Transcript Credit in monetary and

Credit in monetary
and (macro-)prudential policy
by
Claudio Borio*
Bank for International Settlements, Basel
Sveriges Riksbank Workshop on “Housing Markets, Monetary Policy
and Financial Stability”
Stockholm, 12 November 2010
* Deputy Head of the Monetary and Economic Department, Director of Research and Statistics. The views
expressed are those of the author and not necessarily those of the BIS.
Introduction

Question:
•

What can be the role of (private sector) credit in monetary (MP) and
macroprudential (MaP) policy?
Bottom line:
•
Helpful guide for adjustments in MP and MaP instruments
• So as to edge closer to lasting monetary and financial stability
1
Structure of presentation

Brief historical background on role of credit in macroeconomic policy in
post-war period
• From monetary to financial stability

Predictive content of credit for macroeconomic outcomes
• Systemic banking crises
• Output and inflation
• Key notion: financial cycle is distinct but closely related to the
business cycle

Policy applications
• MP and MaP
2
I. A brief history of credit: decline

Heyday: 1950-1960s owing to
• Objectives: domestic and external balance (less focus on inflation
per se)
• Regulated financial systems and scepticism about role of interest
rates in the transmission mechanism

Fall out of favour: 1970-80s
• Monetarism and greater focus on inflation
• Less strong theoretical and empirical link with inflation
• But still used in some countries
• Objectives (eg external balance) and controls

Wilderness (alongside money): 1990s-2000s
• Inflation targeting
• Liberalised financial systems
3
I. A brief history of credit: revival

Great Moderation ushers in the Great Financial Crisis
•
Greater awareness of risk, and output costs, of banking crises even
in mature economies
• Costs: DPV = 20% to well in excess of 100% of GDP

Credit is a the heart of such crises
•
Credit losses and defaults
•
Shift to MaP perspective
• shift from individual bank loan portfolio to aggregate credit
• Concern with “procyclicality”
• in which credit extension and contraction plays on key role
4
II. Information: paradox of financial instability

Paradox: financial system looks strongest precisely when it is most fragile
(systemic risk is highest) (Graphs)
• Short-term volatility and risk premia are unusually low; credit growth,
asset prices and profits high; leverage at market prices artificially
compressed as risk builds up
• What looks like low risk is a sign of high risk-taking
• Stability betrays underlying instability

“Raw” market prices and income/balance sheet data behave more like
contemporaneous indicators of financial distress (FD) than as leading
indicators (2-4 years ahead)

Key distinction
• (systemic) FD is an ex post event
• systemic risk (= financial instability) is an ex ante concept
⇨ Leading indicators of FD = contemporaneous indicators of financial
instability/systemic risk
5
See Borio and Drehmann (2009a)
6
See Borio and Drehmann (2009a)
7
II. Information: leading indicators


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Most promising real-time indicators of FD exploit the paradox of financial
instability to their advantage
Joint positive deviations (“gaps”) of credit-to-GDP ratio and asset prices
(especially real estate) from historical norms
• Best signal of FD 2-4 years ahead (also out of sample)
• Signal of overstretched balance sheets on the back of
aggressive risk-taking (“financial imbalances”)
• They also have information about output weakness and (less
strong?) disinflation over similar horizons
• Why?
• Credit-to-GDP gap: very rough measure of economy-wide
leverage
• Asset price gap: very rough measure of likelihood and size of
reversal
US example (Graph)
8
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II. Information: key features of the relationship



Information content is highly non-linear and episodic:
• Only beyond certain thresholds
Mean-reversion is key (boom-bust)
Linear correlations do not help

Financial and business cycles are related but distinct (Graph)
• Financial cycles linked to FD have a lower frequency than business
cycles
- Twenty years?

Not all variables have the same information content
• Property prices are better than equity prices
• The credit gap is the best single variable

The credit cycle is not symmetric
• Boom: credit plays a facilitating role
• Its stock is not a constraint
• Bust: debt overhang
• Gradual working off; forcing variable
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The business and financial cycles: US example
 The business and financial cycles interact but are not the same
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Private credit/GDP and property price gap1
Sweden
Vertical shaded areas indicate the starting years of system wide banking crises.
1
Deviation of each variable from its one-sided long-term trend (that is, a trend determined only
from information available at the time assessments are made); credit/GDP ratio in percentage
points; property prices in per cent.
Source: National data
.
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III. Policy: Macroprudential: general

Objective: limit the procyclicality of the financial system

How ? Build up buffers in good times to draw them down in bad times
•
Run down: allows system to absorb strains (limit fire sales/credit
crunch)
•
Build up:
• Optimises timing: when cheaper and easier
• May act as brake on the build-up of financial imbalances

Broad range of instruments affect credit terms
•
eg, LTVs, statistical provisioning, countercyclical capital buffers
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III. Policy: Macroprudential: Basel III
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Key component: countercyclical capital buffer
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Simplicity: what single variable can best guide build-up and release
phase?
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Problem:
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
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Build-up phase: best leading indicator of FD
•
Release phase: best contemporaneous indicator of FD
• Hard to imagine how same variable can do both
Answer
•
Build-up: credit-to-GDP gap
•
Release: signs of stress (eg credit terms, losses, etc.)
Not work too badly! (US, UK, ES; graph)
•
Weights for cross-border exposures address losses due to foreign
cycles (eg CH, DE)
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Countercyclical capital buffer1: United States
Vertical shaded areas indicate the starting years of system wide banking crises.
1 The countercyclical buffer is 0 when the value of the credit/GDP gap is below 2 and 2.5 when it is above 10 per
cent; for gaps between 2 and 10 percent the buffer is calculated as 2.5/8 times the value of the credit/GDP gap
exceeding 2 per cent.
Source: BIS calculations
15
Countercyclical capital buffer1: United Kingdom
Vertical shaded areas indicate the starting years of system wide banking crises.
1 The countercyclical buffer is 0 when the value of the credit/GDP gap is below 2 and 2.5 when it is above 10 per
cent; for gaps between 2 and 10 percent the buffer is calculated as 2.5/8 times the value of the credit/GDP gap
exceeding 2 per cent.
Source: BIS calculations
16
Countercyclical capital buffer1: Spain
Vertical shaded areas indicate the starting years of system wide banking crises.
1 The countercyclical buffer is 0 when the value of the credit/GDP gap is below 2 and 2.5 when it is above 10 per
cent; for gaps between 2 and 10 percent the buffer is calculated as 2.5/8 times the value of the credit/GDP gap
exceeding 2 per cent.
Source: BIS calculations
17
Countercyclical capital buffer:1 Sweden
Vertical shaded areas indicate the starting years of system-wide banking crises.
1
The countercyclical buffer is 0 when the value of the credit/GDP gap is below 2, and 2.5 when it is above 10%;
for gaps between 2 and 10% the buffer is calculated as 2.5/8 times the value of the credit/GDP gap exceeding
2%.
Source: BIS calculations.
18
Countercyclical capital buffer1: Norway
Vertical shaded areas indicate the starting years of system wide banking crises.
1 The countercyclical buffer is 0 when the value of the credit/GDP gap is below 2 and 2.5 when it is above 10 per
cent; for gaps between 2 and 10 percent the buffer is calculated as 2.5/8 times the value of the credit/GDP gap
exceeding 2 per cent.
Source: BIS calculations
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III. Policy: monetary: why?
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MaP policy is not enough for financial stability
Imprudent to believe otherwise
• Evidence as brake on financial imbalances is mixed
• Financial boom-busts can be very damaging even if financial crises
are avoided
Influence of MP on credit conditions, asset prices and yields is not in
doubt
• Hard to see how could affect expenditures otherwise!
Growing evidence of influence on risk-taking
• Risk measures/tolerance move in sync with asset prices, profits,
cash flows
• Nominal rates below historical norms can lead to search-for-yield
• Asymmetric reaction functions provide a form of insurance
MP cannot be arbitraged away so easily
• Sets the universal price of leverage in a given currency
• But issues in highly open economies
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III. Policy: monetary: how?
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Retain the “response option”
•
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Tighten policy even if near-term inflation appears under control
How?
•
Lengthen policy horizon
•
Assess the balance of risks based on indicators of the financial cycle
• Key role of credit
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Selected references to BIS work

BCBS (2010): An assessment of the long-term economic impact of stronger capital and liquidity requirements, August

Borio, C (2009): The financial crisis of 2007-?: macroeconomic origins and policy lessons, in proceedings of a G20
Workshop on the Global Economy - Cause of the crisis: Key Lessons,
http://www.g20.org/Documents/g20_workshop_causes_of_the_crisis.pdf

——— (2010) “Implementing a macroprudential framework: blending boldness and realism”, keynote address for the
BIS-HKMA research conference on “Financial Stability: Towards a Macroprudential Approach”, Honk Kong SAR, 5-6
July 2010. http://www.bis.org/repofficepubl/hkimr201007.12c.htm

Borio, C and M Drehmann (2009a): “Towards an operational framework for financial stability: 'fuzzy' measurement and
its consequences”, in Banco Central de Chile (ed), Financial stability, monetary policy and central banking; also
available as BIS Working Papers, no 284.

——— (2009b): “Assessing the risk of banking crises – revisited”, BIS Quarterly Review, March, pp 29–46.

Borio, C. and P. Lowe (2002). Asset prices, financial and monetary stability: exploring the nexus. BIS Working Papers,
No. 114.

——— (2004). Securing sustainable price stability. Should credit come back from the wilderness? BIS Working
Papers, No 157.
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Borio C and H Zhu (2008): “Capital regulation, risk-taking and monetary policy: a missing link in the transmission
mechanism?”, BIS Working Papers, no 268, December.
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Drehmann, M., C. Borio, L. Gambacorta, G. Jimenez and C. Trucharte (2010): "Countercyclical capital buffers:
exploring options", BIS Working Papers, no 317, July
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