“The amount of credit created and its allocation is too important to be left to
3.2 Types of macroprudential instruments
This section considers the types of macroprudential instruments. Macroprudential tools fall into two main categories: structural (eg capital and liquidity) and cyclical (eg
countercyclical capital buffers and LTV and DTI limits). The former are aimed at “building 9 structural resilience in the financial system throughout the business cycle.” The latter are 10 aimed at “mitigating systemic risk that can build up over the business cycle”. As 11
mentioned above, the former work by increasing costs while the latter imposes direct quantitative restrictions.
There are also broader macroprudential tools such as the “stress testing” programmes, which subject regulated entities to regular assessments based on standardised scenarios designed to test their resilience in the face of a variety of demanding economic
contingencies. The ability of these institutions to withstand these stresses reinforces the stability of the financial system as a whole. Those that are found to be inadequate need to increase their capital and liquidity. In addition, there are a number of other actual and
José Viñals, ‘Making macroprudential policy work’, speech at the Brookings Institution, Washington D.C.,
9
16th September 2013
Loretta Mester, ‘The nexus of macroprudential supervision, monetary policy and financial stability’, speech
10
at the Federal Reserve Bank of Cleveland and the Office of Financial Research 2014 Financial Stability Conference, 5th December 2014
Ibid, Mester. This is sometimes known as the “Kindleberger cycle” where “optimism over asset price rises
11
[which] leads to lower credit standards in which the lender relies on asset price growth to absorb any credit defaults”
potential macroprudential tools. These include monetary policy, fiscal measures, in particular the use of taxation and the use of central bank facilities to provide liquidity to institutions and markets as the “lender of last resort”. A number of Asian states have 12 specifically combined macroprudential and fiscal measures to restrict the growth of credit. This raises important issues which are considered later in both this chapter and chapter 6. Finally, there is the employment of conduct of business regulation as a macroprudential tool. The latter is often over-looked as a macroprudential policy tool and its importance is a key theme in this thesis.
As discussed in the previous chapter, macroprudential tools can be widely defined to include a range of measures including stress testing, recovery and resolution planning, deposit protection insurance and the national and cross-border regulatory and supervision architecture as a whole. All of these help provide resilience to the financial system. There is a sweeping counter-argument which states, in a number of guises, that regulation, and in particular, deposit protection schemes, increase moral hazard because layers of safety- nets and protections encourage risk-taking and undermine prudence and caution. There 13 is extensive literature discussing this issue which, however, falls outside the scope of this thesis. 14
It is also worth taking a broader perspective when considering possible macroprudential tools. For example, it is likely that the search for higher returns during a period of low inflation and interest rates has encouraged financial institutions to innovate. This may undermine financial stability. It may be less costly for macroprudential policy if financial 15 institution assets were “neutralised” by requiring a large proportion of them to be deposited
Andrew Campbell and Rosa Lastra, ‘Revisiting the lender of last resort - the role of the Bank of England’,
12
in Iain MacNeil and Justin O’Brien (eds)The future of financial regulation,, (Hart, Oxford, 2010), 161-178, 163 Charles Calomiris and Stephen Haber, Fragile by design, (Princeton, New Jersey, 2014), 36-37 and
13
461-462, Andrew Campbell, “Designing a framework for protecting bank depositors”, in James Devenney, and Mel Kenny (eds), Consumer credit, debt and investment in Europe, (Cambridge University Press, 2012), 234-252, 234. See also Charles Goodhart, The regulatory response to the financial crisis, (Edward Elgar Publishing, Cheltenham, 2009), 42-44 who recognising the morale hazard risks but says that deposit protection needs to be balanced by heavy regulation
Ben Bernanke, Essays on the Great Depression, (Princeton, New Jersey, 2000) 89-97. See also Frederic
14
Mishkin, Prudential supervision: what works and what doesn’t, (University of Chicago Press, Chicago, 2001), 6-7; Chapt 2, n162, (Freixas, Laeven and Peydró), 37 and 112-113 and Franklin Allen, Elena Carletti and Agnese Leonello, ‘Deposit insurance and risk taking’, (2011) 27 (3) Oxford Review of Economic Policy, 464-478
Adair Turner, The Turner review, (Financial Services Authority, London, 2009), 47-49
at the central bank. This is a slightly less radical approach to those that advocate strict “narrow banking” where, for example, bank deposits can only be invested in government funds or deposited with the central bank. However, these restrictions have a history of 16 being avoided. 17There are also measures adopted in Canada and Australia which require the insurance, often by government agencies, of higher risk mortgage lending.18 It has also been suggested that market forces could be harnessed by, for example, the Bank of
England by increasing the liquidity requirements and paying higher rates of interest on bank reserve deposits and thus reducing the incentive for banks to develop new higher risk products. This is a very broad subject and, again, outside the scope of this thesis. 19 It has also been suggested that microprudential supervision can be dispensed with for individual financial organisations that are not systemically important and reliance placed wholly on macroprudential policy. Individually, these smaller firms may not be able to 20 damage financial stability but collectively, as a “herd”, they may threaten the stability of the system. Hence macroprudential policy can substitute for microprudential supervision of
Jaromir Benes and Michael Kumhof, ‘The ‘Chicago Plan’ revisited’, (2012) IMF Working Paper, WP/
16
12/202, 4. This was a plan devised by Henry Simons of University of Chicago in 1930s and publicised by Irving Fisher of Yale in 1936. The plan would require “100% backing of deposits by government-issued money, and second” by ensuring that new bank credit was only financed by retained earnings. It would end fractional reserve banking since banks could only lend by borrowing money from the government. John Kay revived elements of this in Narrow banking: the reform of banking regulation, (2009, Centre for the Study of Financial Innovation, London). The subject is considered in Adair Turner’s, ‘Credit, money and leverage: what Wicksell, Hatek and Fisher knew and modern macroeconomics forgot’, presentation at the Stockholm School of Economics conference, ‘Towards a sustainable financial system’, Stockholm, 12th September 2013
For example, prior to the financial crisis in 1907 in the US national banks had been heavily regulated and
17
had to keep 25% of deposits in cash and gold and were prohibited from making loans secured on land. Trust organisations, however, had quickly developed and only had to keep 5% of deposits in cash and had no restrictions on lending. The US financial system came close to collapse when almost all the trusts failed - leading to the establishment of the Federal Reserve, Ellis Tallman and Jon Moen, ‘Lessons from the panic of 1907’, (May/June 1990) Economic Review, Federal Reserve Bank of Atlanta, 11-12. See also Larry Neal, ‘Trust companies and financial innovation, 1897-1914’, (Spring 1971) The Business History Review, Vol. 45, No. 1, 35, 37, describing the rapid rise of trusts out of the insurance industry into “shadow banks”, (page 39). See also Robert Bruner and Sean Carr, The panic of 1907, (John Wiley, London, 2007) Professor Bruner draws on his research as Dean of Darden School of Business, University of Virginia
Ivo Krznar and James Morsink, ‘With great power comes great responsibility: macroprudential tools at 18
work in Canada’, (2014) IMF Working Paper 14/83, 15-16
Anil Kashyap and Jeremy Stein, ‘The optimal conduct of monetary policy with interest on reserves’,(2012)
19
American Economic Journal: Macroeconomics 2012, 4(1): 266, 270 Chapt 2, n97, (Brunnermeier), 28
these firms. As can be seen macroprudential policy and its operational tools can cover a 21 very wide spectrum. The next section narrows the scope of these measures to those that seek to limit the growth of certain types of bank balance sheet assets.
This chapter has already mentioned the role of counter-cyclical capital and liquidity, since, in particular, the former has been the main macroprudential policy used in the UK todate. As already noted, capital and liquidity requirements are also the mainstays of
microprudential regulation and supervision. They operate by raising the costs of financial institutions and hence reduce short-term profitability and returns to shareholders. The main focus is on tools which have curbing the growth of credit as their objective since,as
mentioned,this is viewed as at the core of most financial crises and a cause of financial instability. It is worth noting that surges in the expansion of credit have also been blamed 22 for the misallocation of national resources and high levels of inflation. However, the main 23 focus of the next sections will be on LTV and DTI measures which are perceived as
exclusively macroprudential tools to control the growth of credit by limiting the quantity of the latter’s use in financing property transactions. These tools work best when operating 24 “with the grain” of monetary policy and fiscal measures. 25
Note that there may be some rationality in such “herd” behaviour relevant to both macroprudential policy
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and microprudential supervision, Raghuram Rajan, ‘Why bank credit policies fluctuate: a theory and some evidence’, (1994) The Quarterly Journal of Economics, Vol. 109, No. 2, 399, 402
Chapt 2, n39, (Reinhart and Rogoff), xxv; Chapt 2, n58, (Kindleberger), 16; Atif Mian and Amir Sufi, The 22
house of debt, (University of Chicago Press, Illinois, 2015), 75-91 and 65-66; Franklin Allen and Douglas Gale, Understanding financial crises, (Oxford University Press, Oxford, 2007), 237-238; Robert Shiller,
Irrational Exuberance, (Princeton University Press, Princeton, New Jersey, 2015),61-64; (Shiller goes further saying that from his survey of mortgagees in the US they saw their large debts as a means of buying
properties larger than they could afford in order to take advantage of rising property prices in order to give themselves financial security in an unstable world, 61). See also Chapt 2, n71, (Aikman, Haldane, Nelson), 1
Stacey Schreft, ‘Credit controls: 1980’, (November/December 1990) Economic Review, 26-27 considers
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the rationale for ending limits on war-time house purchase credit by Congress in 1953. See also Douglas Elliott, Greg Feldberg, and Andreas Lehnert, ‘The history of cyclical macroprudential policy in the United States’, (2013) Office of Financial Research Working Paper No. 8, Department of the Treasury, Washington DC, 13-16 references comments made by William McChesney Martin, to a 1952 Congressional hearing on the need to maintain “real estate credit regulations in this country aim[ed] principally at influencing the flow of particularly important, unstable, and pervasive tributaries of the general flow of credit” (page 13). The Credit Control Act 1969 did retain powers for the Federal Reserve Board to control access to credit but Nancy Teeters, Governor of the Federal Reserve Board of Governors, testified to a Congressional committee “that we have no intention of using [these powers] in circumstances short of a national war.” (page 16)
Andrew Haldane, ‘Macroprudential policy in prospect’ in George Akerlof, Olivier Blanchard, David Romer
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and Joseph Stiglitz (eds), What have we learned?: macroprudential policy after the crisis, (The MIT Press, Cambridge, Massachusetts, 2014), 67. See also Olivier Jeanne and Anton Korinek, ‘Macroprudential Regulation Versus Mopping Up After the Crash’, (2014), NBER Working Paper 18675
Hyun Song Shin, ‘Macroprudential policies beyond Basel III’, (2010), Princeton University Policy Memo,
25