June 24, 2014 6:11 pm
The central bank has new tools to stop bubbles. Now they face their first test
©FT Mark Carney: 'Macroprudential policy is not a substitute for monetary policy'
In June 2010 George Osborne, Britain’s newly appointed chancellor, stood before a stony-faced audience of bankers and money managers in the City of London and announced a revolution in the way finance would be supervised.
The Bank of England was to be handed enough regulatory weapons to make it one of the most powerful central banks on earth. With those new tools would come orders to end the country’s cycle of boom and bust.
Only four years later, the central bank’s willingness to take up arms to preserve financial stability is about to be tested. Members of its Financial Policy Committee, led by Mark Carney, the governor, will gather on Thursday in an auditorium in the bank’s Threadneedle Street headquarters to reveal what they plan to do about a housing market that is heading into double-digit price growth.
The theory behind these weapons – including ceilings on the amount of mortgage debt a borrower can take on relative to their incomes and increases the amount of capital banks have to hold against risky loans – is that they will head off feast-or-famine cycles in the financial system. Yet many of these so-called macroprudential regulations are relatively untested.
Central bankers are deeply divided over how heavily they can rely on them without also changing monetary policy – especially at a time when stocks, bonds and other assets around the world are being stoked by five years of cheap money.
Philipp Hildebrand, the former head of the Swiss central bank and now a vice-chairman of BlackRock, worries that in a worst-case scenario central banks could end up being accused of having failed twice – first by fuelling market distortions through loose monetary policy and then proving unable to tackle them because of incomplete tool kits.
Policy makers should use macroprudential rules to curb imbalances, he argues, but they should also be aware that they can be politically unpopular and that people can find a way around them. “It is not a perfect substitute for monetary policy. And the politics – I went through this myself – are far more complicated than the politics of monetary policy,” he says.
The BoE has one of the most wide-ranging tool kits of any central bank. It has the power to boost banks’ capital requirements against asset classes such as real estate, request tougher affordability tests on borrowers, and counsel the introduction of maximum ceilings on loan-to-value or loan-to-income ratios, as well as mortgage terms.
Mr Osborne this month vowed to further strengthen its armoury by putting the power to set loan-to-income ratios on a statutory footing. But Britain’s experience has shown that developing an extensive macroprudential arsenal is only the beginning. It must also figure out how to use it.
Macroprudential levers are meant to prevent boom-to-bust cycles in finance by curbing surging optimism before dangerous bubbles form. They can add resilience to financial institutions, helping them withstand a downturn in asset prices, and, in the words of Mr Carney, provide insurance against a future crash by curbing excessive credit.
Putting these ambitious ideas into practice has thrown up serious challenges in the UK. After taking power in 2010, the Conservative-led coalition government junked the old regulatory structure and handed a swath of responsibilities to the BoE. But tensions quickly developed between regulators who wanted to shockproof the financial system and politicians anxious to nurture the recovery.
Mr Osborne told the BoE, then under Mervyn King, the former governor, not to undermine growth by insisting on a financial system with “the stability of the graveyard”. Vince Cable, the business secretary, went as far last year to complain that the BoE was a “capital Taliban”. This was backed up by a Treasury official complaining of a “jihadist” tendency in Threadneedle Street.
Further tussles ensued over whether macroprudential tools should operate behind the scenes or in the public glare. Under Lord King, the settled view in the BoE was that the central bank should not set highly visible limits on mortgage lending, which would be unpopular with the public.
Technocrats preferred the subtler gambit of tweaking bank capital requirements rather than overtly preventing citizens from buying homes deemed to be beyond their means.
But the Bank for International Settlements and others have endorsed the use of measures such as loan-to-income ratios to damp the credit cycle. Mr Osborne declared this month that he would legislate to hand these tools to the BoE in an announcement that dispelled any doubt about where responsibility for curbing housing excesses lies.
The UK debate is dogged by the question of whether macroprudential policy should attempt to prick asset price bubbles that are not primarily associated with a sharp rise in credit. Such episodes include the dotcom bubble of the 1990s, and now – arguably – London’s house price boom, which has been accompanied by relatively modest lending growth.
Yet perhaps the most difficult conundrum of all is the degree to which macroprudential policies can take a contrasting stance to monetary policy. Can a country have interest rates at the floor, providing incentives to borrow, while wielding macroprudential weapons to prevent excessive borrowing?
There was a time when the BoE appeared to think there was no tension between the policies. Mr Carney said last November that actions by the FPC to trim mortgage lending would allow monetary policy to provide “exceptional” stimulus to the economy.
More recently, the governor has made it clear that there is a limit to the degree of divergence. “Macroprudential policy is not a substitute for monetary policy,” Mr Carney said this month, as he put markets on notice that a rate increase is on the horizon.
Many economists expect some kind of action to be announced on Thursday. Adam Posen, president of the Peterson Institute in Washington and a former BoE policy maker, argues it is important to respond to London’s red-hot housing market – whether or not it is a full-blown bubble – to prevent it from causing serious imbalances in the broader economy.
Rate rises would be too blunt an instrument for tackling the problem, he argues, making the case for macroprudential action, potentially coupled with taxes on foreign buyers.
Among the possible moves are ceilings on loan-to-income ratios or limits on mortgage terms, as well as tougher interest rate scenarios for gauging mortgage affordability. Erlend Nier, deputy chief of the International Monetary Fund’s monetary and macroprudential policies division, says the experience of Hong Kong in the 1990s and South Korea in the 2000s shows these tools are effective not only in reducing the upswing but also in increasing the resilience of the borrowers to asset-price shocks.
However Matthew Whittaker, economist at the Resolution Foundation, a think-tank, warns that the BoE needs to tread carefully as it ventures into unfamiliar territory. The risk is that macroprudential interventions could end up having the perverse effect of plunging existing households into even deeper debt problems.
He estimates that the introduction of a maximum loan-to-income ratio of 3.5 times – as suggested by Mr Cable this month – would affect no fewer than 2.7m existing borrowers, making it harder for them to remortgage and putting their finances under strain.
Then there is the “fighting the last war” argument: there is no guarantee that the next crisis will start in real estate. Super-low volatility, high bond prices, declining lending standards and excessive investor risk-taking suggest that the biggest risks may be brewing in the financial markets.
Mr Haldane last week compared the current conditions with those leading up to the crisis of 2007-09, pointing out that while two years ago yields on Italian and Spanish debt were 5 percentage points above US Treasuries – viewed as the most secure and liquid government bonds in the world – they have now sunk below US Treasury yields.
Officials in the Federal Reserve and elsewhere are working on additional regulatory levers that could help trim risks in financial markets – by controlling margin requirements on transactions or introducing exit fees to reduce the danger of stampedes from bond funds – but their thinking remains in its infancy. “This is very much frontier territory,” says Mr Nier.
As a result, many economists argue that central banks may need to use the more traditional lever of interest rates to help ward off dangerous booms in financial markets.
Jeremy Stein, a former Fed governor, has said that disruptions originating in the capital markets may be “less amenable to being dealt with via financial regulation”. It is possible for investors to dodge regulatory barricades, whereas monetary policy “gets in all of the cracks”, he has argued.
Sushil Wadhwani, a former BoE policy maker who now runs a hedge fund, is among those who argue there are signs of “irrational exuberance” building in some corners of the market. This is in part due to the actions of central banks themselves, which are enlivening investor spirits and suppressing volatility by signalling interest rates will stay low through so-called forward guidance.
“The notion that you can find some specific macroprudential tool and leave ‘forward guidance’ in place is fanciful – it is not going to work,” he says. “With our current level of ignorance it is dangerous to put too much reliance on these tools.”
1928 – The US Federal Reserve tightens monetary policy, motivated in part by worries over stock market speculation. The Great Crash occurs in 1929, followed by the Great Depression.
1989 – Japan raises interest rates and tightens regulation to quell lending to real estate projects and companies, but the moves came too late to stop a disastrous bubble from developing.
1995 – Hong Kong adopts a maximum loan-to-value ratio of 70 per cent as a formal regulatory policy in the property market. The next year the regulator recommended a maximum ratio of 60 per cent on luxury properties.
1996 – Alan Greenspan, the Fed chairman, uses the phrase “irrational exuberance”, which was interpreted as a signal that asset values might be overvalued. But the Fed does not take action to damp stock market gains. His philosophy was to allow bubbles to burst and mop up afterwards – which he does after the dotcom boom.
2004 – Mervyn King, Bank of England governor, warns house prices may fall because they are above sustainable values. The housing market does not undergo a major correction until four years later, when the banking crisis strikes.
2013 – The Reserve Bank of New Zealand introduces loan-to-value ratio restrictions on home loan lending. It takes some steam out of the market, although values still rose at an 8.1 per cent annual clip in May 2014.
2014 – Switzerland doubles the size of a capital buffer banks must hold against risks in their mortgage books as house prices rise to historic highs. Prices have continued to grow – albeit at a slower pace.
2014 – George Osborne, UK chancellor, says he will legislate to grant the BoE legal powers to “direct” limits to the amount of money people can borrow as a ratio of their salary or impose loan-to-value caps on the size of a mortgage in relation to the purchase price.
Copyright The Financial Times Limited 2014.