Macroprudential – Page 4 – Digital Finance Analytics (DFA) Blog

Macroprudential Policy in the U.S. Economy

Fed Vice Chairman Stanley Fischer spoke at the “Macroprudential Monetary Policy” conference. He remains concerned that the U.S. macroprudential toolkit is not large and is not yet battle tested. The contention that macroprudential measures would be a better approach to managing asset price bubbles than monetary policy, he says, is persuasive, except when there are no relevant macroprudential measures available. It also seems likely that monetary policy should be used for macroprudential purposes with an eye to the tradeoffs between reduced financial imbalances, price stability, and maximum employment.

This afternoon I would like to discuss the challenges to formulating macroprudential policy for the U.S. financial system.

The U.S. financial system is extremely complex. We have one of the largest nonbank sectors as a percentage of the overall financial system among advanced market economies. Since the crisis, changes in the regulation and supervision of the financial sector, most significantly those related to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) and the Basel III process, have addressed many of the weaknesses revealed by the crisis. Nonetheless, challenges to our efforts to preserve financial stability remain.

The Structure, Vulnerabilities, and Regulation of the U.S. Financial System
To set the stage, it is useful to start with a brief overview of the structure of the U.S. financial system. A diverse set of institutions provides credit to households and businesses, and others provide deposit-like services and facilitate transactions across the financial system. As can be seen from panel A of figure 1, banks currently supply about one-third of the credit in the U.S. system. In addition to banks, institutions thought of as long-term investors, such as insurance companies, pension funds, and mutual funds, provide anotherone-third of credit within the system, while the government-sponsored enterprises (GSEs), primarily Fannie Mae and Freddie Mac, supply 20 percent of credit. A final group, which I will refer to as other nonbanks and is often associated with substantial reliance on short-term wholesale funding, consists of broker-dealers, money market mutual funds (MMFs), finance companies, issuers of asset-backed securities, and mortgage real estate investment trusts, which together provide 14 percent of credit.

In the first quarter of this year, U.S. financial firms held credit market debt equal to $38 trillion, or 2.2 times the gross domestic product (GDP) of the United States. As the figure shows, the size of the financial sector relative to GDP grew for nearly 50 years but declined after the financial crisis and has only started increasing again this year.

From the perspective of financial stability, there are two important dimensions along which the categories of institutions in figure 1 differ. First, banks, the GSEs, and most of what I have called other nonbanks tend to be more leveraged than other institutions. Second, some institutions are more reliant on short-term funding and hence vulnerable to runs. For example, MMFs were pressured during the recent crisis, as their deposit-like liabilities–held as assets by highly risk-averse investors and not backstopped by a deposit insurance system–led to a run dynamic after a large fund broke the buck. In addition, nearly half of the liabilities of broker-dealers consists–and consisted then–of short-term wholesale funding, which proved to be unstable in the crisis.

The pros and cons of a multifaceted financial system
The significant role of nonbanks in the U.S. financial system and the associated complex web of interconnections bring both advantages and challenges relative to the more bank-dependent systems of other advanced economies. A potential advantage of lower bank dependence is the possibility that a contraction in credit supply from banks can be offset by credit supply from other institutions or capital markets, thereby acting as a spare tire for credit supply. Historical evidence suggests that the credit provided by what I termed long-term investors–that is, insurance companies, pension funds, and mutual funds–has tended to offset movements in bank credit relative to GDP, as indicated by the strong negative correlation of credit held by these institutions with bank credit during recessions. In other words, these institutions have acted as a spare tire for the banking sector.

However, complexity also poses challenges. While the financial crisis arguably started in the nonbank sector, it quickly spread to the banking sector because of interconnections that were hard for regulators to detect and greatly underappreciated by investors and risk managers in the private sector.⁶ For example, when banks provide loans directly to households and businesses, the chain of intermediation is short and simple; in the nonbank sector, intermediation chains are long and often involve a multitude of both banks and other nonbank financial institutions.

Regulatory, supervisory, and financial industry reforms since the crisis
U.S. regulators have undertaken a number of reforms to address weaknesses revealed by the crisis. The most significant set of reforms has focused on the banking sector and, in particular, on regulation and supervision of the largest, most interconnected firms. Changes include significantly higher capital requirements, additional capital charges for global systemically important banks, macro-based stress testing, and requirements that improve the resilience of banks’ liquidity risk profile.

Changes for the nonbank sector have been more limited, but steps have been taken, including the final rule on risk retention in securitization, issued jointly by the Federal Reserve and five other agencies in October of last year, and the new MMF rules issued by the Securities and Exchange Commission (SEC) in July of last year, following a Section 120 recommendation by the Financial Stability Oversight Council (FSOC). More recently, the SEC has also proposed rules to modernize data reporting by investment companies and advisers, as well as to enhance liquidity risk management and disclosure by open-end mutual funds, including exchange-traded funds. Other provisions include the central clearing requirement for standardized over-the-counter derivatives and the designation by the FSOC of four nonbanks as systemically important financial institutions. The industry has also undertaken important changes to bolster the resilience of its practices, including notable improvements to internal risk-management processes.

Some challenges to macroprudential policy
The steps taken since the crisis have almost certainly improved the resilience of the U.S. financial system, but I would like to highlight two significant challenges that remain.

First, new regulations may lead to shifts in the institutional location of particular financial activities, which can potentially offset the expected effects of the regulatory reforms. The most significant changes in regulation have focused on large banks. This focus has been appropriate, as large banks are the most interconnected and complex institutions. Nonetheless, potential shifts of activity away from more regulated to less regulated institutions could lead to new risks.

It is still too early to gauge the degree to which such adaptations to regulatory changes may occur, although there are tentative signs. For example, we have seen notable growth in mortgage originations at independent mortgage companies as reflected in the striking increase in the share of home-purchase originations by independent mortgage companies from 35 percent in 2010 to 47 percent in 2014. This growth coincides with the timing of Basel III, stress testing, and banks’ renewed appreciation of the legal risks in mortgage originations. As another example, there have also been many reports of diminished liquidity in fixed-income markets. Some observers have linked this shift to new regulations that have raised the costs of market making, although the evidence for changes in market liquidity is far from conclusive and a range of factors related to market structure may have contributed to the reporting of such shifts.

Despite limited evidence to date, the possibility of activity relocating in response to regulation is a potential impediment to the effectiveness of macroprudential policy. This is clearly the case when activity moves from a regulated to an unregulated institution. But it may also be relevant even when activity moves from one regulated institution to an institution regulated by a different authority. This scenario can occur in the United States because different regulators are responsible for different institutions, and financial stability traditionally has not been, and in a number of cases is still not, a central component of these regulators’ mandates. To be sure, the situation has improved since the crisis, as the FSOC facilitates interagency dialogue and has a shared responsibility for identifying risks and reporting on these findings and actions taken in its annual report submitted to the Congress. In addition, FSOC members jointly identify systemically important nonbank financial institutions. Despite these improvements, it remains possible that the FSOC members’ different mandates, some of which do not include macroprudential regulation, may hinder coordination. By contrast, in the United Kingdom, fewer member agencies are represented on the Financial Policy Committee at the Bank of England, and each agency has an explicit macroprudential mandate. The committee has a number of tools to carry out this mandate, which currently are sectoral capital requirements, the countercyclical capital buffer, and limits on loan-to-value and debt-to-income ratios for mortgage lending.

A second significant challenge to macroprudential policy remains the relative lack of measures in the U.S. macroeconomic toolkit to address a cyclical buildup of financial stability risks. Since the crisis, frameworks have been or are currently being developed to deploy some countercyclical tools during periods when risks escalate, including the analysis of salient risks in annual stress tests for banks, the Basel III countercyclical capital buffer, and the Financial Stability Board (FSB) proposal for minimum margins on securities financing transactions. But the FSB proposal is far from being implemented, and a number of tools used in other countries are either not available to U.S. regulators or very far from being implemented. For example, several other countries have used tools such as time-varying risk weights and time-varying loan-to-value and debt-to-income caps on mortgages. Indeed, international experience points to the usefulness of these tools, whereas the efficacy of new tools in the United States, such as the countercyclical capital buffer, remains untested.

In considering the difficulties caused by the relative unavailability of macroprudential tools in the United States, we need to recognize that there may well be an interaction between the extent to which the entire financial system can be strengthened and made more robust through structural measures–such as those imposed on the banking system since the Dodd-Frank Act–and the extent to which a country needs to rely more on macroprudential measures. Inter alia, this recognition could provide an ex post rationalization for the United States having imposed stronger capital and other charges than most foreign countries.

Implications for monetary policy
Though I remain concerned that the U.S. macroprudential toolkit is not large and not yet battle tested, that does not imply that I see acute risks to financial stability in the near term. Indeed, banks are well capitalized and have sizable liquidity buffers, the housing market is not overheated, and borrowing by households and businesses has only begun to pick up after years of decline or very slow growth. Further, I believe that the careful monitoring of the financial system now carried out by Fed staff members, particularly those in the Office of Financial Stability Policy and Research, and by the FSOC contributes to the stability of the U.S. financial system–though we have always to remind ourselves that, historically, not even the best intelligence services have succeeded in identifying every significant potential threat accurately and in a timely manner. This is another reminder of the importance of building resilience in the financial system.

Nonetheless, the limited macroprudential toolkit in the United States leads me to conclude that there may be times when adjustments in monetary policy should be discussed as a means to curb risks to financial stability. The deployment of monetary policy comes with significant costs. A more restrictive monetary policy would, all else being equal, lead to deviations from price stability and full employment. Moreover, financial stability considerations can sometimes point to the need for accommodative monetary policy. For example, the accommodative U.S. monetary policy since 2008 has helped repair the balance sheets of households, nonfinancial firms, and the financial sector.

Given these considerations, how should monetary policy be deployed to foster financial stability? This topic is a matter for further research, some of which will look similar to the analysis in an earlier time of whether and how monetary policy should react to rapidly rising asset prices. That discussion reached the conclusion that monetary policy should be deployed to deal with errant asset prices (assuming, of course, that they could be identified) only to the extent that not doing so would result in a worse outcome for current and future output and inflation.

There are some calculations–for example, by Lars Svensson–that suggest it would hardly ever make sense to deploy monetary policy to deal with potential financial instability. The contention that macroprudential measures would be a better approach is persuasive, except when there are no relevant macroprudential measures available. I believe we need more research into the question. I also struggle in trying to find consistency between the certainty that many have that higher interest rates would have prevented the Global Financial Crisis and the view that the interest rate should not be used to deal with potential financial instabilities. Perhaps that problem can be solved by seeking to distinguish between a situation in which the interest rate is not at its short-run natural rate and one in which asset-pricing problems are sector specific.

Of course, we should not exaggerate. It is one thing to say we have no macroprudential tools and another to say that having more macroprudential measures–particularly in the area of housing finance–could provide major financial stability benefits. It also seems likely that monetary policy should be used for macroprudential purposes with an eye to the tradeoffs between reduced financial imbalances, price stability, and maximum employment. In this regard, a number of recent research papers have begun to frame the issue in terms of such tradeoffs, although this is a new area that deserves further research.

It may also be fruitful for researchers to continue investigating the deployment of new or little-used monetary policy tools. For example, it is arguable that reserve requirements–a traditional monetary policy instrument–can be viewed as a macroprudential tool. In addition, some research has begun to ask important questions about the size and structure of monetary authority liabilities in fostering financial stability.

Conclusion
To sum up: The need for coordination across different regulators with distinct mandates creates challenges to the timely deployment of macroprudential measures in the United States. Further, the toolkit to act countercyclically in the face of building financial stability risks is limited, requires more research on its efficacy, and may need to be enhanced. Given these challenges, we need to consider the potential role of monetary policy in fostering financial stability while recognizing that there is more research to be done in clarifying the potential costs and benefits of doing so when conditions appear so to warrant.

After all of the successful work that has been done to reform the financial system since the Global Financial Crisis, this summary may appear daunting and disappointing. But it is important to highlight these challenges now. Currently, the U.S. financial system appears resilient, reflecting the impressive progress made since the crisis. We need to address these questions now, before new risks emerge.

Does Macroprudential Limit Risky Lending?

An interesting BIS working paper “Higher Bank Capital Requirements and Mortgage Pricing: Evidence from the Countercyclical Capital Buffer (CCB)”, examines the impact of implementing CCB on the mortgage market in Switzerland. Does the CCB have the potential to shift lending from less resilient to more resilient banks, and from riskier to less risky borrowers? This paper looks beyond just trying to control total credit growth. They conclude that the CCB does affect the composition of mortgage supply and raises the prices of more risky loans. In fact banks try to pass on the extra capital costs of previously issued mortgages to new customers. However, it does not stop more risky lending, because the link between borrower risk characteristics (here, loan-to-value (LTV) ratios) and capital requirements is too weak to actively discourage banks from offering mortgages to high-LTV borrowers after the CCB is activated.

Macroprudential policies have recently attracted considerable attention. They aim at both strengthening the resilience of the financial system to adverse aggregate shocks and at actively limiting the build-up of financial risks in the sense of “leaning against the financial cycle”. One reason for the appeal of such policies is that, by explicitly taking a system-wide perspective, they complement macroeconomic and prudential measures in seeking to address systemic risks arising from externalities (such as joint failures and procyclicality) that are not easily internalised by financial market participants themselves. Against this background, the new Basel III regulatory standards feature the Countercyclical Capital Buffer (CCB) as a dedicated macroprudential tool designed to protect the banking sector from the detrimental effects of the financial cycle. We provide the first empirical analysis of the CCB based on data from Switzerland – which became the first country to activate such a buffer on February 13, 2013. To reinforce banks’ defenses against the build-up of systemic vulnerabilities, the activation of the CCB raised their regulatory capital requirements, thereby contributing to the sector’s overall resilience. However, little is known about the CCB’s contribution towards the second macroprudential objective: higher requirements might slow bank lending or alter the quality of loans during the boom and thereby enable policy-makers to “lean against the financial cycle”. Up to now, policy debates have focused mainly on the quantity of aggregate credit growth. We aim to shift the focus of the debate towards the quality, namely the composition of lenders and how tighter capital requirements interact with borrower risk characteristics. Does the CCB have the potential to shift lending from less resilient to more resilient banks, and from riskier to less risky borrowers? Based on our findings, our analysis advances the understanding of some mortgage supply side aspects about whether the CCB can contribute towards the second objective of macroprudential policy, the “leaning against the financial cycle”.

To answer these questions, we examine how the CCB affects the pricing of mortgages. Our unique dataset obtained from an online mortgage platform allows us to separate mortgage supply from demand: each mortgage request receives several binding offers from several different banks, and, each bank can offer mortgages to many different households with distinct borrower risk characteristics. To identify the CCB effect on mortgage supply, we exploit lagged bank balance sheet characteristics that might render a bank more sensitive to the regulatory design of the CCB. To examine whether risk-weighting schemes that link borrower risk characteristics to capital requirements do, in fact, amplify the CCB effect, we use comprehensive information as specified in the mortgage request. The procedures of the online mortgage platform warrant that banks submit independent offers that draw precisely on the same set of anonymized hard information observed by their competitors (and available to us), undistorted by any private or soft information.

Two sets of results stand out. First, the CCB affects the composition of mortgage supply. Once the activated CCB imposes higher capital requirements, capital-constrained banks with low capital cushions raise their mortgage rates relatively more than their competitors. Further, after the CCB is activated, specialized banks that operate a very mortgage-intensive business model also raise their mortgage rates to a greater degree in relative terms. In fact, the CCB applies to new mortgages as well as to the stock of all mortgages held on a bank’s balance sheet. Our results for specialized mortgage lenders thus suggest that banks try to pass on the extra capital costs of previously issued mortgages to new customers. Both insights are indicative of changes in the composition of mortgage supply. Based on the assumption that, ceteris paribus, households prefer lower mortgage rates over more expensive ones,2 we conclude that the CCB tends to shift new mortgage lending from relatively less well capitalized banks to relatively better capitalized ones, and from relatively more to relatively less mortgage-exposed banks. For these reasons, both changes in the composition of mortgage supply are broadly supportive of the second macroprudential objective in that they tend to allocate new mortgage lending to banks that are more resilient.

Our second set of core findings incorporates the borrower side and the effectiveness of common risk-weighting schemes that translate borrower risk into bank capital requirements. We find that banks generally claim extra compensation for granting riskier mortgages (ie, by charging higher mortgage rates). However, these risk-weighting schemes do not appear to amplify the effect of the CCB on mortgage rates or mortgage creation. Apparently, the link between borrower risk characteristics (here, loan-to-value (LTV) ratios) and capital requirements is too weak to actively discourage banks from offering mortgages to high-LTV borrowers after the CCB is activated.

Our paper contributes to the literature in three different respects. First, our empirical setup allows us to advance the understanding of the effects of the CCB as a macroprudential policy tool, particularly in the context of Basel III. More generally, our insights also contribute to a better understanding of how higher capital requirements impact the pricing of loans to private households. Second, our dataset allows us to disentangle mortgage supply from mortgage demand. By merging bank-level information with the respective offers, we can attribute changes in the composition of mortgage supply to distinct bank balance sheet characteristics that shape a bank’s pricing of mortgages. These dimensions of our data set our approach apart from standard analyses based on mortgage contracts, which have a blind spot with respect to the spectrum of all offered (but non-concluded) rates. Third, our analysis informs the debate on the effectiveness of risk-weighting schemes, a standard concept in bank regulation.

Note that BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.

The Long-Term Evolution of House Prices: An International Perspective

Excellent speech from Lawrence Schembri, Deputy Governor, Canadian Association for Business Economics on house price trends. The speech, which is worth reading, contains a number of insightful charts. Australian data is included. He looks at both supply and demand issues, and touches on macroprudential. You can watch the entire speech.

I have highlighted some of the main points:

First, Chart 1 shows indexes of real house prices since 1975 for two sets of advanced economies. Chart 1a shows Canada and a set of comparable small, open economies (Australia, New Zealand, Norway and Sweden) with similar macro policy frameworks and similar experiences during and after the global financial crisis. In particular, they did not have sizable post-crisis corrections in house prices. For comparison purposes, Chart 1b shows a second set of advanced economies that did experience significant and persistent post-crisis declines in house prices.

Since 1995, house prices in Canada and the set of comparable countries have increased faster than nominal personal disposable income (Chart 2a). During this period, all of these countries experienced solid income growth, with the strongest growth in Norway and Sweden (Chart 2b).

During the global financial crisis, these countries also experienced house price corrections. This caused the ratios of house prices to income to decline temporarily, after which they continued climbing.

One of the factors that has affected population growth rates is migration. Net migration was highest in Australia and Canada over the entire sample. In addition, net migration increased importantly in all five countries in the second half of the sample period (Chart 3b)

In Australia, Canada and New Zealand, the rate of population growth of the approximate house-owning cohort of those aged 25 to 75 declined in the second part of the sample period. This likely reflects the aging of their populations as the postwar baby boom generation moved from youth into middle age (Chart 4). Nonetheless, the growth rate of this cohort still remains well above 1 per cent for these three countries.

Chart 9 provides some suggestive evidence on the impact of land-use regulations on median price-to-income ratios. Many of the cities with higher ratios also have obvious geographical constraints—Hong Kong and Vancouver are good examples—so the two sources of supply restrictions likely interact to put upward pressure on prices.When we look at the post-crisis experiences of the countries in our comparison group, they have similar levels of household leverage, measured by household debt as a ratio of GDP (Chart 12). Household leverage has risen along with house prices, as households have taken advantage of low post-crisis interest rates. The one exception is New Zealand, where a modest degree of household deleveraging seems to have occurred. For Canada, the ratio of household debt to GDP has risen since 1975, although the growth of this ratio has notably declined since 2010. For Sweden and Norway, the ratio also grew at a modest pace in the post-crisis period. Note Australia has the highest ratios.

Charts 13a and b draw on recent work by the IMF, which shows that macroprudential policies in the form of maximum loan-to-value (LTV) or debt-to-income (DTI) ratios have tightened across a broad range of countries over the past 10 years. The IMF’s research, as well as that of other economists, has found evidence suggesting that the tightening has helped to: reduce the procyclicality of household credit and bank leverage; moderate credit growth;
improve the creditworthiness of borrowers; and lower the rate of house price growth.

The most effective macroprudential policies to date appear to have been the imposition of maximum LTV and DTI constraints. Increased capital weights on bank holdings of mortgages have also had an impact. While long-term evidence on these instruments is not yet available, permanent measures that address structural regulatory weaknesses and that are relatively straightforward to implement and supervise will likely be the most effective over time.

Interesting to note that in Canada, they have had four successive rounds of macroprudential tightening, primarily in terms of the rules for insured mortgages. The maximum amortization period for insured loans has been shortened from 40 years to 25. LTV ratios have been lowered to 95 per cent for new mortgages, and 80 per cent for refinancing and investor properties. These latter two changes effectively eliminate new insurance for refinancing and investor properties. Qualification criteria such as limits on the total debt-service ratio and the gross debt-service ratio, as well as requirements for qualifying interest rates, have also been tightened.

Conclusion

Let me conclude with a few key points from the mountain of facts, graphs and analysis that I have reviewed with you today. As I mentioned at the outset, the purpose of my presentation is to help provide more context for an informed discussion about housing and house prices given their importance to the Canadian economy and the financial system.

First, real house prices have been rising relative to income in Canada and other comparable countries for about 20 years. There are many possible explanations, mostly from the demand side, but also from the supply side.

Second, in terms of demand, demographic forces, notably migration and urbanization, have played a role in the evolution of house prices, as have improving credit conditions through lower global real long-term interest rates and financial liberalization and innovation. There are, of course, other demand factors that warrant more data and analysis, including the impacts of foreign investment and possible preference shifts.

Third, in terms of supply, the constraints imposed by geography and regulation have decreased housing supply elasticity, especially in urban areas. This reduced supply elasticity has interacted with demand shifts toward more urbanization to push up house prices in major cities.

Fourth, the credible and effective macro and financial policy frameworks in place in Canada and the other countries considered here have contributed to a high degree of macroeconomic and financial stability. Consequently, in the face of a protracted global recovery, their countercyclical policies successfully underpinned domestic demand in the post-crisis period. The resulting strength in the housing market has increased household imbalances, but the risks stemming from these vulnerabilities have been well managed by complementary macroprudential policies.

The experience in these countries therefore suggests that macroprudential policies that address structural weaknesses in the regulatory framework are best suited for mitigating such financial vulnerabilities. They reduce tail risks to financial stability and enhance the overall resilience of the financial system.

Macroprudential Policy: from Tiberius to Crockett and beyond

In a speech to TheCityUK Jon Cunliffe charts the development of macroprudential policy and the establishment of the macroprudential policy framework in the UK by the Bank of England’s Financial Policy Committee (FPC) since the Committee’s inception in 2011. He also looks ahead at some of the policy questions facing the FPC.

A key outcome of the financial crisis was the recognition that international standards were needed not just to ensure that individual banks were safe but also to ensure that the financial system as a whole was safe. The crisis showed that there are powerful dynamics in the financial system itself which drive booms in good times and busts in bad times. Seven years on from the crisis and four years from the establishment of the FPC, Jon says it is fair to ask how well regulators have done in putting in place the machinery to manage those risks and whether these have come at the expense of economic growth.

The contours of the new regulatory framework are clear and agreed and implementation is well underway, Jon notes, citing rules on bank capital and liquidity, resolution and work on addressing risks from outside the banking system, for instance from derivatives.

But he argues that this “standing framework” can only go so far in addressing risk. The role of macro-prudential authorities like the FPC is not just to ensure that regulations address the risk that financial firms and banks can pose to the financial system as a whole. It is also to monitor the build-up of risk and the development of new types of risk and to take action to address them.

In this area, macroprudential policy is at a much earlier stage of development, partly because the focus has so far been on creating the framework for policy, partly because there are still differing views internationally as to what time-varying, countercyclical macroprudential policy should and could do. Nonetheless, the FPC has taken some important steps here.

First, using macroprudential policy to address changing risks depends upon a clear assessment of risks and of the action necessary to address them. This is why the FPC has changed the structure and content of the Financial Stability Report. “The intention is that such a shorter, more focussed report will create a discipline for the FPC’s thinking, aid its communication and make it easier for others to hold us to account.”

Second, the Committee is developing the use of stress testing to assess macroprudential as well as microprudential risk. “At present we are using stress testing to help us judge how resilient the banking system is to different, severely adverse, but plausible, scenarios. A development of this approach would be to use stress testing more countercyclically. Rather than testing every year against a scenario of constant severity, the severity of
the test and the resilience banks need to pass it would be greater in boom times when credit and risk is building up in the financial system and it has further to fall, and then reduced in weaker periods when there is less risk in the system and the economy needs the banking system to maintain lending.”

Thirdly, the FPC has been looking at macroprudential risks beyond the banking system. Its recommendation on portfolio limits for high loan-to-income mortgages is an example of the committee taking a broad view of financial stability that goes wider than direct risks to the banking system.
On the question of whether financial regulation has gone too far, Jon says only now that reforms are being implemented is it possible for policymakers to see the whole picture of how they work together in practice and that some adjustments will be needed. “Given the depth and complexity of the financial crisis and the corresponding depth and complexity of the reforms, we should expect rather than be surprised that we will need to refine and adjust some of the regulatory reforms.”

However, while some adjustments may be necessary as we see how the reforms work in practice, Jon warns against seeking more generally to trade-off between financial stability and growth and notes that the post-crisis world requires a major adjustment in bank business models.
Jon also points out that in the long build-up of the credit cycle ahead of the crisis, while lending nearly doubled this did not lead to a very large increase in the financing of companies. Instead, lending was mainly directed to other financial institutions, mortgages and real estate.
“While we have relearned some familiar lessons in recent years, we have also learned some new ones. We have had to develop a new regulatory framework, macroprudential institutions like the FPC, and new policy approaches. Over the next few years we will certainly need to refine all of these. The implementation of the detailed reforms will inevitably throw up unforeseen effects in particular places, and where it is justified, we
will need to revisit issues. But we should be careful about talking about turning back the overall regulatory dial or trying to trade off the risk of financial instability for short-term growth.”

Strengthening Macroprudential Policy in Europe

Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the Conference on “The macroprudential toolkit in Europe and credit flow restrictions.”

The current euro area environment, with policy rates required to stay low for a prolonged period of time and an apparent disconnect between the business and financial cycle, clearly points to a situation where monetary policy cannot deviate from price stability objectives to influence the financial cycle. This is the task of macroprudential policy. While acknowledged in principle, this fact has not yet been fully reflected in our policy frameworks.

In summary, two major moves are required. First, macroprudential policy must place greater emphasis on preventing large fluctuations in the financial cycle, rather than simply increasing resilience to shocks when they occur. In addition to the bank-side capital based measures enhancing banks’ resilience, borrower-based instruments (such as LTVs or DSTIs), which have proved to be more effective in curtailing excessive credit growth, and are also applicable in a time-varying fashion, should gain more prominence. In particular, borrower-based measures should be properly embedded in European legislation, which is not the case at present. Second, a broader macroprudential toolkit is needed to address risks stemming from the shadow banking sector due to its increasing role in credit intermediation. This could involve measures such as redemption gates and loading fees to provide additional safeguards. Guided stress tests can provide comparable assessments of the health of individual institutions and of the resilience of the financial system as a whole. Appropriate policy responses to mitigate growing risks need however to be calibrated, in order to ensure a contained impact on credit supply to the real economy.

LTV and DTI Limits—Going Granular

DFA analysis of Australian mortgages highlight that we have high LTI ratios, and high LVR ratios, both indicating a build up of systemic risks in the system. We used postcode level analysis, and believe that it is essential to “get granular”.

Now the IMF has released a working paper on the effectiveness of using loan-to-value (LTV) and debt-service-to-income (DTI) limits as many countries face a new round of rising house prices. Yet, very little is known on how these regulatory instruments work in practice. This paper contributes to fill this gap by looking closely at their use and effectiveness in six economies—Brazil, Hong Kong SAR, Korea, Malaysia, Poland, and Romania.

In most cases,the caps on LTV and DTI started in the range of 60–85 percent and 30–45 percent, respectively, for mortgage loans. In all countries, there were changes to the limits of LTV/DTIs typically because the authorities noted that they were not having the desired effect. In some cases, house price and mortgage growth did not fall, and in other cases, the limits did not bind. Concerned with speculative activities, authorities in some countries lowered the caps selectively either for speculative prone (geographical) areas or for individuals with multiple mortgages. In one case, the centrally set caps were removed and banks were allowed to set their own limits, validated by supervisors. However, this did not work, and stricter requirements were put back in place.

To curb leakages, the limits were extended in some of the countries to insurance companies, mutual funds and finance companies that advertised mortgage products. It was also extended to development financial institutions.

Insights include: rapid growth in high-LTV loans with long maturities or in the number of borrowers with multiple mortgages can be signs of build up in systemic risk; monitoring nonperforming loans by loan characteristics can help in calibrating changes in the LTV and DTI limits; as leakages are almost inevitable, countries strive to address them at an early stage; and, in most cases, LTVs and DTIs were effective in reducing loan-growth and improving debt-servicing performances of borrowers, but not always in curbing house price growth.

Note: The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Does Easing Monetary Policy Increase Financial Instability?

An IMF working paper “Does Easing Monetary Policy Increase Financial Instability?” looks at the interaction between monetary and macro-prudential policies.

Using modelling, they show that that real interest rate rigidities have a different impact on financial stability depending on the sign of the shock hitting the economy. In response to positive shocks to the risk-free interest rate, real interest rate rigidity acts as an automatic macro-prudential stabilizer. This is because higher debt today associated with lower interest rates (relative to the flexible interest rate case) is offset by lower interest repayments, resulting in higher net worth and lower probability of a crisis in the future. In contrast, when the risk-free rate is hit by a negative shock, real interest rate rigidity leads to a relatively higher crisis probability through the same mechanisms working in reverse (borrowing and consumption are relatively lower today, but they are offset by relatively higher debt service tomorrow, resulting in lower future net-worth and higher crisis probability).

In addition, they show that when the interest rate is the only policy instrument to address both the macroeconomic and the financial friction, and a shock that lowers interest rates hits the economy, a policy trade-off emerges. This is because the two frictions require interventions of opposite direction on the same instrument. Other instruments, however, may be at the policy-maker’s disposal in order to achieve and maintain financial stability.

An implication of their analysis is that the weak link in the U.S. policy framework in the run up to the Global Recession was not excessively lax monetary policy after 2002, but rather the absence of an effective regulatory framework aimed at preserving financial stability.

Note that 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 Case Studies

The IMF just released a working paper “Experiences with Macroprudential Policy—Five Case Studies” which discusses the implementation of macroprudential policies, mainly to attempt to manage the housing sector at a time of rising prices and high levels of bank lending.

The paper presents case studies of macroprudential policy in five jurisdictions (Hong Kong SAR, the Netherlands, New Zealand, Singapore, and Sweden). The case studies describe the institutional framework, its evolution, the use of macroprudential tools, and the circumstances under which the tools have been used. In all cases macroprudential tools have been used to address risks in the housing market. In addition, some of them have moved to enhance the resilience of their banks to more general cyclical and structural risks.

In all the cases reviewed, the macroprudential tools have been used primarily to address risks in the real estate sector. Partly for this reason, the loan-to-value (LTV) limit was the most popular macroprudential tool, used in the five cases. Some jurisdictions have used multiple tools to help the effectiveness of the measures. For instance, Hong Kong SAR and Singapore have used the debt service–to-income (DSTI) ratio and taxes applied to real estate transactions along with the LTV ratio. Sweden and Hong Kong SAR also have imposed additional capital requirements for mortgages.

To enhance the resilience of the banking system, some authorities in these five cases also have used, or plan to use, additional macroprudential tools to address risk in the time and structural dimensions. Most of these measures were adopted in response to the global financial crisis. New Zealand, for instance, moved quite quickly compared to other countries and imposed liquidity requirements to contain bank funding risks, and gradually increased the requirement. Sweden did the same in 2013. Banks in both countries rely heavily on wholesale funding. Countercyclical capital buffers will take effect in Sweden in the Fall of 2015 and in Hong Kong SAR in phases beginning 2016, while the Netherlands intends to impose them too. Furthermore, systemically important institutions will have to hold additional capital buffers starting in 2015 in Sweden and 2016 in Hong Kong SAR and the Netherlands.

It is too early to gauge the full impact of the measures that have been undertaken. In addition, some measures will only take effect in the future. Nevertheless, there is some early evidence that the implementation of macroprudential measures have enhanced banking system resilience and helped reduce the build-up of housing sector leverage in the cases reviewed. For instance, LTV ratios declined in Hong Kong SAR, New Zealand, and Singapore following the adoption of LTV limits. House prices growth was also affected. For example, the rate of growth of house prices peaked in New Zealand following the imposition of a cap on LTVs. House prices also leveled off in Hong Kong SAR under the combined weight of macroprudential tools and taxes, with the taxes appearing to have a more immediate impact.

CONCLUDING REMARKS
Increasing attention has been given to the field of macroprudential policy following the global financial crisis. This paper reviews the use of macroprudential policy in five economies (Hong Kong SAR, the Netherlands, New Zealand, Singapore, and Sweden). All these jurisdictions actively implemented macroprudential policy measures following the global financial crisis. The analysis shows that each jurisdiction reviewed adopted an institutional framework for macroprudential policy suited to their own circumstances. The evidence reviewed confirms that “one size does not fit all,” and that it is possible to conduct macroprudential policy with a heterogenous set of institutional frameworks. In all cases, most of the macroprudential tools used were directed at containing risks arising from a booming housing market (for e.g., LTV and DSTI ratio limits). Some of the cases studied also took steps to enhance the resilience of the banking system to more general cyclical and structural risks (for e.g., liquidity requirements and additional capital requirement for systemically important institutions). While there is some early evidence that the measures taken have enhanced banking system resilience, it is still early to determine their full impact.

Applying an Inflation Targeting Lens to Macroprudential Policy `Institutions’

The Reserve Bank of NZ just released a discussion paper on inflation targetting in the light of the macroprudential role of supervisory organisations.

Inflation targeting has been an influential and durable monetary policy framework. It has been widely adopted, and the attributes of inflation targeting have been widely lauded for their contribution to price stability. Yet in recent years the global financial crisis and the sovereign debt crisis have challenged macroeconomic frameworks, providing substantial impetus to concerns about financial stability. In this paper we examine macroprudential policy frameworks through an inflation targeting lens, to understand whether the positive attributes of inflation targeting can and should inform macroprudential frameworks.

We use the four attributes of inflation targeting – independence, transparency, accountability and the explicit inflation objective – to help frame debate about the institutions used to govern macroprudential policies. Overall, we argue that these attributes are important for effective macroprudential frameworks. There are, however, some points of difference.

First, the merits of independence are not as clear for macroprudential policy. One reason to appoint an independent policymaker is to take advantage of `expertness’. However, this advantage must be balanced against the possibility that the policymaker may pursue tradeoffs at odds with the mandate provided by government and the public at large. The scope for such tradeoffs is exacerbated if outcomes are not directly observable or if outcomes are not self-evidently related to the policies that have been implemented. These problems seem more substantial for macroprudential policy than for monetary policy.

We have also argued that macroprudential policies are interdependent and cannot be pursued entirely `independently’. Monetary and macroprudential policies are unified by their connection to social welfare, and policies should be implemented to optimize their marginal contribution to this overarching notion of welfare. In principle, policies must be coordinated if they are to be set optimally, but whether the interdependencies are material remains uncertain. Of course, macroprudential and monetary policy could be coordinated even if they were housed in separate institutions. There is a strong case for monetary authorities to be independent and/or for other constraints that prevent political authorities from monetizing budget deficits (since political authorities may have little regard to the inflationary consequences of doing so). While political authorities could use macroprudential policies indirectly to stimulate the economy and therefore increase tax revenue, it may be more difficult to use macroprudential policies to deal with such funding issues. Thus, the case for appointing an agent to run macroprudential policy independently of political authorities is arguably somewhat weaker.

The second observation we make is that financial stability objectives and intermediate targets should be made more explicit. Policymaking involves strategic interaction between policymakers and private agents, and is an exercise in influencing the behaviour and expectations of private agents. While announcing objectives can foster coordination in strategic games, we do not see that financial stability objectives, as commonly expressed, provide enough guidance about the macroprudential policies that will be implemented in future.

Our third observation is that macroprudential policymakers need to consciously address their communication of future policy actions. As advocates for transparency, we suggest that the institutions of policymaking should explicitly address when policy decisions will be announced and/or implemented, and greater attention should be paid to the menu of macroprudential policies. Macroprudential policies governed by principled rules-based behaviour would make clear what policies will be pursued and how they will be adjusted through time, but much work needs to be done before operational, state-contingent macroprudential rules can be identified.

Our fourth observation is that applying the accountability mechanisms of inflation targeting to macroprudential policies has been a desirable development, though these mechanisms should be strengthened further. We remain convinced that transparent communication to the general public remains a significant element in ensuring accountability.

Lastly, while the accountability institutions for macroprudential and monetary policies are well developed, oversight and accountability are materially constrained by the quality of current analytical frameworks. Such uncertainty makes it difficult to provide objective assessments of macroprudential policies. Looking forward, we must fully expect that macroprudential policies will evolve as views solidify about the most important distortions and the most important macroprudential mechanisms. Institutional frameworks should be flexible enough to accommodate such changes.

Note: The views expressed in this paper are those of the author(s) and do not necessarily reflect the views of the Reserve Bank of New Zealand

What The UK Regulators Are Focussing On Next

Donald Kohn, External Member of the Financial Policy Committee, Bank of England, addressed the Society of Business Economists giving views on some broad priorities for the FPC in coming years. First, how the FPC can continue to build a systematic and disciplined approach to macroprudential policy – to identifying risks and using our powers of direction and recommendation to address them; and second, how the FPC can contribute to fostering safe and resilient market alternatives to bank finance in the UK.

I have been a member of the Committee since its inception as the interim FPC in the spring of 2011. In that time I believe we have accomplished much to make the UK financial system safer and put in place the foundations for continuing that work in the future. We have worked with the Prudential Regulation Authority (PRA) to build the resilience of the UK banking system – especially to build its capital cushion against future shocks – so that it can continue to deliver financial services to the real economy in the face of adverse economic and financial developments, and without requiring further taxpayer support. To this end, we phased in the Basel 3 capital risk-weighted capital requirements as quickly as possible for UK banks and instituted a minimum leverage ratio; there is still some work to be done, but major UK banks are now comfortably ahead of the Basel 3 transition timetable. Greater capital supports growth not only by making crises less likely and less severe, but also because well-capitalized banks have been shown to be more willing to lend.

Last year the FPC and the PRA initiated concurrent capital stress tests across large UK banks and are making these tests a regular part of the capital framework. This was a major innovation and strengthens our ability to be explicit about what we see as the important risks to financial stability in the UK and to test the banks’ resilience to those risks. Last year we tested banks’ resilience against the effects of a substantial rise in UK interest rates and a fall in property prices; this year our stress scenario originates in a major shortfall in growth in the rest of the world. The horizontal comparisons across banks from these tests can be particularly revealing about the relative capital positions, modelling characteristics, and risk management capabilities of each major UK bank.

These tests also importantly increase transparency to the public about the FPC’s view of risks to financial stability, the individual bank’s ability to withstand those risks, and the actions the FPC and PRA are taking in response to the results. In that regard the stress tests are an important new element in the accountability of the FPC and the PRA. I expect the stress test to play a major role in our execution of macroprudential policy in the future and I expect us to continue to develop our ability to use the information we collect to identify threats to financial stability, such as procyclicality of bank risk models, interconnections among banks that may not be evident on the surface, and crowded and correlated positions that make the system vulnerable to particular asset price movements.

The FPC has also identified various risks to financial stability beyond those posed by potential bank credit losses and made recommendations to deal with them. For example, we highlighted the dangers of cyber attack, and the potential for rising house prices to cause borrowers to become so indebted for the purchase of houses such that they would need to cut back sharply on spending should interest rates spike unexpectedly or income be temporarily depressed. In both cases we made recommendations that were implemented to counter the perceived risks. And we worked with the banks to enhance their disclosures and thereby strengthen the ability of their private sector counterparties to monitor and price the riskiness of banks through greater bank transparency – especially around capital risk calculations.

Finally we have put in place much of the basic framework required to operate macroprudential policy on an ongoing basis. We worked with HM Treasury and Parliament to get authority for the tools we need – including powers of direction over capital, leverage and key terms of lending against residential real estate. And we issued policy statements outlining how we might use these powers of direction to sustain financial stability.

As a Committee, we have established good working relationships with the PRA, the Financial Conduct Authority (FCA) and the Monetary Policy Committee (MPC). Macroprudential policy is implemented mostly through the PRA and FCA and they and we need to have a good understanding of what each authority is trying to accomplish and how our actions affect the objectives of the others. The chief executives of the PRA and FCA are both members of the FPC and have provided guidance on how to shape our recommendations to accomplish our objectives. Both macroprudential and monetary policy seek to accomplish their separate objectives by affecting aspects of financial conditions, so it is critical that each committee understand what and how the other intends to operate and can weigh the implications for meeting its objectives. The FPC has been asked to provide an independent voice on financial stability – by the MPC and by Treasury (in help-to-buy) to assess the financial stability implications of their policies. We are not completely finished with establishing the macroprudential framework: we need to complete the capital framework; we have requested powers of direction for buy-to-let lending; and the FPC will always need to be alert to the possibility that preserving financial stability in an evolving financial landscape could require new tools in new areas. But I believe the basic structure is largely in place.

Going forward we will be placing more emphasis on how we use the structure; it is a time of transition for the FPC. Having just begun a new three-year term with the FPC, I would like to use this occasion to look forward, to reflect now on what I hope we can accomplish in the next three years, building on the approach already in place. I will concentrate on two broad challenges: first, how the FPC can continue to build a systematic and disciplined approach to macroprudential policy – to identifying risks and using our powers of direction and recommendation to address them; and second, how the FPC can contribute to fostering safe and resilient market alternatives to bank finance in the UK.