needed to foster macroeconomic stability prior to and during the crisis, and premature removal of monetary stimulus to alleviate risk-taking behaviour could fall short of having a significant impact on the financial imbalance, hinder the recovery that it helped generate, or, under low capital or liquidity levels, even lead to a credit crunch. In addition, low interest rates may have direct positive effects on financial stability. For example, higher profit margins and lower delinquency and default rates may decrease risk aversion and raise prices of legacy assets or collateral assets, leading to healthier balance sheet.

Thus, central banks cannot rely on a combination of conventional and unconventional monetary policies alone to offset the effects of financial crises. Clearly, some form of micro- and macroprudential policies are also required to lower both the likelihood and severity of a crisis. The research surrounding the global financial cycle suggests that macroprudential policies in SOEs need to be coordinated carefully across borders and within the country itself. While capital controls may potentially diminish the impact of global financial cycles, the additional cost that they impose is likely too large. Discussions on potential use of capital controls should also be mindful of the limited evidence of their effectiveness, the absence of adequate cost-benefit analysis in the literature, their potential spillovers (i.e., the potential to divert capital flows to other countries), as well as the limited data available to assess their impact on developed-country capital markets.

Note: Bank of Canada staff working papers provide a forum for staff to publish work-in-progress research independently from the Bank’s Governing Council. This research may support or challenge prevailing policy orthodoxy. Therefore, the views expressed in this paper are solely those of the authors and may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank.

New Zealand Banks Will Benefit from Tighter Rules on High-LTV Mortgage Loans – Moody’s

According to Moody’s, New Zealand banks will benefit from tighter rules on high-LTV mortgage loans.It is also worth noting how the market responded to earlier less aggressive macroprudential measures.

On 19 July, the Reserve Bank of New Zealand (RBNZ) released a consultation paper outlining a proposal to limit bank lending to home investors at loan-to-value ratios (LTVs) above 60% to 5% of new originations and lending to owner-occupiers at LTVs above 80% to 10% of new lending. These restrictions are credit positive for New Zealand banks and their covered bond programs because they reduce their exposures to higher-risk lending at a time when house prices are at historic highs.

The proposal will be particularly beneficial to New Zealand’s four major banks, ANZ Bank New Zealand Limited, ASB Bank Limited, Bank of New Zealand and Westpac New Zealand Limited. These four banks hold approximately 86% of all New Zealand residential loans.

The tighter restrictions on LTV limits will benefit banks and their cover pools by providing a buffer against declining house prices before the size of the loan exceeds the value of the property. In the longer run, banks will have fewer high LTV loans to sell into their cover pools, which will strengthen the pools’ credit quality.

The new rules would replace existing limits that restrict new lending to investors in Auckland at LTVs greater than 70% to 5%, lending to owner-occupiers in Auckland at LTVs above 80% to 10%, and all other housing lending outside of Auckland at LTVs above 80% to 15%. The proposal is in response to the boom in New Zealand house prices, which are at historical highs, creating a sensitivity to a sharp reversal in home prices.

Although LTV restrictions protect banks against a sharp correction in house prices, it remains to be seen how effective these measures will be in moderating house price appreciation if interest rates decline further. In March 2016, the Reserve Bank of New Zealand reduced its policy rate by 25 basis points to 2.25%, the fifth reduction since June 2015, while also stating that further policy easing may be required. Furthermore, strong immigration and supply shortages continue to support house prices, particularly in Auckland.

The first of New Zealand’s macro-prudential measures, introduced in October 2013, had a sharp but temporary effect on house price growth. Further measures were introduced in 2015 that also immediately reduced house price growth in fourth quarter of 2015. However, prices rebounded and have appreciated in 2016.

The Reserve Bank of New Zealand is inviting market feedback on its proposal until 10 August, after which, a final policy will be released to take effect from 1 September 2016.

Is The Root Cause Of High House Prices What You Think It Is?

A snapshot of data from the RBA highlights the root cause of much of the economic issues we face in Australia. Back at the turn of the millennium, banks were lending relatively more to businesses than to households. The ratio was 120%. Roll this forward to today, and the ratio has dropped to below 60%. In other words, for every dollar lent now it is much more likely to go to housing than to business. This is a crazy scenario, as we have often said, because lending to business is productive – this generates real productive growth – whilst lending for housing simply pumps up home prices, bank balance sheets and household balance sheets, but is not economically productive to all.

There are many reasons why things have changed. The finance sector has been deregulated, larger companies can now access capital markets directly and so do not need to borrow from the bank, generous tax breaks (negative gearing and capital gains) have lifted the demand for loans for housing investment, and the Basel capital ratios now make it much cheaper for banks to lend against secured property compared to business. In fact the enhanced Basel ratios were introduced in the early 2000’s and this is when we see lending for housing taking off.

So how much of the mix is explained by tax breaks for investors? If we look at the ratio of home lending for owner occupation, to home lending for investment, there has been an increase. In 2000, it was around 45%, now its 55% (with a peak above 60% last year). This relative movement though is much smaller compared with the switch away from lending to business. Something else is driving it.

We therefore argue that whilst the election focus has been on proposed cuts to negative gearing and capital gains versus a company tax cut, the root cause issue is still ignored. And it is a biggie. The international capital risk structures designed to protect depositors, is actually killing lending to business, because it makes lending for housing so much more capital efficient. Whilst recent changes have sought to lift the capital for mortgages at the margin, it is still out of kilter. As a result, banks seek to out compete for mortgages and offer discounts and other incentives to gain share, whilst lending to business is being strangled. This is exacerbated by companies being more risk adverse, using high project hurdle thresholds (despite low borrowing rates) and smaller businesses being charged relatively more – based on risk assessments which are directly linked to the Basel ratios. Our SME surveys underscore how hard it is for smaller business to get loans at a reasonable price.

The run up in house prices is a direct result of more available mortgage funding, and this in turn leaves first time buyers excluded from the market. But it is too simple to draw a straight line between negative gearing and first time buyer exclusion. The truth is much more complex.

We are not convinced that a corporate tax cut, or a further cut in interest rates will stimulate demand from the business sector. Nor will reductions in negative gearing help that much. We need to re-balance the relative attractiveness of lending to business versus lending for housing. The only way to do this (short of major changes to the Basel ratios) is through targeted macro-prudential measures. In essence lending for housing has to be curtailed relative to lending to business. And that is a whole new box of dice!

Monetary/fiscal policy mix has implications for debt and financial stability

The mix of monetary and fiscal policies in an economy has important implications for debt levels and financial stability over the medium term, Bank of Canada Governor Stephen S. Poloz said.

In the Doug Purvis Memorial Lecture given at the Canadian Economics Association’s annual conference, Governor Poloz used the Bank’s main policy model to construct three “counterfactual” scenarios of events from the past 30 years that show how different policy mixes can influence the amount of debt taken on by the private and public sectors.

Tight monetary policy with easy fiscal policy may lead to the same growth and inflation results as easy monetary policy paired with tight fiscal policy in a given situation, the Governor explained. However, the consequences for government and private sector debt levels would be quite different.

Recent experience in Canada and elsewhere shows that debt levels—whether public or private—can provoke financial stability concerns, said Governor Poloz. The insight about policy mix is important as authorities worldwide work to incorporate financial stability issues into the conduct of monetary policy, he added.

The Governor stressed that the counterfactuals are intended to illustrate the impact of the policy mix on debt levels; they aren’t meant to be taken as an opinion about what the best policy mix was in the past or is now.

“Hindsight is always 20:20 and such a discussion would have little meaning,” Governor Poloz said. “The best mix of monetary and fiscal policy will depend on the economic situation.”

There should be a degree of coordination between the monetary and fiscal authorities that allows both to be adequately informed of each other’s policies and consider their implications on debt levels over the medium term, the Governor said. In Canada’s case, the central bank operates under an explicit inflation-targeting agreement with the federal government that enshrines its operational independence, while allowing for both parties to share information and judgment, Poloz said. This framework represents “a simple yet elegant form” of policy coordination, he noted.

The lecture honours Doug Purvis, a Canadian macroeconomist and Queen’s University professor. In 1985, Purvis delivered the Harold Innis Lecture, in which he argued that rising government debt levels would eventually compromise the ability of authorities to implement stabilization policies. Governor Poloz said his lecture today is meant to build on Purvis’ initial insights by bringing more advanced macroeconomic models to bear on the topic, and linking them to the topical issue of financial stability.

Unintended Consequences of Macroprudential

An IMF working paper, just released examines the impact of macroprudential policy. They conclude that implementing macroprudential does reduce the expansion of bank credit, but this is offset by a growth in non-bank credit and foreign bank lending, so the overall braking effect is less severe than expected. This substitution effect needs to be incorporated into the policy settings to deliver the desired credit growth management. Here is a summary.

Macroprudential policy is alive and kicking. It is being used actively both in emerging market economies and—following the global financial crisis—in advanced economies. It includes measures that apply directly to lenders, such as countercyclical capital buffers or capital surcharges, and restrictions that apply to borrowers, such as loan-to-value (LTV) and loan-to-income (LTI) ratio caps. Most macroprudential measures activated around the globe between 2000 and 2013 apply to the banking sector only, including borrower-based measures.

The widespread use of macroprudential policy is aimed at reducing systemic risks. Yet the use of national sector-based measures may be subject to a boundary problem, causing substitution flows to less regulated parts of the financial sector. Specifically, macroprudential policy may have the consequence of shifting activities and risks both to: (i) foreign entities (e.g., bank branches and cross-border lending); and (ii) nonbank entities (e.g., shadow banking, also referred to as market-based financing). Whereas several papers have estimated intended effects of macroprudential policies (MaPs) on variables such as credit growth and housing prices, and whether measures leak to foreign banks, cross-sector substitution effects have—to the best of our knowledge—not yet been tested empirically.

This paper aims to fill this gap. It investigates whether macroprudential policies lead to substitution from bank-based financial intermediation to nonbank intermediation. In addition, it uses event study methodology to shed light on the timing of the effects of policy measures on bank and nonbank intermediation around activation dates. Moreover, we contribute to the literature by distinguishing between the effects of quantity versus price-based instruments and lender versus borrower-based instruments, given that the effects may differ. We also check whether results differ for advanced economies (AEs) versus emerging market economies (EMEs) and bank versus market-based financial systems.

Our results support the hypothesis that macroprudential policies reduce bank credit growth. In our sample, in the two years after the activation of MaPs, bank credit growth falls on average by 7.7 percentage points relative to the counterfactual of no measure. This effect is much stronger in EMEs than in AEs. Beyond this, our results suggests that quantity-based measures have much stronger effects on credit growth than price-based measures, both in advanced and emerging market economies. In cumulative terms, quantity measures slow bank credit growth by 8.7 percentage points over two years relative to the counterfactual of no policy change.

Our main contribution to the literature relates to substitution effects: we find that the effect of MaPs on bank credit is always substantially higher than the effect on total credit to the private sector. Whereas bank credit growth falls on average by 7.7 percentage points relative to the counterfactual of no measure, total credit growth falls by 4.9 percentage points on average. The reason for this is the increase in nonbank credit growth. We also find significant differences between country groups and instruments. First, substitution effects are stronger in AEs. This is in line with expectations given their more developed financial systems, with a larger role for market-based finance. Second, substitution effects are much stronger in the case of quantity restrictions, which are more constraining than price-based measures. Finally, we find strong and statistically significant effects on specific forms on nonbanking financial intermediation, such as investment fund assets.

Our paper builds on a rapidly expanding literature. While the concept of macroprudential policy can be traced back at least to the late 1970’s, it has become a common part of the policy lexicon in the first decade of this millennium. The global financial crisis has led not only to much more interest in the macroprudential approach, but also to active use of macroprudential instruments around the world.

The active use of instruments has spawned a growing empirical literature on the effectiveness of macroprudential policies, in individual country, regional and global settings. The most comprehensive study, who uses an IMF survey to document macroprudential policies in 119 countries over the 2000–13 period. They find that the implementation of such instruments is generally associated with the intended lower impact on credit, but that the effects are weaker in financially more developed and open economies.

In addition, to its intended effects, macroprudential policy may leak. Macroprudential policy may also increase crosssector substitution. A recent study by the IMF finds that more stringent capital requirements are associated with stronger growth of shadow banking. Our paper uses both net flow measures and an event study methodology to shed light on the size and timing of cross-sector substitution effects. Our empirical framework builds on work that has sought to explain credit growth, for instance to understand credit rationing and the monetary transmission mechanism. We control for macroeconomic fundamentals to filter out effects of policy on credit growth in a crosscountry panel setting.

Our results do not allow us to assess whether substitution effects reduce or increase systemic risks. A lowering of systemic risks may be expected, as risks may shift to institutions that are less leveraged and less subject to maturity mismatch. But this need not be the case, as market failures and systemic risks may also arise outside the regulated banking sector.

Overall, our findings underline the relevance of such a broad approach to monitoring and addressing systemic risks, especially for advanced economies. Earlier findings on cross-border leakages indicate that macroprudential policy should not take a narrow national perspective, as this would fail to internalize cross-border substitution effects. Our results on cross sector substitution complement these findings, and suggest that macroprudential policy should not take a narrow sectoral perspective.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Macroprudential, Capital and LVR Controls

A newly released IMF working paper examines the impact of macroprudential controls, including lifting capital ratios, and reducing allowable loan to value (LVR) ratios. They find that first, monetary policy and macroprudential policies related to bank capital are likely to be transmitted through the same channels in the banking system as they both affect the cost of loans. So, they should be expected to reinforce each other. Second, capital buffers or liquidity ratios targeting specific sectoral exposures are likely to be effective in slowing down credit growth in the mortgage market. Third, macro-prudential instruments affecting the cost of capital or the liquidity position could usefully be complemented by instruments related to non-price dimensions of mortgage loans such as limits on LTVs. The evidence also suggests that tightening of LTVs is more effective in slowing down credit growth and house price appreciation when monetary policy is too loose.

The design of a macro-prudential framework and its interaction with monetary policy has been at the forefront of the policy agenda since the global financial crisis. However, most advanced economies (AEs) have little experience using macroprudential policies, while there is, by contrast, more evidence about macro-prudential instruments aimed at moderating the volatility of capital flows in emerging markets. As a result, relatively little is known empirically about macroprudential instruments’ effectiveness in mitigating systemic risks in these countries, about their channels of transmission, and about how these instruments would interact with monetary policy.

Many countries publish bank lending surveys that provide very useful information on how banks modify the price and non-price terms of loans to the private sector, and on the drivers of these lending conditions. Some of the terms of loans (such as actual loan-to-value ratios (LTVs)) or some of the drivers of the lending standards (such as the cost of bank capital or the liquidity position of a bank) are directly related to macro-prudential instruments considered to be key in the policy toolkit of many jurisdictions. In this paper, we make use of the European Central Bank Lending Survey to develop a methodology and estimate empirically the likely effectiveness of some of these macro-prudential policies, their channel of transmissions and their interactions with monetary policy.

There is thus far little knowledge about how (policy driven) changes in the cost of bank capital (which could be the result of the implementation of a countercyclical capital buffer, of time contingent or sectoral risk weights, or more generally of bank specific changes in the capital adequacy ratio) or in the bank liquidity position would be transmitted to credit supply. Specifically, would such policy actions be transmitted through non-price factors (such as LTVs, collateral requirements, or maturity) or through price factors (such as price margins or fees)? There is also relatively little knowledge about whether limits on LTVs could significantly slow down house price appreciation and/or mortgage loan growth. Should measures affecting capitalization be complemented by non-price measures constraining lending standards? Can some of these macro-prudential policies be effective during housing booms when traditional monetary policy is typically too loose? Assessing such interactions and the transmission channel of macro-prudential instruments, with a specific focus on the real estate market, is important, as shocks to the real estate market have been a key source of systemic risk during the recent financial crisis.

The Euro-system Bank Lending Survey (BLS) contains information on overall changes in lending standards, or net tightening of lending standards and changes in lending standards related to non-price factors (LTVs, collateral requirements, maturity), price factors (such as margins) and factors contributing to the changes in lending standards, including balance sheet characteristics (such as capital and liquidity ratios) which can be mapped to specific macroprudential targets set by national regulators. However, identification of the impact of macro-prudential policies requires addressing specific challenges. The BLS does not require banks to specify the exact nature of the shocks that cause a change in lending standards or in the cost of capital, even though it provides information on perceptions of risks, economic activity, and competition pressures, and their contribution to the change. Hence, our approach is potentially subject to omitted variable bias, reverse causality and measurement bias (as expectations about house prices and credit growth may be mis-measured). Moreover, our observable variables (lending standard, and the contribution of balance sheet factors to lending standard) are not policy variables, which in our case are unobserved shocks affecting our observables. To address these issues, we develop methodologies relying upon instrumental variables and GMM estimators; our study also includes various control variables such as growth prospects, financial conditions, perception of risks and monetary policy cycle. Still, a potential advantage of our approach is that we would be able to capture the impact of the announcement of macro-prudential measures on lending standards, even before the actual implementation of the policy.

Our main findings are the following. First, our estimates suggest that measures that increase the cost of bank capital are effective in slowing down credit growth and house price appreciation. Second, changes in LTV also impact credit growth and house price appreciation but their impact tends to be more moderate. Third, macro-prudential policies affecting the cost of capital are transmitted mainly through price margins, with very little impact on LTV ratios or other non-price characteristics of mortgage loans. The evidence also suggests that tightening of LTVs is more effective in slowing down credit growth and house price appreciation when monetary policy is too loose.