Policymakers around the globe are agreed that something needs to be done about the pro-cyclicality of regulatory capital, which has been exacerbated by the introduction of Basel II.
The problem is obvious — in good times banks’ loans perform well, reducing the capital they are required to hold and encouraging the loosening of underwriting criteria, which in turns spurs further lending growth. In the bad times, as loans fall into arrears and investors demand higher capital ratios, capital declines precipitously. As banks scramble to preserve their capital, lending volumes contract and the economic downturn deepens.
Consequently, the G20 has agreed on the need for counter-cyclical capital buffers which will build up during the good times and run down in the bad, hopefully moderating this boom-bust effect.
Officially, policymakers have for the time being delegated devising the precise form of the capital buffers and the indicators used to calibrate them to the Basel Committee on Banking Supervision, but they have indicated their thinking in their public pronouncements.
In the immediate aftermath of the crisis, many regulators and politicians thought they had found the answer in Spain’s system of dynamic provisioning, introduced by the Banco de Espana in 2000. The European Commission published a consultation paper in August based explicitly on the Spanish model. Under this approach, the amount of dynamic provision is a function of loan growth and historical losses through the cycle.
Over time, however, many policymakers have voiced concern about the Spanish approach — it did after all fail to prevent one of the worst housing bubbles in the world.
Most of the arguments offered against it have concerned the quantum of the buffer — it was simply too small to meaningfully constrain balance sheet growth.
Recently, however, some in the Anglo-Saxon world have hinted at another motivation — the Spanish approach lacks the ability to distinguish between different sectors of the economy, so an attempt to constrain residential mortgage lending, for instance, would also hit lending to small and medium sized businesses.
New approach, same problem
In the last week, alternative approaches have been proposed in both the US and the UK that would involve regulators exercising their judgment to micromanage the credit market cycle in a far more granular fashion than ever before.
On Monday, the Bank of England published a discussion paper on macro-prudential policy suggesting that the main policy tool could be a counter-cyclical capital surcharge applied to different “risk buckets”, including secured and unsecured household lending, corporate lending, and lending to financial institutions.
Meanwhile in the US, the House Financial Services Committee approved an amendment to its draft Financial Stability Improvement Act which would require regulators to study the feasibility of varying the risk retention requirement for securitisers in order to mitigate real estate bubbles.
The arguments for such a granular approach are, on the face of it, reasonable. Besides its inability to distinguish between sectors, the Spanish approach could also incentivise riskier lending during growth years as banks seek higher margin business to compensate for their higher capital requirements.
Yet even independent central banks have done a fairly poor job of spotting economy-wide bubbles and deflating them with their blunt tool of policy rates — the Fed has received considerable blame for holding its rates too low after the 2001 recession, allowing the housing boom to grow out of control.
Is it likely that central banks or, worse, politically controlled macro-prudential supervisors, would be able and willing to spot bubbles in individual market sectors and throttle them, over the protests of government, industry and homeowners?
Even without external pressure, the Bank of England admits that a strictly rule based approach would be impossible, as no one set of indicators would be applicable in all circumstances. Inevitably this will leave a macro-prudential supervisor at risk of always spotting the last bubble and never the next.