New macro prudential policy tools are almost certainly needed to manage potentially unstable cycles of credit and asset prices and these tools may need to distinguish between different types of credit, according to Financial Services Authority (FSA) chairman, Lord Turner.
In a lecture at the CASS Business School in London, entitled, “What do banks do, what should they do and what public policies are needed to ensure best results for the real economy?” Adair Turner focused on the role that credit can play in driving asset price cycles, which in turn can drive credit supply in a self-reinforcing and destabilising process. In the case of commercial real estate, for example, he comments that “increased credit extended to commercial real estate developers can drive up the price of buildings whose supply is inelastic, or of land whose supply is wholly fixed. Increased asset prices in turn can drive expectations of further price increases which drive demand for credit; but they also improve bank profits, bank capital bases, and lending officer confidence, generating favourable assessments of credit risk and an increased supply of credit to meet the extra demand”.
However, Adair Turner warned that using a ‘one size fits all’ policy approach to curbing asset price bubbles in commercial or residential real estate could have the unintended consequence of restricting credit to other real estate sectors of greater economic benefit. He commented: “There is, therefore, a danger that at some points in the credit/asset cycle, appropriate actions to offset the economic and financial stability dangers of exuberant lending will tend to crowd out lending which funds productive investments”.
In addition, Adair Turner noted the huge growth in scale of the financial system over the last 15 years, driven by increased leverage in household and some corporate sectors, complex securitisation and trading. He said it was important to ask whether this growth had created ‘economic value added’. In addition to his point about policy tools to influence credit, he made two additional conclusions:
* The financial innovations of complex securitisation and credit derivatives may, if purged of their excesses, have potential to improve bank risk management, but the pre-crisis argument they created major economic efficiency benefits was hugely overstated. We need to recognise that securitised credit can increase the volatility of supply: so macro prudential tools, therefore, need ideally to be able to constrain securitised credit markets as well as on-balance sheet credit.
* We need a new philosophical approach to “market liquidity” which recognises that market liquidity is beneficial up to a point but not beyond that point, so that more liquidity, supported by more trading, is not always necessarily beneficial. This implies a bias to conservatism in our setting of capital requirements against trading activity: it reinforces the case for limiting via capital requirements the extent to which commercial banks are involved in proprietary trading; and it may argue in favour of financial transaction taxes.
Considering the detail of how macroprudential tools would work Adair Turner considered the advantages and disadvantages of four approaches:
* The first is for interest rate policy to take account of credit/asset price cycles as well as consumer price inflation. But that option has three disadvantages: that the interest elasticity of response is likely to be widely different by sector – non commercial real estate SMEs hurting long before a real estate boom is slowed down: that higher interest rates can drive exchange rate appreciation: and that any divergence from current monetary policy objectives would dilute the clarity of the commitment to price stability.
* The second would be across-the-board countercyclical capital adequacy requirements, increasing capital requirements in the boom years, on either a hard-wired or discretionary basis. But that too suffers from the challenge of variable elasticity effects, given that capital levers also work via their impact on the price of credit.
* The third would be countercyclical capital requirements varied by sector, increased say against commercial real estate lending but not against other categories. That certainly has attractions, but might be somewhat undermined by international competition, particular within a European single market.
* The fourth would entail direct borrower focussed policies, such as maximum limits on loan-to-value ratios, for instance, either applied continuously or varied through the cycle.
Adair Turner concluded: “There are no easy answers here: but some combination of new macro prudential tools is likely to be required. We need ways of taking away the punchbowl before the party gets out of hand. And a crucial starting point in designing them is to recognise that different categories of credit perform different economic functions and that the impact of credit restrictions on economic value added and social welfare will vary according to which category of credit is restricted.”
