Archive | April 2016

Bank regulators are confused by their own mess

Regulators are getting confused by their own reform package. After years of promoting contingent convertible bonds (CoCos) as a good alternative to pure equity capital, and basing a number of their regulatory changes on them, they are now backtracking, as the FT reports (at least in the case of the ECB):

Cocos are a key pillar in the regulatory regime drawn up to strengthen banks’ capital levels and prevent taxpayer bailouts after the financial crisis. But while they are supposed to increase financial stability, concerns about them helped whip up market volatility in February.

Senior executives at several large banks have told officials at the [Single Supervisory Mechanism] that the rules for cocos are too complicated and they could undermine a bank’s financial position rather than strengthen it in a crisis.

CoCos are a form of hybrid debt that converts into equity when a bank’s regulatory capital ratio falls below a certain threshold. They are currently accounted for as ‘Tier 1 capital’. On paper, they sound quite straightforward.

In reality, they are quite opaque. Nobody really knows how to accurately value them. They have both equity and debt-like properties: cash flows are less recurring than debt but more than equity. Nobody really knows how those instruments will fare from a legal point of view when a firm goes into administration. Regulation in some jurisdictions also prevent coupon payments in some unclear cases, even when the bank isn’t about to fall into bankruptcy.

The market has boomed over the past few years as rates on offer looked attractive in a low interest rate environment that pushed many investors to search for yield. CoCos, apparently safer than stocks, seemed to be the easy choice. Some commentators started to worry that interest rates on new issues were way too low for an equity-like instrument (yields fell to about 6% and remained there since 2013, see The Economist chart below, whereas the required return on equity is usually estimated around 11 or 12%). And indeed, CoCos’ valuations suffered during the bank sell-off earlier this year as investors suddenly woke up to the fact that they actually didn’t fully understand those instruments. This CoCo sell-off actually endangered the stability of the banking system, at odds with regulators’ original aim.

CoCo yields

Regulators are also backtracking on capital requirements, as they see how damaging they are for smaller banks. Reuters report:

The European Union will propose changing the bloc’s rules on bank capital requirements to ease the burden on smaller lenders in a bid to boost growth, EU financial services chief Jonathan Hill said on Thursday.

In a speech in Amsterdam where EU finance ministers are meeting, Hill said he wants to lighten reporting and disclosure requirements for smaller banks.

“I also want to see whether the intricate calculations banks have to do to comply with prudential rules could be simplified. And whether there is a case for small banks with limited trading activities to be exempt from capital requirements for trading book exposures,” Hill said.

Hill’s speech underscored the willingness of the EU to deviate from globally-agreed capital norms to encourage more banks to lend more.

What the EU is proposing to create is a multi-speed regulatory framework. And we know how damaging multi-speed systems are: firms and individuals engage in regulatory engineering or even stop or reduce their activities in order not to move into the next, more burdensome and constraining, bucket, as this could imply larger additional marginal costs than marginal revenues.

We all know that small banks suffer from those misguided regulatory packages that Basel 3/Dodd-Frank/CRD 4 are, but the best solution is to repeal them for all banks, not create a multi-speed system and introduce further distortions and regime uncertainty that paralyse lending and prevent economic recovery. We’ve had enough of this mess.

PS: Bloomberg reports that Credit Suisse is looking to issue a new type of fixed income instrument that would cover potential operational losses due to rogue trading, fraud or cybercrime, in cooperation with the Zurich Insurance group. As Bloomberg says:

Regulators require banks to hold funds as a safeguard against various kinds of vulnerability, leaving them with less money to build the business.

Here again this potentially difficult to value instrument emerges from the willingness to offset the often unnecessary costs of capital regulation. But it doesn’t take a genius to figure out that those ‘solutions’ create problems of their own.

Update: Regulators are also about to introduce a new capital requirement for interest rate risk, which is likely to seriously weigh on banks’ profitability. It is funny that central bankers, who ow also often are regulators, decide to boost the economy by pushing rates down as much as possible, but then penalise banks for the same reason. Such incoherence is not going to help lending volumes, I’m telling you.


Academics’ unhealthy obsession with bank opacity

I just read a January 2015 paper (not very recent, I know, but my reading list is huge) that was not only curious, but also plain wrong. The paper, titled Understanding the role of debt in the financial system and written by Bengt Holmstrom, illustrates a curious belief among a number of academic economists: that banking, in order to be stable, should be opaque.

The abstract sets the tone:

Money markets are fundamentally different from stock markets. Stock markets are about price discovery for the purpose of allocating risk efficiently. Money markets are about obviating the need for price discovery using over-collateralised debt to reduce the cost of lending.

Later, he adds that

Without the need for price discovery the need for public transparency is much less. Opacity is a natural feature of money markets and can in some instances enhance liquidity

His views about the stock market/money market differences are summarised in the following table:

Holmstrom money markets

Now let me say that there is virtually nothing in his arguments that is grounded in reality. This theory is completely disconnected from the day-to-day routine of finance workers.

Let’s start with Holmstrom’s definition of ‘money markets’. Following his paper, money markets only involve repurchase agreements. This cannot be further from the truth. Money markets (which we can also call interbank markets) not only involve repos, but also uncommitted and unsecured interbank placements (which include Fed funds). In fact, for many banks, those placements represent the bulk of their money market exposures. For instance, according to the financial database Bankscope, JPMorgan’s assets comprised $213Bn of reverse repos and $340Bn of interbank placements. Citigroup: $120Bn and $112Bn. Deutsche Bank: EUR107Bn and EUR13Bn. HSBC: $147Bn and $96Bn*. Small banks, that have very limited trading activities, have almost no reverse repo transactions outstanding.

So the unsecured, relatively longer-term, interbank market is at the least a sizeable portion of money markets. And it is completely ignored by Holmstrom’s generalisation. Given that his arguments rest on the ability of the lender to over-collateralise his exposure, they suddenly weaken considerably.

More fundamentally, Holmstrom really misunderstands the differences between stock and money markets. In reality, both markets are very information sensitive and require transparency. Both markets rely on fundamental financial analysis to assess the riskiness of any investment. Equity markets are more liquid because they involve only a single instrument by issuing firm; instrument whose value is highly sensitive to the profitability of the firm because its yield depends on it.

Credit markets are much, much, larger and involve a multitude of instruments by issuing firm, covering a broad spectrum of hybrids from pure credit to almost equity-like debt. Those debt instruments are ranked differently in the hierarchy of creditors. Senior creditors, including unsecured money market placements, have the first claim on a bankrupt firm’s assets. Does this mean they are information insensitive? Certainly not. But the market value of a firm’s assets fluctuates less than the same firm’s profits/cash flows. Price discovery is continuous; either at issuance (the higher the risk, the higher the interest rate), or on the ‘secondary’ market: given that interest rates on issues are usually fixed, a decline or improvement in the risk profile of the issuer triggers a change in the market price of related issues. Therefore information, and indeed transparency, is crucial in this continuous risk assessment process.

So Holmstrom’s generalised arguments about ‘money markets’ are simply wrong. But are secured credit markets, including reverse repos, devoid of the above rules? Does collateral-posting allow the lender to avoid assessing the inherent riskiness of his counterparty?

While it is true that collateral mitigates risk, no serious lender would ever blindly lend merely on the basis of collateral availability. There are a number of reasons for that. First, collateral is also subject to credit risk, and needs separate assessment. Second, collateral is subject to market risk (i.e. market price fluctuations), requiring the application of a haircut. Despite the haircut, when a crisis strikes and markets all fall simultaneously, the value of your collateral can potentially collapse as fast, if not faster, than the amount you lent. Third, legal risk means that there can be a delay between the insolvency event and the moment you can legally take possession of the collateral (depending on the original contract). And fourth, the news that you had exposure to a collapsing firm, even if you were secured, can easily raise risk-aversion towards you and trigger financial difficulties.

In the end, even in the case of secured lending, fundamental analysis, which relies on transparent information, is necessary. Opacity, unlike what our economists believe, is usually ‘credit negative’ and accentuates the compensation and/or the collateralisation that the lender requires. Moreover, how can the collateralisation level of a transaction be determined without some sort of initial price discovery? Holmstrom does not answer this question.

Unfortunately, Holmstrom’s piece is full of facts that are grounded in an imaginary world. For instance, see his claim that

When new bonds are issued, the issue is typically sold in a day or less. Little information is given to the buyers. It is very far from the costly and time-consuming road shows and book-building that new stock issues require in order to convey sufficient information.

Please, I beg you never to say that sort of things at a financial conference if you don’t want to get laughed at. The truth is that specific roadshows targeting fixed income investors are regularly organised by companies. Fixed income managers also employ buy-side analysts who spend their day analysing those firms, as well as reading pieces of financial research published by sell-side analysts. According to Holmstrom, those people do not seem to exist.

He also claims that bond ratings are ‘coarse’, and that this is “another example of what appears to be purposeful opacity.” I find this amazing, given that rating agencies have about 22 different base rating notches, to which a multitude of extra ratings are added in order to provide the information Holmstrom believes is opaque. Now compare this with the usual three-notch stock rating system of Buy/Hold/Sell and you might conclude he got seriously mixed up here.

This tendency to believe that opacity ‘helps’ markets seems to be spreading. In 2014, Gorton et al (which included, unsurprisingly, Holmstrom) published a very weird paper titled Banks as Secret Keepers, which argues precisely that:

Banks are optimally opaque institutions. They produce debt for use as a transaction medium (bank money), which requires that information about the backing assets – loans – not be revealed, so that bank money does not fluctuate in value, reducing the efficiency of trade. This need for opacity conflicts with the production of information about investment projects, needed for allocative efficiency. Intermediaries exist to hide such information, so banks select portfolios of information-insensitive assets. For the economy as a whole, firms endogenously separate into bank finance and capital market/stock market finance depending on the cost of producing information about their projects.

The paper is based on a mathematical model that seems unable to describe what happens in real financial and deposit markets. And indeed they don’t bother providing much empirical evidence of their claims (as I am writing this post, Kadhim Shubber of FT Alphaville quotes the exact same paper rather uncritically).

At the end of the day, Holmstrom’s and Gorton’s theories seem to justify government intervention in deposit and money markets. But as Kevin Dowd just brilliantly reminded us, those ‘opacity’, ‘information asymmetry’ and ‘market failures’ in no way justify banking regulation, unless you disregard all empirical and historical evidences. And, of course, unless you don’t believe in government failure. Sadly, it seems that imagination wins over reality nowadays in academia.


*Moreover, some of the ‘reverse repo’ figures might include collateral posted against other sort of trades, as well as transactions with non-financial counterparties, implying that the ‘pure’ money market reverse repo portion mentioned here is likely smaller.

This post was re-published on Alt-M.

Even central banks suffer from negative rates

The FT reports today that central banks also suffer from negative interest rates. It couldn’t be more ironic.

Investors ranging from small German savers to global life insurers have long complained about central banks’ use of negative interest rates.

Now, however, another group is feeling the pain from negative rates — central banks themselves.

European and Japanese rate cuts are putting pressure on many central banks’ returns — a source of income used to cover running costs and to provide finance ministries with profits on which they have come to rely.

A poll of reserve managers from 77 central banks, entrusted with reserves worth $6tn last August, found a clear majority were changing their portfolio management strategy as a result — including taking steps such as buying riskier assets.

Central banks are indeed big players on the market due to their OMO and related policies that involve purchasing and selling billions of assets in order to influence market prices, aggregate amount of high-powered money and interest rates. They also invest in other currencies and commodities and place cash with other central banks.

Unfortunately, a number of their placements are now generating negative returns and yields on their fixed income investments (often government bonds) are now very low, if not negative.

The irony of the whole situation is that central banks initiated their conventional and unconventional policies partly in order to help (i.e. force) the private sector to take more risks (‘search for yield’). What goes around comes around, and it is now central banks’ turn to follow the same route. In short, they are now turning into vulgar commercial banks that attempt to please their shareholders (i.e. budget-constrained governments who need this cash).

But in doing so, they also potentially endanger their capital base. While it isn’t clear whether or not central banks can fall into bankruptcy and what happens afterwards, I guess we’d all be better off not to reach a point from which we start asking this question.

PS: A French newspaper highlights the very close links between the French government and its domestic financial sector. Many government appointees were formerly financial executives, and many current executives used to work in government. This reminds me of this.

PPS: A few weeks ago, Huw van Steenis, bank analyst at Morgan Stanley, published a good article in the FT about the effects of negative rates on banks. His views are very similar to mine.

April fools and risk-weights

The Basel regulatory framework might look like a bad April fool. On the 1st of April (you couldn’t make that up) the BIS published a document reviewing the practices and average risk-weights applied to various types of assets by large banks. Since the introduction of Basel 2, large banks usually utilise the IRB framework, or ‘Internal-rating based’, which allows them to calculate their own risk-weight, which are then used to compute their regulatory capital ratio. Other banks use risk-weights directly provided by Basel (under Basel 1, all banks used fixed risk-weights).

One could believe that giving banks the ability to define their own risk-weight is a good thing, as it mimics a free market setting (i.e. banks rather than regulatory directives deciding how much capital they need to keep aside). Unfortunately it isn’t. Regulators verify banks’ models and validate them. The consequence of this is that banks attempt to benefit from this by amplifying the differential between what regulators usually view as risky and safe assets.

This is where the BIS paper comes in. It demonstrates the extent of risk-weight gaming among large international banks. The table below shows that median risk-weight on mortgage lending is 17%, whereas median SME corporate lending is 60% and large corporate lending 47%. Given that interest rates on corporate lending is usually not much higher (and sometimes lower, see this earlier analysis on the ECB’s TLTRO) than interest rates charged on mortgage lending, it is not surprising to see banks’ favouring real estate lending: it is much more efficient per unit of capital. Call this capital, or RoE, optimisation.


There are quite a few other interesting charts in this publication, see the following one:

BIS IRB loss rates

This chart shows that actual loss rates on defaulted exposures aren’t much higher for small corporate lending than for mortgage lending. This adds to the increasing amount of evidence that nothing justifies Basel’s and regulators’ much higher capital requirements for corporate exposures. Other charts the paper provides seem to confirm this view.

Finally, the paper also looks at the new Basel 3 leverage ratio, which was supposed to avoid capital gaming by getting rid of risk-weights altogether, hence becoming a ‘backstop’ ratio. Ironically, Basel geniuses reintroduced risk-weights into the leverage ratio, but under another form: credit conversion factors (CCF). CCF essentially provide various risk-weights for various types of off-balance sheet products and commitments (see pages 18 and 19 of this document). Consequently, banks’ lending decisions also become affected by CCF… Here again you couldn’t make it up. The paper provides various implied CCF used by large banks, although by asset class rather than by product type.

PS: I wrote another post on the topic of risk-weight gaming about a year ago here.

PPS: There was a good article on shareholder value in The Economist, reminiscent of some of my own arguments.

Update: SNL reports that the BIS is thinking of preventing large banks to use their own IRB models to calculate risk-weights on loans to other loans and larger corporations. It’s not going to solve anything.

Understanding banking mechanics isn’t sexy; but it is essential

Banking and finance blogging seems to attract a lot fewer readers than economics blogging. This is unfortunate.


It sounds boring and too technical. The terms used to describe banks’ characteristics are mostly ignored by the wider public, and even by many more informed people and economists. Ask the layman what a leverage ratio, a Tier 1 ratio or NPLs are, and you will be met with raised eyebrows. In contrast, GDP, NGDP/aggregate demand, opportunity cost, inflation/CPI, money supply and so forth, are much more wildly known (not enough many would argue, and I’d agree).

Some would reply that economic terms are more ‘important’ in order to understand how the world works. Fair enough. Still, jargons in other industries are also relatively broadly known: horsepower, torque, medical terms, megabyte, dB, resolution, kWh…

Banking seems to be one of the few exceptions. Here again, some would reply that this is not such an issue, as banking is regulated, and supervisors that are more knowledgeable are in charge of monitoring banks. And I would have to strongly disagree.

It is crucial that the public understands at least some basic banking mechanics. Not doing so creates a number of issues. First, moral hazard: it is well-researched that deposit insurance led to banks free riding on depositors’ blind belief that their money was in safe hands. The same reasoning applies to leaving regulators in charge of the monitoring of the financial system. Second, it leaves an open door to politicians and regulators to manipulate the industry through various legislative acts.

And don’t tell me that understanding a leverage ratio or a loan loss coverage ratio is a lot more difficult than understanding broadband speed, computer memory, or fixing a car engine. Moreover, the public can nowadays rely on specialised magazines and websites to test and give awards to the best consumer products. Banks could be reviewed in a similar way and rating agency reports be made much more widely available. Banks could start advertising their strong capital ratios rather than merely their ability to allow you to make cheap payments while travelling abroad.

So banking is viewed as boring. Unsexy. And regulations introduced decade after decade are partly to blame for that as they have shielded the broader public from the need to understand the institutions with which they placed their money.

But understanding banking mechanics and regulation is also crucial. It is crucial because the financial system is the heart of the economic system: it allocates loanable funds to sectors and customers that are likely to generate the most economically efficient outcomes. As such, it is intimately linked to the economic subject as a whole, despite some economists begging us to stop talking about banking. When this mechanic is disrupted by new frameworks of rules, the whole economy is affected and either doesn’t produce optimally, or worse, generate malinvestments by not producing the goods that the public want in the long run. And crises ensue.

Free Banking scholars have demonstrated that many of the 18th and 19th century crises had roots in misguided banking rules. The same applies today. One cannot understand our most recent crisis, and possibly our future crises, without knowledge of the small and dull bits that currently dictate, or at least strongly influence, capital flows. As much as ‘macro’ is sexy, the devil is in the details.

I know my work will remain ‘niche’. It is clear that my most successful blog posts have so far treated relatively non-technical topics or banking framed within a more general economic view. But I’ll keep producing ‘niche’ posts nevertheless; because it is necessary. I’ll keep pushing to make readers understand how much they’ve been scr**d by what seems, at first glance, boring details of financial regulation.

Sadly, those boring details may well trigger the next crisis, and make us lose our job.

Regulatory study says regulators were right

Some regulators seem to be ready to publish the most idiotic arguments to justify their earlier work. A new flawed study about an ill-conceived measure for small firms lending (SME) by the European Banking Authority did just that.

Despite continuously denying that capital requirements have anything to do with SME and other corporate lending, authorities have decided to experiment in 2014 by allowing banks to hold less capital against such lending (a measure called ‘SME Supporting Factor’). In order to find out whether or not this measure had any effect on SME lending, the EBA launched a study that concluded that there was (in the words of Reuters):

“no sufficient evidence” that lower capital charges provided additional stimulus for lending to SMEs compared to large corporates

First, let’s notice the very small timeframe of the study: less than 18 months. Banks are unlikely to be able to grow their loan book by much in a safe fashion in such short timeframe. Second, the demand side seems not to be factored in (but I believe it to be a minor point). Third, SME SF only applied to tiny loans (not more than EUR1.5m, which is too small for medium sized firms). And indeed, the EBA report highlights that “SMEs subject to SF represent 4% of the aggregate corporate portfolios, 11% of the aggregate retail portfolios, and, in case of SA banks only, 6% of the aggregate exposures secured by immovable property.” In other word, they represent a very small share of banks’ loan books.

But the main issue with this measure, and indeed with this study, is that this SME SF has barely tightened the differential between risk-weights applied to SME/corporate exposures and risk-weights applied to real estate/sovereign exposures. SME SF only introduces a 24% capital discount to that form of lending (see table below for Basel’s ‘Standardised Approach’ for SME lending). The result, as the EBA shows, is that total risk-weighted assets (RWA, the denominator used to calculate regulatory capital ratios) only declined by…1.2%. This has effectively zero impact on banks’ RoEs.


Let’s make a quick calculation. A bank has total assets of $2,500 to which an average of risk-weight of 40% is applied, giving $1,000 RWAs. The bank also has $100 in regulatory capital (in order to simplify, let’s assume it only consists of plain vanilla shareholder equity), leading to a 10% regulatory capital ratio. The bank also makes $10 net profit, implying a 10% RoE.

A 1.2% decline in RWAs would lead to RWAs falling by a mere $12, making the capital ratio 10.1%*. Assuming the bank decides to maintain a 10% ratio, the newly-freed capital would allow RoE to improve by…0.1 percentage point. Impressive effect, to say the least.

Irony aside, SME SF was a very ill-conceived measure: its scope was too narrow (targeting firms that are too small), and the incentives it gave banks were very superficial given the remaining differential between the risk-weights applied to SME and other types of exposures (Standardised Approach risk-weight on mortgages remain way below at 35% – and median risk-weight is 17% on an IRB basis** – see upcoming post – UPDATE: here). The mini-gains that banks’ could have expected would have possibly been more than offset by the risk of rapidly growing an SME loan book in an uncertain economic environment.

The study also found that current capital requirements for small and large corporates were adequate, and that applying SME SF would lead to those exposures being undercapitalised. This is in complete opposition with the (mostly independent, that is, not published by EU regulators) papers I reported on a few weeks ago.

In the end, this research undertook by a regulatory body succeeded to prove what it wanted to prove: regulatory measures were right from the start. If only it were not completely wrong.

*This is in line with the EBA’s findings:


**Standardised method refers to a RWA calculation method that applies to relatively small banks, which use fixed risk-weights provided by Basel rules. IRB (Internal Rating Based) refers to more flexible (but validated by regulators) risk-weights calculated internally by large banks using complex models.

My contribution to the Cato Institute/Alt-M

A few weeks ago, George Selgin, director of the Center for Monetary and Financial Alternatives at the Cato Institute, contacted me and kindly suggested that some of my Spontaneous Finance posts be cross-posted on the Cato’s specialised monetary and financial blog, Alt-M. Given that I have a very high estimate of Alt-M’s (as well as its predecessor ‘Free Banking’) and George’s work, I happily accepted to contribute.

An introductory post co-written by George and me was published today on the Alt-M blog. It briefly sums up a number of the ideas I developed on Spontaneous Finance. From now on, I may cross-post on both this blog and Alt-M from time to time.

Research on macro-prudential regulation: barely any effect

I promised last time a new post on macro-prudential regulation. Here it is. I recently reviewed six academic publications and noticed a curious fact: while most, if not all, of those papers conclude that some macro-prudential policies can have some effects on some asset prices or credit growth, they remain quite careful in their conclusions and are often aware of the limitations of their methodology. However, when other papers refer to them (usually in their literature review), they always overemphasise the apparent successes of those policies and avoid mentioning their shortcomings and limitations almost entirely. Consequently, a reader that would only open one of those research papers would only see macropru under an overwhelmingly positive light.

But, don’t be mistaken, it is not what most of those researchers said. Their conclusions are usually much more nuanced than the depiction and oversimplification we hear in the media and in the mouth of other academics and central bankers.

The first paper, published in 2011 by IMF staff, titled Macroprudential Policy: What Instruments and How to Use Them? Lessons from Country Experiences, was an early attempt at looking at the economic effects of macropru. While thick, the paper is clearly not comprehensive and a number of its findings were in opposition with findings of later research.

Running a cross-country regression analysis on data from 49 countries, they found that a number of macropru instruments were effective in dampening procyclicality. Most ‘effective’ instruments were targeting particular products or asset classes (i.e. LTV or DTI caps), although they did find that fluctuating reserve requirements helped, in contradiction with other papers.

Importantly, they stress that there are ‘costs’ involved in using those instruments. That is, potentially lower economic growth or ‘unintended distortions’. They also point out that macropru could be subject to regulatory and cross-border arbitrage and show that discretionary decision-making, rather than rules, dictate the use of those policies. Finally, they also warn against using macropru as an alternative to monetary policy in order to address ‘excess demand’, and subsequent research has indeed shown that macropru is no substitute for monetary instruments. They do not research any of those issues.

Debunking the myth that macropru was a ‘new’ tool for central bankers, they show that many, many countries has already utilised them before the crisis.

My main issue with this paper is that, similarly to another macropru research paper I reviewed in a previous post, it takes correlations way to literally. For instance, it says that macropru was successfully used in China to limit credit and house price growth, and in Spain to help cover the large losses of the financial crisis. Well, it seems to me that, those ‘successes’ have been rather poor given how severely Spanish banks suffered during the crisis and how rapidly credit growth has been since the implementation of those measures in China… I would at best call this a ‘quarter-success’, and this, even without even looking at the potential credit allocation distortions macropru has brought about in those countries.

Moreover, their correlations are not fully convincing: from some of their charts, it seems that the implementation of a macropru measure was sometimes followed by no effect for a while, or in other cases, that the implementation only occurred after a change in credit growth trend (see chart below).

Macropru 2011

The second paper, published in 2012 also by IMF staff, is titled Macroprudential Policies and Housing Prices – A New Database and Empirical Evidence for Central, Eastern, and Southeastern Europe. This one is more targetted, both in term of geography and in terms of target (housing prices). Here again they show that many countries had been using macropru for quite some time, and that it didn’t help them much preventing crises.

They find that some macropru measures, such as raising minimum regulatory capital ratios, did have an impact on house price growth, while others, such as increasing reserve requirements or dynamic provisioning, did not. However, those effects only slow down the housing cycle rather than stop or reverse it, and more importantly, they are temporary. Growth seems to reaccelerate a few months after their introduction. Their study does not look beyond this short timeframe.

Curiously, and in contradiction with a later study (see below), they find that easing regulatory capital requirements helped dampen the effects of a crisis.

The authors also show that different countries demonstrate different macropru ‘activism’ (see chart below), and that, as expected, a number of measures adopted were procyclical, amplifying the crisis. Clearly, this is a major weakness for macro-prudential policies.

Overall, this paper does not look at whether macropru leaks in a way or another, but does show that its effectiveness is limited and temporary, and that it is clearly subject to usual problems of discretionary policies and central planning.

Macropru 2012

The third paper, published in 2013 by BIS staff, is titled Can non-interest rate policies stabilise housing markets? Evidence from a panel of 57 economies. Like the previous one, the scope of this paper is limited to housing markets. But at least it allows us to easily compare their results in order to check the consistency of those findings.

The authors used two types of regressions to assess the effects of certain types of macropru tools affecting the supply side (reserve/liquidity requirements, limits on credit growth, risk weighting and provisioning requirements, limits on housing sector exposure) or the demand side (cap on LTV and debt service to income and housing-related taxes).

What did they find? Not much:

From a policy perspective, the negative results are in some respects as important as the positive ones. 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. Exposure limits, which work not by the cost of lending but through the quantity restrictions on banks’ loan supply, may be an exception in this regard, although the  small  number  of  documented  policy actions makes it hard to draw firm conclusions. 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. None of the policies designed to affect either the supply of or the demand for credit has a discernible impact on house prices. This has implications for the degree  to  which  credit-constrained  households are the marginal purchasers of housing or for the importance of housing supply, which is not explicitly considered in this study. Only tax changes affecting the cost of buying a house, which bear directly on the user cost, have any measurable effect on prices.

In other words, apart from increasing taxes on housing (which isn’t really macropru), none of the macro-prudential instruments studied had any actual effect on housing prices. This doesn’t sound very positive. Moreover, due to the narrow scope of the paper, it doesn’t look at potential distortions resulting from the same policies.

Interestingly, the paper provides a quite comprehensive database of macro-pru and tax-related measures taken since the 1980s (see below). After seeing this, I’m really unsure how macropru proponents can still claim this type of regulation is new and effective.

Macropru 2013

The fourth paper (another IMF staff one) was published in 2014 and is titled Macro-Prudential Policies to Mitigate Financial System Vulnerabilities. Looking at a database of 2,800 banks in 48 countries, they analyse the balance sheet response to various types of macro-prudential tools during the 2000-2010 period. A quick remark first of all: they seem to only use USD balance sheet figures, which I find surprising given that year-on-year FX fluctuations would affect their conclusions. They don’t seem to be controlling for this effect, but I might have misread.

They find

in particular caps on borrower and financial institutions assets and liabilities–based measures to be effective, while buffer-based policies seems to have little impact on asset growth. Overall, there is little evidence that the effectiveness of these tools varies by the intensity of the cycle.

Caps on borrowers (LTV, DTI…) are confirmed to have an effect, in line with some of the studies above (although the end goal remains to control housing price growth, and the previous study seems to show that this was not happening). However, the effect is small to say the least: banks’ asset growth was reduced by 0.44% in average. More surprisingly, they find that countercyclical capital buffers not only have little effects on credit growth, but also

do not help to provide cushions that alleviate crunches during downswings. As such, macro-prudential tools may be less promising to mitigate adverse events.

This is a major issue for regulators as countercyclical buffers and dynamic provisioning have been mostly advertised as helping alleviate a downturn by making banks more solid, thereby providing continuity to the flow of credit to the economy.

Finally, they find that macropru has been mostly used by closed capital countries, which have less liberalised financial systems. This makes sense as there are then fewer opportunities for those measures to ‘leak’. But this has not prevented many of those developping countries to experience crises anyway.

More recently (end-2015), BoE staff published a piece titled Regulatory arbitrage in action: evidence from banking flows and macroprudential policy. The piece is interesting because it demonstrates how regulatory arbitrage within a macro-prudential framework. It is based on a database of banking flows in 37 countries (but not on individual banks data), between 2005 and 2014.

They find that macropru measures that do not apply to all banks within a certain country suffer from leakages. This is possible because, apart from countercyclical buffers, Basel 3 do not impose cross-border regulatory coordination. Consequently, macropru tools that affect capital levels only apply to domestic banks and domestic subsidiaries of foreign banks, but not to branches of foreign ones. The result is an increase in foreign borrowing by domestic corporates when capital constraints are tightened for the domestic banking system.

However, when macropru tools (such as tigthening of lending standards) apply indiscrimenately to all banks within a given jurisdiction, they find no evidence of this cross-border borrowing (the charts they present aren’t as clear cut, even though the effect is clearly weaker – see below). Evidence is mixed when reserve requirements are varied.

Macropru 2015

More worryingly, their conclusion points to macropru regulation as a major driver of cross-border capital flows through regulatory arbitrage:

This suggests that uneven application of regulation may be a driver of international capital fows. This is over and above the effect, which has been documented extensively in the literature, where banks transfer funds to markets with fewer banking regulations. Our results show a subtle contrast:  banks transfer funds to countries which tighten regulatory standards, but transfer these funds when the regulatory tightening does not apply to them, and instead confers upon them a competitive advantage.

Finally, the latest paper I rewiewed, published in January 2016 by BIS staff, is titled Is macroprudential policy instrument blunt?. The paper seems to suffer from a ‘correlation does not imply causation’ issue. It focuses on Japan from the 1970s to the 1990s, as local authorities used a policy instrument called ‘quantitative restriction’ (QR), which requires banks to reduce their real estate lending.

I won’t spend long on this paper as I believe it doesn’t bring much to the literrature given its reliance on what seems to be spurious correlations. We all know the booms that Japan experienced in the 1980s. We also all know that when this boom turned into a burst, the whole economy collapsed. Does this have anything to do with the implementation of QR? Unlikely. Yet this is what the researchers who wrote this paper seem to say, as they write that “QR affected the aggregate economy by damaging the balance sheet of banks and non-financial sectors”. Unless it was the crisis.

Macropru 2016

In the end, it does look like the evidence that macro-prudential policies are effective is rather inconclusive. Some seem to have minor effects, temporarily, providing one does exclude potential leakages and distortions and believes in the timely implementation of those tools by regulators. Others seem to have no effect whatsoever. And worse, academics seem to reach different conclusions regarding the exact same instruments.

Yet, the literrature review section of many of those papers depicts macropru in rather positively. Take the fourth paper listed above. Referring to the first paper listed in this post, it says that its authors “document evidence of some policie being effective in reducing the procyclicality of credit and leverage.” Well, I had a slightly different reading.

To be fair, they do also report the relatively negative results of some other studies (such as the third one above). This is in stark contrast with most central bankers and regulators, who describe macro-prudential regulation under an overwhelmingly positive light, and who would like us to believe that enlightened policymakers manipulating macropru can solve all the problems that their own misguided monetary policy creates, independently of any Public Choice issue. Let’s not believe.

PS: you can see my take on a few other research reports on macro-prudential instruments, and on the fact that macropru cannot offset the damages of monetary policy, here, here and here.


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