Credit in monetaryand (macro-)prudential policy

byClaudio Borio*

Bank for International Settlements, Basel

Sveriges Riksbank Workshop on “Housing Markets, Monetary Policyand 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.

2

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

3

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

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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

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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

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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

7See Borio and Drehmann (2009a)

8See Borio and Drehmann (2009a)

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II. Information: leading indicators

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)

10

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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

12

–6

–3

0

3

6

9

–20

–10

0

10

20

30

80 85 90 95 00 05

Credit/GDP (rhs)Property prices (rhs)GDP growth (lhs)

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.

–40

–20

0

20

40

80 85 90 95 00 05

Credit/GDP Property prices

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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

Key component: countercyclical capital buffer Simplicity: what single variable can best guide build-up and release

phase? Problem:

• 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

0.0

0.5

1.0

1.5

2.0

2.5

80 85 90 95 00 05Vertical 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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Countercyclical capital buffer1: United Kingdom

0.0

0.5

1.0

1.5

2.0

2.5

80 85 90 95 00 05

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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Countercyclical capital buffer1: Spain

0.0

0.5

1.0

1.5

2.0

2.5

80 85 90 95 00 05Vertical 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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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.

0.0

0.5

1.0

1.5

2.0

2.5

80 85 90 95 00 05

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Countercyclical capital buffer1: Norway

0.0

0.5

1.0

1.5

2.0

2.5

80 85 90 95 00 05Vertical 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? 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?

Retain the “response option”

• 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. 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. Drehmann, M., C. Borio, L. Gambacorta, G. Jimenez and C. Trucharte (2010): "Countercyclical capital buffers:

exploring options", BIS Working Papers, no 317, July