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How to Prevent Future Credit Bubbles?

Raj Nallari's picture

Several institutions, such as the US Federal Reserve Bank, the Bank of England, the Bank for International Settlements, and the IMF among others as well as private consultancy firms (e.g. McKinsey) have opined on the above question. Here is what we know from their writings. There is now a broad consensus that advanced country monetary policy had focused almost exclusively on inflation-targeting or in the case of the US, a very narrow definition of price stability, and had neglected the speculative bubbles which were jeopardizing the financial stability. The correct policy response during 2002-08 should have been higher policy rates and containing the credit-driven asset booms. But the identification of bubbles and credit booms is fraught with problems. Should credit growth of 1.5 times the nominal GDP be considered a credit boom?

Should monetary policy respond to a boom? The consensus view before the crisis was that monetary policy should focus on keeping inflation low (as this is conducive for growth). Asset prices are monitored for information related to the economic situation but never targeted by central banks. For example, there was a boom in stock prices in most emerging market economies but seldom did their central banks attempt to contain the ‘irrational exuberance.’ This narrow focus of monetary policy is based on the view that it is difficult to differentiate between a speculative boom and episodes of rational decisions by individuals. Moreover, monetary policy may be a blunt instrument to stop a boom and it may end up doing more harm to the whole economy while trying to contain a boom. For example, during booms, the expected returns on assets may be so high that small changes in policy interest rate may have little or no effect on investors’ decisions. However, higher interest rates can lower demand and supply of bank loans and could have mitigated the US and European housing boom. Similarly, raising reserve requirements can sometimes be effective in limiting credit growth in domestic currency. As discussed below, flexible prudential regulations and tightened supervision may be better tools in managing a boom.

Growth in credit and financial leverage should be monitored for systemic risk. The ratio of credit to GDP and its growth is a useful warning bell of boom conditions and leverage. Other leverage indicators could be data on borrowers and analysis of balance sheets of firms for exposures. Details of capital accounts in balance of payments could provide useful information about unsustainable leverage positions and can provide an early warning about ‘good’ and ‘bad’ booms. In addition, housing price and real-estate price booms typically involve a high degree of borrower leverage. Depending on individual country circumstances, Central Banks should develop a range of measures to assess systemic risks. These measures should include firm-specific measures and system-wide risks, including leverage and foreign exposures.

What should policy makers do in future? The 2008-09 financial crisis was in part due to unusually high over-leverage ratios of 40 to 1 by financial firms in the US and Europe. Credit flows to real estate was way too high compared with credit for small-and-medium enterprises in these countries, in part due to tax-incentives (low interest rates and tax deductions for mortgage interest) and the politicization of housing (the so-called American dream to own a house). The ongoing global crisis necessitates that at least for the next 2-3 years there will be de-leveraging, rising deficits-debt-default, and re-regulation. At the same time, there is the danger of prematurely withdrawing fiscal stimulus and monetary easing that may send the economies into another tail-spin. To minimize credit bubbles in the future, there is a need for policy makers to:

  1. Develop an international system of monitoring leveraging by banks and financial institutions, particularly the large ones, including leveraging among the various sectors in different geographical areas. There is a need for developing such a ‘heat map’ because central banks are usually unable to identify credit bubbles but can monitor leverage ratios at micro and macro levels.
  2. Encourage banks to develop risk models to include leverage ratios and internal risk-adjusted weights in each of the real sectors. Can private sector risk managers do it by themselves? Not really; the private sector has invested heavily in risk management tools and progressed quite a bit in quantitative and qualitative tools but they would need global institutions that have an advantage in comparing and contrasting across countries and sectors and firms. Stress-testing by private sector has failed. The behavior of financial firms and their counterparties has been disappointing during this crisis because the best risk-management would have been for the credit agencies to insist that mortgage originators should have a stake in the debt instruments at all times.
  3. Regulate pockets of leverage (e.g. trade brokers in certain institutions), including ensuring more capital for such highly-leveraged firms or by increasing margin requirements or by restrictions such as loan-to-value ratios for housing loans. Capital requirements are necessary but not sufficient.
  4. Phase out the distortions arising from bias in terms of directed credit and tax exemptions for the real-estate.

 

Booms and busts have been the norm for quite some time. It will continue to be the norm in the near future. The answer is not to move to Repressed Markets of the past. We have been there and done that !

Comments

I agree we should not repress markets but that must include not creating artificial incentives that confuse the markets… such as those amazing low capital requirements allowed for what some human fallible (and therefore prone to be captured) credit rating agencies perceived about badly defined risks of default. The way regulators naively trusted the capacity of determining risks, really took us back to the Middle Ages. In January 2003 the Financial Times published a letter in which I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds.”… but the world decided it was better off trusting blindly in what the regulators were up to in Basel. And, apparently, incredibly, it still does.

So risk factor is natural for the growth or profit they need to invest. Latest credit bubble is only due to repayment failures by borrowers and loss in investments. To my opinion the major reason was inflation or price rise of basic necessities of individuals led to high cost of living which failed expenditure in other areas and mortgage payments. Too much control on banks may mean less lending to needy from deposits banks have could also lead to failure. Control over rising poverty and unemployment may be one of the measures. Control over inflation of essential commodities will have less effect on family budget

Submitted by Wail Fahmi Bedawi on
Financial Liberalization vs wage repression, despite growth in productivity, in the USA FOR MORE THAN thirty years. let us remember Keynes who advised us to minimize pronness to crisis, and that is by stating that: "any increase in the level of investment must met with increase in the marginal propensity to consume", and of course to reduce unemployment rates. if this principle had been respected poverty would had been reduced and crisis had been resisted by consumers, who now been encouraged to increase their consumption for resisting recession and retain investors' (lost) confidence. of course nobody would agree the repression to market natural forces, but yes for the financial, rather than wage-earners, sector as they are dealing with something that must be repressed, mainly the derivatives, despite being toxic or not, to minmize the risk of future crisis.

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