On March 18th 2014 the US Federal Reserve Chair Janet Yellen stated the need for “reasonable confidence” in order to effectuate a more conservative monetary policy focusing on interest rate raise. Chair Yellen has indicated four macroeconomic factors that need to be further monitored.
- The labor market with further unemployment rate decline;
- A continued rise in currently slumped wages;
- Core inflation stabilization (independent of energy ‘push’);
- A higher “market-based” expected inflation rate.
The Fed’s decision to hold off on short term rate hikes comes one week after its macroprudential bank stress tests. Notable amongst the results was the “conditional approval” of Bank of America’s capital plan, with complete rejection of Deutsche Bank and Santander’s capital plans. It is clear that under Yellen the Federal Reserve is attempting to uphold the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. From a general standpoint, it is also quite glaring that the Federal Reserve as a central bank is fast adopting more of an eco-political role as a quasi-indirect financial system regulator through financial system monitoring. As has been mentioned before, monetary policy is the fastest mechanism to quell financial system defects, as fiscal policy results tend to lag.
Since the 2008 financial crisis, many economists have called for a more active regulatory role from central banks other than pure monetary rate fixes and being a lender of last resort. In January 2013 Fed Governor Powell met with members of the Financial Services Forum Policy Roundtable to the need for further engagement with appropriate bank regulators with regards to Dodd-Frank and specific cooperation among federal banking agencies. Here we see the Federal Reserve’s role expand into embracing full regulatory responsibilities and acknowledging the need to be more cognizant of fiscal agency activities. Since it is fast becoming the trend of the US Federal Reserve and of central banks in general to take up more than pecuniary monetary policy functions, it is the responsibility of the Financial Policy Council to suggest optimal regulatory best practices.
After careful examination, we found great quantitative insight in regards to the prevention, control and monitoring of financial crises by central banks through the International Monetary Fund’s Policies for Macrofinancial Stability: How to Deal with Credit Booms. (Giovanni Dell’Ariccia, Deniz Igan, et al. 2012). As the title suggests, credit booms are cited as the main, very complex cause of large scale financial crises which mere shifts in short term interest rates cannot fully solve. It is important to note that credit booms are intrinsically not detrimental to the financial system and to the macro economy at large, once properly and timely monitored. The tail risk associated with credit booms can bring strong growth or absolute demise to the financial sector depending on how it is mitigated during the boom, and controlled for the expected credit trough cycle. While there is increased regulation of the overall banking sector within the US, there is a renewed tendency towards credit increase within the non-banking business sectors, which in turn spur the banking sector to increase product (mortgage) marketing to remain competitive. This is a structural aspect of the financial system which encourages credit booms, and credit crises within the US.
Credit Boom Identification
- The IMF defines credit boom as any period during which the annual growth rate of the credit-to-GDP ratio exceeds 10 percent. A boom ends as soon as the growth of the credit-to-GDP ratio turns negative; thus, the credit-to-GDP measure for any sovereign is crucial to monitor by the Federal Reserve, even in the resetting of an indirectly related short term market shocks.
- Dell’Ariccia and his IMF colleagues applied the definition of a credit boom and ensuing variance stress tests to a sample of 170 countries with data starting as far back as the 1960s and extending to 2010, with the identification of 175 credit booms therein.
- One of the most telling results of sample testing showed that no matter the country classification or geographical sphere, one in three booms was followed by a banking crisis within three years of the boom. As well, the IMF results showed that the geographical regions that experienced credit booms had even greater credit delinquency during and well after the crises.
- Three out of five booms were followed by subpar growth in spite of further macro economic stimulus packages for at least six years following the credit contractions, or outright credit busts. The referenced term for this phenomenon is a “creditless recovery.” One very strong contributing factor to this type of recovery is a failure of both monetary and fiscal policy to focus on credit aggregates, and instead silo industries and sectors according to individual need (e.g. Real Estate).
- An even more concerning find by the IMF study showed that credit booms generally start at the tail end or after buoyant economic growth. Many decision makers in the lower federal or parliament house tend to believe a credit boom is an absolute sign of economic growth. This is not necessarily so. In many cases, a credit boom occurs to make up for declining economic growth, depending on the sovereign’s liquidity position.
Monetary Policy Control
In particular, credit booms seem to occur more often in countries with expansionary macroeconomic policies, and low quality of banking supervision. This model usually fits a developing country or emerging market paradigm. Thus, it is noteworthy that the major financial crises of 2008 stemmed from the US banking and financial systems, and even more so from a primarily credit risk perspective. It is as if the central banking system completely dismissed signs of macroeconomic overheating. Should monetary policy then remain conservative with high cost of borrowing, low asset price valuations to stifle credit growth? The answer goes both ways. Most times central banks focus on short term rate adjustments to adjust money supply, all the while paying attention to market risk. This was the case of the US Federal Reserve prior to the financial crisis of 2008. We have already pled the case for allowing a credit boom to occur, with control. A credit boom naturally has credit risk to adjust for; therefore it is necessary for central banks to change monetary policy in response to aggregate asset price. We note here that aggregate asset price valuation control is necessary over a focus on individual bank institutions to effectively mitigate credit risk factors.
A serious problem faced by central banking decision makers is tightening monetary control during the first sighting of a credit boom, as purely political decision makers may confuse a credit boom with absolute economic growth. Monetary policy measures to control a credit boom can spur a higher short term unemployment rate, which leads to fiscal issues. Well meaning monetary policy control can also exacerbate macroeconomic pressures: increases in rate borrowing costs can lead to an outflow of funds to foreign lenders, even more creative variable interest only lending options, and a further increase in the banking sector’s debt service.
Almost all sovereigns immediately turn to monetary policy unsupported by immediate regulatory policy to ‘fix’ the repercussions of a credit decline, credit bust, and ensuing financial crisis, since monetary policy does have the ability to create corrective action without an extensive time lag. The IMF study states that stand-alone monetary policy can help slow down a credit boom during economic overheating, or simply put, when the economic crisis hits. However stand-alone monetary policy is still reactive without the support of immediate macro prudential regulatory policy, with a policy framework considering aggregate changes.
Fiscal policy has the least immediate positive effect on immediately controlling credit booms. Fiscal policy counts in the long term outcome of controlling the likelihood of credit booms through resetting tax provisions that affect borrowing. The IMF study cites that fiscal consolidation independent of a credit boom can bolster the financial sector in case of a credit crisis. However, the time lag and political implications associated with fiscal policy are inhibiting factors to a proactive control at the early stages of a credit boom. This brings to question the overall effectiveness of governmental fiscal policy in an ever changing and increasingly sophisticated global financial arena. Empirical support from the IMF study suggests that fiscal tightening is not associated with a reduced incidence of credit booms that lead to financial crises in the short to medium term. If so, it may be quite precarious to place increased financial system decision making in governmental folds.
Dell’Ariccia and his IMF colleagues propose countercyclical taxes on debt to offset the credit cycles, and so add tightening balance during a credit boom. In this regard, there will be further fiscal consolidation, or “buffers” that may act in the same manner as a regulatory capital requirement. A salient point made in favor of this measure is that the taxation would apply to the very active nonbank financial institutions as well. The issues cited with such fiscal policy modifications have to do with an easy circumvention of tax policy through various “tax planning” mechanisms especially employed by the nonbank sectors. Indeed, the IMF regression results actually depict that during a period of high economic growth, increasing tax revenues are simultaneously correlated with an increase in credit lending by both bank and nonbank entities. Further taxation may then truly be counterproductive to financial system tightening.
Macro prudential policy consists of capital and liquidity requirements, and regulatory stress testing of the banking sector throughout the economic cycle. Capital and liquidity requirements act as countercyclical buffers to control the cost of bank capital; loan-loss provisions especially demand capital increases to account for an economic trough. When put into practice in a consistent manner, regulatory policies provide adequate information to decision makers on the credit health of the banking sector. To date, most of these policies have been fully monitored and implemented in hindsight as it pertains to curtailing and preventing a credit boom. Regulatory policy as a stand-alone has not been fully effective with curtailing the start and duration of an overheating credit boom.
Aggregate measures of macro prudential policy include the following:
- Differential treatment of deposit accounts;
- Reserve requirements;
- Liquidity requirements;
- Interest rate controls;
- Credit controls;
- Open foreign exchange.
The IMF team found through empirical analysis that these measures are truly helpful in predicting a negative outcome of a current credit boom, rather than being able to actually prevent credit overheating in the financial system. The IMF also found that the global banking sector has been able to circumvent credit controls such as asset concentration by utilizing foreign partner or parent banks, and/or by creating foreign banking and nonbanking spinoffs. Empirical analysis also suggests that the Loan to Value (LTV) ratio monitoring is particularly prudent in restricting negative credit overheating, especially when faced with real estate credit crises.
The IMF study suggests and we agree that financial policy is justifiable in preventing, curbing and monitoring credit overheating in the global economy. We also see that stand-alone policies are not fully effective in mitigating negative credit and tail risks with the boom. Overall, a credit boom occurring during an economic boom can have positive returns once aggregate risk is effectively managed. Since the 2008 financial crisis we see the US Federal Reserve take a more active role in setting financial system policy monitoring, which in effect may be necessary given the highest stand-alone weakness of fiscal policy. Suggestions are as follows:
- When credit booms coincide with a general economic boom, monetary policy can be the initial (not sole) tool to manage and slow down economic overheating.
- During the early stages of a credit boom, macro prudential and other regulatory policies should be effectuated in line with monetary policy to ensure capital buffers to mitigate a credit crisis.
- The IMF has stressed that the governing body to enforce macro prudential polices must have a thoroughly structured task force to supervise and detect when capital requirement thresholds are triggered on a case basis and in the aggregate.
- More than half of credit booms examined that started at an initial credit-to GDP ratio higher than 60 percent ended up in crises. This ratio needs to serve as a primary quantitative credit risk trigger for central banks and federal agencies.
- Fiscal policy falls short in curbing credit overheating in the short term, even when coupled with monetary or macro prudential policies. Fiscal policy providing tax code provisions to limit borrowing can bolster the overall health of an economic boom, but possibly may not aid in curbing a specific credit overheating.
As global markets become more sophisticated and fast paced, we see the need for central bank decision making for the financial system, which entails a marked focus on credit risk and macroeconomic indicators. We expect to see the US Federal Reserve and central banks in general employ a well structured mix of financial policies to manage credit booms, mitigate associated risks, and turn around “creditless recoveries” into long term economic stability.
Giovanni Dell’Ariccia, Giovanni, Igan, Deniz et al. “Policies for Macrofinancial Stability: How to Deal with Credit Booms.” The International Monetary Fund Staff Discussion Note. June 2012.
Matthews, Steve. “Yellen Is Watching These Four Indicators for Signals on When to Raise Rates.” Bloomberg Business Online. March 2015.
The US Federal Reserve Regulatory Reform. “Resolution Framework.” The US Federal Reserve Online. March 2015.
Van den end, Jan Willem et al. “The Interaction between Central Banks and Government in Tail Risk Scenarios.” De Nederlandsche Bank Working Paper. March 2013.