Don Kohn of BoE Examines Lessons from Last Global Financial Crisis

Macro-prudential policy tries to assure that the financial system does not amplify shocks and will continue to deliver its essential services, even after severe, unexpected developments. In this context, he discussed the contribution of the countercyclical capital buffer (CCyB) of Basel III. increases in this buffer have come to be used in a number of jurisdictions, as economies and banking systems have recovered from the crisis, including in the UK. Setting this requirement does have its challenges, including identifying and scaling vulnerabilities in environments in which, as is often the case, indicators are giving mixed signals, and then calibrating the appropriate CCyB setting. A second challenge to macro-prudential policy more generally is identifying and dealing with financial vulnerabilities outside the banking system, where they could be lodged in lightly regulated entities and markets. A third challenge is avoiding arbitrage across geographical jurisdictions that simply pushes risk around globally integrated financial markets. According to Mr. Kohn, progress has been made on all three of these fronts since the global crisis, but more remains to be done. Despite these challenges, global financial stability would be better assured if more jurisdictions, including the U.S., adopted a more active use of the CCyB—making sure that banks and other intermediaries retained enough capital in the upswing now going on to safeguard their ability to deliver essential services at reasonable prices in the next downswing.

He said that stress tests are a critical building block for gauging the appropriate level of countercyclical capital. Stress tests should be a key input into a decision about the CCyB, but they are not a substitute for explicitly setting CCyBs. However, the CCyB alone will not be the most efficient or even a sufficient way to mitigate many financial stability risks. For example, mortgage lending against residential real estate has been the culprit in quite a few financial sector problems in many jurisdictions. The externality from troubled housing markets can come from the cutbacks in spending by borrowers who are struggling to service their debt as well as from lenders. The ability to set minimum standards for mortgage lending should be in the tool kit of every macro-prudential authority and that authority should be willing to use it countercyclically. He mentioned that, in this regard, the U.S. falls short of even having the typical macro-prudential tools, much less of an intention to use what controls there are to foster financial stability. Under most circumstances, macro-prudential tools of the sort we have been discussing are likely to be far more effective dealing with financial stability risks than would be the interest rate tools of monetary policy, whose comparative advantage is countering real and price shocks.

As per Mr. Kohn, tightening regulation in good times when the financial system is perceived to be strong, and easing requirements when developments threaten to weaken it, will not be intuitive to many people. Banking lobbies will be opposed to increases in capital requirements or greater restrictions on loan terms; they will try to rally the public to their perspective by citing increased costs of credit. People worried about protecting taxpayers and deposit insurance funds will be hesitant to buy into any relaxation when the cycle turns. Thus, he concluded that “we” need to be active now in explaining to the general public as well as to their elected representatives the public benefits of countercyclical macro-prudential policy and reminding them of the lessons learned about increasing complacency in good times leading to the kinds of serious economic deprivations that were experienced not so many years ago.

Related Link: Speech

Keywords: Europe, UK, Banking, Basel III, CCyB, Macro-prudential Policy, FPC, BoE