RDP 2010-06: Asset Prices, Credit Growth, Monetary and Other Policies: An Australian Case Study 2. Asset Prices, Monetary and Other Policies

2.1 The Recent Debate

The weight of opinion prior to the global financial crisis was that central banks should respond aggressively to the contractionary effects of sharp asset price falls but not respond directly to asset prices during upswings (Issing 2009).^[4] A prominent advocate of this view was Alan Greenspan (former Chairman of the US Federal Reserve System), who argued that identifying a bubble with a degree of certainty was not possible and that any pre-emptive policy response would likely be destabilising. Rather, central banks should pick up the pieces afterwards (Greenspan 2002, 2004, 2010).^[5] However, the global financial crisis demonstrated that the cost of an asset price and credit market collapse may be large enough to warrant paying some short-term cost to avoid or contain it. As such, there is now less focus on whether policy should respond and much more attention being paid to which policies should respond and by how much (Bean 2009, Trichet 2009).^[6]

There are two broad views on how this should be done. On the one hand, there are those who see a greater role for monetary policy to stem excessive financial cycle upswings. On the other hand, there are those of the view that monetary policy should play a minimal role, but that the policy framework more generally is inadequate and in need of reform. In particular, there has been renewed interest in additional policy instruments – macroprudential tools – often motivated by the argument that multiple objectives (price and financial stability) require multiple instruments (Tinbergen 1952).^[7] Both streams typically accept the arguments that: better enforcement of existing regulations is required; some regulatory reform may be beneficial^[8]; and that reforms should not unduly impinge upon efficiency, nor simply push credit provision outside of the regulatory net.

For those who see a greater role for monetary policy, a number of different approaches have been suggested. One possibility – and the focus of earlier work – is that asset prices could be: added to the central bank's target by including them in the consumer price index; or incorporated in Taylor-type rules and explicitly referred to in the central bank's mandate (Bryan, Cecchetti and O'Sullivan 2003 and Cecchetti, Genberg and Wadhwani 2003). There are arguments against this, not least that it is difficult to know exactly which asset prices should be included, as well as the fact that mechanical approaches have difficulty distinguishing what might be relatively sustainable increases in asset prices (Goodhart and Hofmann 2002). Others emphasise that large rises in asset prices are more likely to be problematic when accompanied by rapid growth in credit and declining lending standards.^[9] Proponents of this view argue that a central bank could use its judgement about low frequency movements in a range of variables (not unlike the case of more standard monetary policy decisions) to motivate ‘leaning against’ emerging financial imbalances. In this regard, concerns should mostly be about growth rates (rather than levels) of key variables, such as asset prices or credit, for a number of reasons. First, it is hard to know what constitutes a sustainable or fundamental level of such variables. Second, while high levels of indebtedness, for example, may imply greater vulnerability to adverse shocks, rapid growth may also suggest that individual, as well as system-wide, risks have not been fully appreciated, and that a larger share of exposures have yet to be tested by a period of economic weakness. Third, monetary policy cannot hope to be concerned with the level of a particular variable, such as property prices, but by altering the price of credit it can influence the willingness to service existing debts and to take on new ones.

Counterarguments to a pre-emptive monetary policy approach are numerous (see Bernanke 2002, Greenspan 2002 and Gruen, Plumb and Stone 2005, for example). There are those who argue that asset price changes may be fundamentally based and the associated higher leverage sustainable, so policy should not resist them. And even if it is possible to identify a bubble with some confidence, others argue that countering it with monetary policy would require such an aggressive response that the cost to the ‘non-bubble’ sectors of the economy would be too high. Some suggest that trying to end an asset price boom late in the piece might in fact make things worse. Finally, the use of monetary policy for this purpose may be difficult to explain given central banks' current mandates. Hence, if CPI inflation is contained, new and more targeted ‘macroprudential’ policies may be preferred.

More recent discussion has focused on these macroprudential policies, which could serve as either substitutes for, or complements to, monetary policy.^[10] These policies involve targeting the incentives and ability of lenders to extend credit. A number of instruments have been widely discussed, including dynamic provisioning, which involves setting aside provisions for expected – rather than actual – losses, direct controls on loan-to-valuation ratios and, more recently, directly linking regulatory capital to credit and asset price developments.^[11] One advantage of these measures is that they target the problem of rapidly increasing financial system leverage. A key disadvantage is that they may drive the more risky behaviour outside of the regulatory net. The US subprime crisis provided an example of this, with a large build up of risk in the ‘shadow banking system’ prior to the crisis eventually putting severe strain on the banking system proper. And while it may be possible to bring the existing ‘shadow banking system’ under the regulatory umbrella, it is unlikely that new regulation could circumvent regulatory arbitrage over the longer term. Indeed, financial innovation is often focused on ways to get around the regulatory net. Furthermore, in a globalised financial system, regulatory arbitrage may involve financial participants moving across borders, complicating the domestic policy options, and necessitating international cooperation.

As with monetary policy, some suggest that macroprudential instruments could be subject to a rule (say for LVRs or capital requirements) based on the behaviour of particular macro variables, such as asset prices or credit (Goodhart and Persaud 2008 and Posen 2009, for example).^[12] Others highlight the importance of discretion on the part of policy-makers given the high degree of uncertainty surrounding the most effective approach to combating any particular imbalance (Tucker 2009).^[13] Many of the same issues about rules versus discretion in monetary policy are equally applicable to the discussion concerning macroprudential instruments.

In summary, while regulatory overhaul has been the main focus of recent policy discussions, debate about the appropriate role of monetary policy has also intensified. The apparent pre-crisis consensus of benign neglect has softened, with increased interest in approaches which involve monetary policy leaning against emerging imbalances to some extent. However, exactly how such imbalances are to be identified remains problematic and it is likely that a significant amount of judgement is required. This is not surprising given that, despite many important similarities, every financial crisis is different from the last in crucial and unexpected ways.

2.2 International Policy Responses – Some Examples

A key argument against the leaning-against-the-wind approach is that policymakers are unlikely to be able to reverse or even slow the course of asset prices during an upswing, at least without causing substantial damage to other parts of the economy. This argument is difficult to assess because there are only a few examples of countries that have explicitly used monetary or prudential policies to slow asset price growth. In what follows, we review three commonly cited cases.^[14]

2.2.1 Hong Kong

Restrictions on land supply between 1984 and 1997, and the peg to the US dollar via a currency board, meant that Hong Kong was particularly vulnerable to boombust cycles in the housing market. Around 1990, as China became more open to investment and trade from Hong Kong, property prices surged. Between 1989 and 1992, residential property prices rose by around 30 per cent per annum on average in Hong Kong (Figure 1). The high concentration of residential loans on the books of Hong Kong's banks (40 per cent of total loans) meant that a rapid reversal of such strong price growth was a sizeable risk for the banking system.

In May 1991, the Hong Kong Commissioner of Banking urged financial institutions to tighten lending standards and lower the proportion of net worth that could be lent. Some institutions adopted self-imposed LVR ceilings, but by November 1991 there was little indication that credit growth was slowing and so institutions were asked to take further action. A number of the major banks lowered their LVR ceilings to 70 per cent (from around 80 to 90 per cent), which saw housing credit growth slow substantially from the December quarter 1991.^[15] The effectiveness of these restrictions in helping to maintain financial stability was tested in 1994 when interest rates increased in line with the US fed funds rate, ending Hong Kong's asset price boom. Although housing prices fell 25 per cent from their peak over the next 18 months, mortgage losses remained below 0.5 per cent of assets and bank profits rose in 1995 (McCauley, Ruud and Iacono 1999).^[16]

Regulatory controls in Hong Kong have been applied in a flexible way, first by the Commissioner of Banking and then by the Hong Kong Monetary Authority (HKMA). Also, regulations have evolved with the financial system. For example, maximum LVRs were increased to incorporate the use of lenders' mortgage insurance (LMI) (Yam 2009). The banking system has been stable despite significant house price volatility. Even during the Asian financial crisis of 1997–1998, banks remained resilient (Gerlach and Peng 2005). More recently, rising asset prices due to low interest rates once again increased concern about a potential boom in credit and asset prices in late 2009. In response, the HKMA decreased the maximum LVR on luxury properties (HK$20 million and above) to 60 per cent.

Hong Kong is commonly cited as an example of the successful use of macroprudential policies in the face of financial imbalances, although the nature of its housing market and financial system means that its experience is somewhat unique.

2.2.2 Spain

Between 1995 and 2000, credit extended to households in Spain grew at an average annual rate of 18 per cent. This strong growth followed, in part, from the reduction in interest rates (due to entry into the euro area) as well as increased competition, which led to an erosion of lending standards; at the same time, specific provisions had declined along with the fall in non-performing loans (Griffith-Jones et al 2009). In response, the Bank of Spain implemented a system of dynamic loan-loss provisions in 2000,^[17] which forced financial institutions to recognise the risk of loan loss when loans entered the balance sheet, rather than once loans became impaired.^[18] The approach was intended to help reduce the volatility of credit growth and profits over the business cycle by increasing the cost to banks of making increasingly risky loans as asset prices rose, and providing them with buffers to protect their balance sheets once prices fell and nonperforming loans increased.

The scheme was significantly scaled back in 2005 as a result of a conflict with the International Accounting Standards Board conventions (adopted by the EU); although, provisions still account for about 1.9 per cent of consolidated assets of Spanish depository institutions, compared with total equity of about 8.3 per cent (Bank of Spain 2010). Griffith-Jones et al (2009) suggest that there is little evidence that the practice of dynamic provisioning has reduced the amplitude of the credit or house price cycle in Spain, with average annual growth in both measures well above the recent historical average between 2000 and 2005 when the dynamic provisioning scheme was in effect. However, Saurina (2009) indicates that much of the pool of provisions amassed since the scheme's inception was drawn on over the course of 2009, supporting financial institutions during the global financial crisis. Overall though, it is perhaps too early to tell the extent to which the use of this policy instrument in Spain was successful in maintaining financial stability.

2.2.3 Sweden

Perhaps the policy response most similar to the Australian experience was that of the Riksbank between 2005 and 2007.^[19] During this period, housing prices and housing credit increased by 11 and 13 per cent per annum on average, respectively. At the same time, the Riksbank raised its policy rate by 200 basis points and publicised its concerns about the sustainability of the expansion and the implications of a sharp house price correction for the financial system and broader economy. In 2005, six of the seven media statements released following policy decisions flagged concerns about developments in asset prices and household credit (Hoerova et al 2009), and in 2006 the policy rate was increased with concerns about rapidly rising house prices and household indebtedness referred to in the policy statement.^[20] The Riksbank was criticised for its approach. In a report commissioned by the Swedish Parliament, Giavazzi and Mishkin (2006) suggested that it was a mistake for policy to consider developments beyond those relevant to CPI inflation. More recently, however, Hoerova et al (2009) contend that the policy tightening, when combined with public announcements about the dangers of the housing market boom, helped to moderate the financial upswing.

Footnotes

For a summary of the state of the literature prior to the global financial crisis see Hunter, Kaufman and Pomerleano (2003), Richards and Robinson (2003) and Cecchetti (2006). [4]

See Borio, Furfine and Lowe (2001) and Bordo and Jeanne (2002) for a discussion of the moral hazard problems associated with this asymmetric approach to policy. [5]

Despite the costs of the recent crisis, some still argue (along established lines) that monetary policy should not respond to asset prices (Kohn 2008, Posen 2009 and Greenspan 2010). [6]

Fischer (2010) notes that this principle only applies when the objective is strict in the sense that it must be satisfied over a relatively short horizon. [7]

This may include measures that better account for the contribution of individual financial institutions to systemic risks (Bank of England 2009, Squam Lake Working Group on Financial Regulation 2009 and Caruana 2010). [8]

A number of empirical papers suggest that there is a role for variables such as money, credit and/or asset prices (particularly property prices) in providing an early indication of emerging financial imbalances that will threaten financial stability. See, for example, Borio and Lowe (2002), Borio and White (2004), Detken and Smets (2004), ECB (2005) and Borio and Drehmann (2009). Inclusion of a monetary aggregate target as one of the two pillars of monetary policy by the European Central Bank constitutes a related approach. [9]

Brunnermeier et al (2009), Fatás et al (2009), FSF (2009) and Haldane (2009). [10]

FSF (2009) discusses these instruments. See also, Borio et al (2001), Borio and Lowe (2004) and Griffith-Jones, Ocampo and Ortiz (2009). [11]

See Christiano, Motto and Rostagno (2007), Borio and Drehmann (2009), Fatás et al (2009), Gerdesmeier, Reimers and Roffia (2009) and Kannan, Rabanal and Scott (2009a) for discussion of the problems associated with the use of a composite indicator in this regard. [12]

This is supported by recent empirical work (such as Kannan, Rabanal and Scott 2009b, Gruss and Sgherri 2009 and N'Diaye 2009), which finds a role for (simple) macroprudential instruments in augmenting monetary policy but stresses the need for discretion in the implementation and application of such instruments. [13]

Another case is Japan's use of tax and land supply policies, as well as caps on lending to real estate industries in the late 1980s in response to a real estate boom between 1987 and 1989. However, the subsequent large decline in land prices and associated problems provide some evidence that these policies were implemented too late (see Okina, Shirakawa and Shiratsuka 2001 for a discussion of this point and Ito and Iwaisako 1995 for details on the episode). [14]

Other initiatives about this time included a 60 per cent LVR ceiling for luxury properties and a recommended ceiling on the growth rate of mortgage portfolios of 15 per cent per annum. [15]

See Mo and Leechor (1998) for detailed coverage of this episode. [16]

See Caruana (2005), Griffith-Jones et al (2009) and Saurina (2009). [17]

For a detailed discussion of dynamic provisioning, see Fernández de Lis, Pagés and Saurina (2000) and Caruana (2005). [18]

See Nyberg (2005), Giavazzi and Mishkin (2006) and Hoerova, Monnet and Temzelides (2009). The banking crisis in Sweden in 1990, which followed a boom in credit and property prices in the late 1980s, required the Government to take a large equity share in the banks. The fact that this severe episode was in the living memory of bankers and policymakers may have contributed to the approach taken to the housing boom of the mid 2000s. [19]

See, for example, http://www.riksbank.com/templates/Page.aspx?id=20017. [20]