PrefBlog

The Bank of Canada has released the Bank of Canada Review: Summer 2010 with articles:

• Lessons Learned from Research on Infl ation Targeting
• Monetary Policy and the Zero Bound on Nominal Interest Rates
• Price-Level Targeting and Relative-Price Shocks
• Should Monetary Policy Be Used to Counteract Financial Imbalances?
• Conference Summary: New Frontiers in Monetary Policy Design

The Financial Imbalances article points out:

Another potentially important cost of leaning against
fi nancial imbalances stems from the difficulty of identifying them and of calibrating an appropriate response. If fi nancial imbalances are falsely identified, responding to them through monetary policy could induce undesirable economic fluctuations (Greenspan 2002; Bernanke and Gertler 1999).

The question, according to the authors, is:

Granted that appropriate supervision and regulation
are the fi rst line of defence against financial imbalances, the key question is whether they should be the only one. In this context, developing a view on whether monetary policy should lean against financial imbalances requires that we first examine the interaction between the effects of prudential tools and those of monetary policy on fi nancial imbalances that stem from various sources.

A credit-fuelled housing bubble is a particularly relevant example of a fi nancial imbalance. This section considers the case of over-exuberance in the housing sector, represented as a temporary increase in the perceived value of housing that results in a short-term surge in mortgage credit. This example is calibrated to produce housing-market dynamics that are roughly similar to those of the housing market in the United States in the run-up to the recent crisis. Specifically, the size of the shock is set at 5 per cent of the value of housing collateral; this leads to an average increase in mortgage debt in the first year of about 16 per cent, comparable with the average annual growth rate of mortgage debt over the 2003–06 period.

We evaluate the relative merits of using monetary policy to contain this imbalance and compare it with a well-targeted prudential instrument—namely, an adjustment in the mortgage loan-to-value (LTV) ratio.

The authors have the fortitude to emphasize:

As mentioned in the introduction, one important argument against using monetary policy as a tool in these situations is that fi nancial imbalances cannot be detected with certainty. This uncertainty applies not only to monetary policy, but also to prudential policy, and should play a role in determining how forcefully to react to the prospect of building financial imbalances.

By me, this is such an important consideration that it virtually negates the concept of leaning against the flow. I am in favour of a progressive surcharge on banks’ Risk Weighted Assets based on how much these have changed over the past few years, but that’s based more on management factors than economic ones.

By definition, a bubble will have lots of defenders ready to explain why it is not a bubble, as discussed recently in FRBB: Bubbles Happen. Trying to nip bubbles in bud on the basis of a bureaucrat deciding that eggs should cost $2.99 a dozen and $3.25 is too much is fraught with dangers.

The Bank of Canada has released:

a comprehensive assessment of the potential impact on the Canadian economy of new global capital and liquidity standards, which are to be finalized later this year by the G-20.

The study is titled Strengthening International Capital and Liquidity Standards: A Macroeconomic Impact Assessment for Canada:

While this country boasts a strong financial sector, it too was buffeted by financial shocks from abroad. Our economy could not escape the spillover effects of the ensuing global economic downturn. Canadian economic output fell by more than 3 per cent during the crisis, and more than 400,000 jobs disappeared.

This looks like mistake number one, according to me – it assumes that the damage caused during the Panic of 2007 was all attributable to the financial crisis itself, which I think is a load of hooey.

Recessions are good things; a recession is nature’s way of telling us we’re doing things wrong. Most of the harm experienced in Canada during the Panic may be ascribed to the auto industry … hands up everybody who thinks that there were no problems in the auto industry prior to the crisis! Didn’t think so … the Panic brought things to light and forced the decision makers to address a problem … it didn’t actually cause the problem.

Financial crises are damaging because they bring a lot of problems to light all at the same time.

But for the first time, I see official acknowledgement that higher capital ratios are not automatically good:

The benefits of higher capital and liquidity standards must be weighed against their potential costs to the Canadian economy. Over time, it is expected that banks will seek to pass on the cost of higher capital and liquidity requirements through higher lending rates to borrowers. The cost of higher capital is higher lending spreads, which the Bank calculates would increase by about 14 basis points for every percentage-point increase in bank capital requirements. This figure was then used as an input to the Bank’s macroeconomic models to gauge the impact on economic output. New liquidity requirements also present costs for the Canadian economy. These requirements are estimated to add roughly an additional 14 basis points to lending spreads, and thus are equivalent in impact to an additional 1-percentage-point increase in bank capital requirements. Consequently, the cost of a 2-percentage-point increase in capital requirements, in conjunction with the new liquidity standards, should be an increase in lending spreads of about 42 basis points.

However, they show more than just a little political influence with:

In the wake of the crisis, the Bank of Canada cut its target for the overnight rate to a historic low of one-quarter of one per cent, and decades of progress in improving Canada’s fiscal position suffered a setback as fiscal support for the Canadian economy pushed federal and provincial government budgets back into substantial deficits.

The GST cut and elimination of the structural surplus had nothing to do with it, so vote Conservative!

The regulators have been busy:

To assess the potential economic implications of these reforms, the Financial Stability Board (FSB) and the BCBS conducted two international studies that assessed (i) the longer-run macroeconomic benefits and costs (the LEI report) and (ii) the shorter-term transition costs (the MAG report) associated with adopting the new standards. (footnote) The reports are: “An Assessment of the Long-Term Economic Impact of the New Regulatory Framework” (the LEI report), and “Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements – Interim Report “ (the MAG report). Both are available at http://www.bis.org.

They do acknowledge a major problem:

No allowance is made for the possibility that households and firms may find cheaper alternative sources of financing in the longer run that would reduce the impact of the new rules on the economy.

If loan rates increase 42bp, I would consider that a certainty. Private mortgages will take off and I’m wondering about the potential to start a private mortgage fund myself. What’s more, this will siphon off the good business from the banks and leave them with the dregs … but there’s no allowance for it.

Specifically, assuming a starting probability of a crisis of 4.5 per cent in any given country, the LEI report found that an increase of 2 percentage points in bank capital ratios reduced the probability of a financial crisis by 2.9 percentage points, while increases in capital ratios of 4 and 6 percentage points reduced the probability of a financial crisis by 3.6 and 4 percentage points, respectively. These calculations assume a combined effect from increases in capital as well as from new liquidity rules.

When these reductions in the probability of a crisis (e.g., 2.9 percentage points for a 2-percentage-point increase in capital ratios) are multiplied by the cumulative cost of crises (63 per cent of GDP), the benefits to annual economic output are potentially large, in the order of 2 per cent of GDP

If, as I assert, the bulk of the costs experienced during financial crises are simply reflections of structural problems that are merely brought to light by the crisis, then this calculation is … er … inoperable.

For example, following the approach used by the United Kingdom Financial Services Authority (U.K. FSA) and described in Barrell et al. (2009), the annual probability of a domestic financial crisis was estimated based on several domestic factors, including the unweighted capital ratio of banks, their liquid assets as a share of total assets, and house prices expressed in real terms. This approach suggests a 1.7 per cent probability of a financial crisis occurring in Canada (implying that a financial crisis occurs, on average, every 60 years or so). This figure is substantially lower than the LEI report’s 4.5 per cent likelihood of a foreign financial crisis (approximately once every 22 years).

Since the banks nearly blew themselves in the late eighties with the MBA crisis, I guess that means we’ve got about forty years to go.

As indicated in Annex 1, most Canadian banks appear to be well placed to meet the new Liquidity Coverage Ratio requirement, since they carry a large stock of residential mortgages that could be converted at a small cost to federal government-guaranteed National Housing Act Mortgage-Backed Securities that would qualify as eligible liquid assets under the new rules.

Great! Wave a magic wand, and suddenly you get to recategorize existing assets. This part really gives me a lot of confidence, you know?

Given the current exceptionally low level of bank deposit rates and the cost of bank debt funding more generally, it is also assumed that the wider interest margins will effectively result in higher interest rates (lending spreads) on bank loans to households, firms, and other sectors of the economy. It is further assumed that the higher lending spreads will be passed along to all bank borrowers, and not just to certain subgroups, such as households or small and medium-sized businesses (SMEs), because all banks in Canada and abroad will be affected by the higher capital and liquidity requirements.

Apparently, Dr. Pangloss had a hand in this report. As noted above, increased spreads will increase the opportunity for shadow banks to move in … there will be a lot of business borrowing at prime (or prime+) who are going to find the commercial paper market (either directly or via BAs) and short-term bond issuance to be a whole lot more attractive if spreads increase 42bp.

Don’t get me wrong! I’m very happy to see that, at last, there is some official acknowledgment that increased capital standards will have a cost. But I think some of the embedded assumptions are more than just a little bit suspect and I look forward to seeing academic attacks on this paper.

A related post is Elliott: Quantifying the Effects on Lending of Increased Capital Requirements