Sunday, July 13, 2014

The return of macroprudential regulation

The Global Financial Crisis and the Great Recession have undermined several macroeconomic orthodoxies. The latest trend, in the context of rising property prices and threats of a real estate bubble, is the return to favor of macro-prudential policies to the toolkit of regulators.

Conventional wisdom has been that such asset bubbles could be regulated through conventional interest rate policies. Monetary tightening would take care of asset bubbles. But in reality monetary tightening has been off the table as an option for a variety of reasons. One, central bankers have always been averse to taking the punch bowl away when the party is on. Two, the prevailing economic weakness, especially in many developed economies,necessitated a prolonged period of monetary accommodation to boost aggregate demand. Finally, the effect of monetary policy changes go beyond real estate markets, with potentially adverse impact on the real economy. Just ask Sweden.

In the circumstances, and especially with the extended period of ultra-low interest rates, it was only natural that real estate bubbles inflate. Faced with these realities, it was only inevitable that macro-prudential policies make a come back as a preferred instrument to regulate real estate markets. However, there exists considerable uncertainty about the consequences of such policies. In particular, given construction sector's close linkage with several other real economy sectors, any adverse impact on it would most likely reverberate across the economy.

There are several macro-prudential instruments available to both rein in housing credit growth and dampen prices. One, a much stricter affordability test to ascertain the borrower's repayment ability. Two, virtual mortgage borrowing limits can be imposed either through Loan-to-value (LTV) or Loan-to-income (LTI) or Debt-to-income (DTI) ratios. Three, counter-cyclical buffers, as mandated by Basel III would force institutions to gradually raise their capital buffers as credit market conditions become imbalanced. Four, bank capital requirements on mortgages can be raised, though it would increase the cost of lending for banks. Finally, higher risk weights for mortgage lending can curb housing credit growth.

Sweden has been trying both higher capital requirements and risk weights to tame real estate prices. Norway has been gradually lowering LTV ratios, raising capital requirements, and even introduced a 1% counter-cyclical buffer. New Zealand has tightened LTV ratios. Bank of England too has embraced it, mandating only 15% of a lender's mortgages should be at an LTI ratio of more than 4.5. However, evidence from Canada, which has been implementing it, has not been encouraging. Singapore, by sharply tightening LTV ratios from 90% in 2009 to 40% in 2013, has managed to stabilize its property market.

An IMF study of macro-prudential and capital flows management (CFM) policies from 46 countries in the 2000-13 period (353 cases of policy tightening and 129 of loosening) has found that the former has been effective in stabilizing housing markets especially in Asia. In fact, even CFM policies have been found useful in damping property prices in Asian markets where they have been used intensively. It finds that macro-prudential policies have reduced credit growth by 2.6 percentage points annually.
A BIS paper that examined nine non-interest rate macro-prudential policies on housing prices and housing credit growth in 57 countries over three decades finds,
We find that changes in the maximum debt-service-to-income (DSTI) ratio have the largest and most robust effects on housing credit, with a typical tightening action lowering the real growth rate by 4 to 7 percentage points over the subsequent four quarters. None of the policies consistently affects house prices with the exception of housing-related tax increases, which slow real house price appreciation by 2 to 3 percentage points... 
However, their negative results are equally instructive,
One such finding is that instruments affecting the supply of credit generally by increasing the cost of providing housing loans (reserve and liquidity requirements and limits on credit growth) have little or no detectable effect on the housing market. Nor do risk-weighting and provisioning requirements, which target the supply of housing credit... Measures aimed at controlling credit supply are therefore likely to be ineffective... Of the two policies targeted at the demand side of the market, the evidence indicates that reductions in the maximum LTV ratio do less to slow credit growth than lowering the maximum DSTI ratio does. This may be because during housing booms, rising prices increase the amount that can be borrowed, partially or wholly offsetting any tightening of the LTV ratio.
Higher taxes are certain to tread on economically uncertain and politically difficult territory. However, in the light of evidence that real estate ownership has been a major contributor to the widening inequality, economists like Larry Summers and Adam Posen have advocated higher property taxes, especially on large homes and those keeping them vacant, and therefore presumably as an investment.

In any case, these econometric findings have limited generalizable external validity and it would also be strongly influenced by other macroeconomic conditions. As Andrew Haldane remarked, "macro-prudential policy is roughly where monetary policy was in the forties", a very much evolving field. The lack of proper understanding of its transmission mechanisms and effects only means that we have to be prepared for cautious experimentation. This insight alone should be invaluable for regulators as they seek to stabilize financial markets.

See also this article by Donald Kohn, currently a member of UK's macro-prudential regulator, Financial Policy Committee, on how the US Financial Stability Oversight Council (FSOC) can be strengthened as a macro-prudential regulator. 

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