Macroprudential regulation: policy dynamics and constraints

The Irish Central Bank is planning to impose macroprudential risk regulation on the domestic banking sector (see here). The general approach of the Irish Central Bank has been widely welcomed by economists, although the specifics of the proposals are controversial.

John Cotter (UCD) and I are planning a conference in September 2015 on macroprudential regulation, the fifth in our series of FMCC conferences on financial risk and regulation. Macroprudential regulation is fairly new, and there are many unanswered questions. Can macroprudential constraints on credit be reliably attuned with the business cycle and/or credit cycle? Are a-cyclical constraints on credit safer and more reliable than attempts at anti-cyclical ones? Should regulators take account of market imperfections, such as the poor performance of the Irish property development industry and the high costs of new housing construction in Ireland, in setting constraints on credit growth?

Macroprudential regulation has particular importance in Ireland, a small open economy buffeted by credit flows from bigger neighbours. The failure to impose macroprudential regulatory control on the Irish banking sector was a central cause of the Irish financial crisis of 2008-2011. During 2000-2007, within a flawed eurozone currency system, a politically-neutered Irish Central Bank ignored a runaway inflow of foreign credit into the Irish banking system. This massive credit inflow undermined the stability of the Irish financial system and led to the disastrous failure of the Irish domestic banking sector.

There is a varied range of views among economists on macroprudential regulation. This is clear in the responses to the Irish Central Bank’s policy discussion document. Three thoughtful responses come from David Duffy and Kieran McQuinn (both at ESRI) here, Ronan Lyons (TCD) here, and Karl Whelan (UCD) here. (For full disclosure, my own response to the Irish Central Bank discussion document is here.) Lyons recommends fixed, a-cyclical credit controls whereas Duffy and McQuinn argue for dynamic, anti-cyclical controls. Duffy and McQuinn stress the need for more new housing in light of fast Irish demographic growth, and the positive role of high housing prices (aided by bank credit growth) in eliciting an adequate supply response. Lyons argues that excessive bank credit growth should not be used as a hidden subsidy for a cost-inefficient building industry.

Lyons makes a case for no loan-to-income (LTI) constraint, instead relying only upon a loan-to-value (LTV) constraint for macroprudential credit control. This contrasts sharply with the view of Karl Whelan who argues for LTI-only macroprudential controls in the current Irish case. Duffy and McQuinn advocate for both controls. I share the view of Duffy and McQuinn. Lyons does not consider the importance of dual-trigger mortgage default in Ireland (that is, mortgage default which is triggered jointly by income stress and negative equity). The amount of Irish mortgage arrears is likely to remain large and volatile, and this is a key potential source of market instability. Both initial LTI and initial LTV ratios are linked to subsequent mortgage default probabilities, so both should be controlled.

There are certainly many points for discussion, which should make for an interesting conference! A formal Call for Papers will follow shortly – if there are particular themes or panels that we should include, feel free to mention them in the comments thread below.

Comments

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7 thoughts on “Macroprudential regulation: policy dynamics and constraints”

  1. Gregory, I printed off the docs you referenced. Thanks for that. I shall endeavour to comment on each separately. Your letter is first. The others later … perhaps.

    For reasons which I appear to have concealed even from myself – I regard our modern financial institutions as being little better than packs of rapid predators. They need to be culled and extirpated – like you would apply irradiation and chemotherapy to a neoplastic tumour. End of rant.

    I cannot conceive of any valid (economic, political or social) reasons for not applying strict legislative controls (caps) onto mortgage (PPR) loans which are at base, leveraged credit against several assets: a fixed structure and a regular series of payments. Its these latter which are the risky bits. Incomes are not secure.

    Historical evidence is available to confirm that the steady application of established and tested LTV + LTI ratios have anchored mortgage default rates (for decades) at less than 1% of loans. That’s impressive. So why were those successful caps abandoned?

    Modern financial (lending) institutions operate globally. They’re like Great Whites – they predate wherever they can capture a yield – regardless. And folk should take notice of the proposed Trans-Pacific Partnership (being discussed in great secrecy) which will involve the establishment of a international tribunal capable of imposing fines and sanctions on governments if any of their domestic laws or regulations hinder or incapacitate the profit potentials of MNCs. If readers are wondering what the TTP may have to do with the proposal of the ICB to apply LTV + LTI caps on mortgage loans – then I would suggest some lateral thinking may be useful. Am I being paranoid? Probably.

    Its not either LTV or LTI: its LTV and LTI. You have to apply both in synchrony. The point of departure for the arguments, pro-or-con the caps, has to be the fundamental economic objective of the caps: the financial protection of individual borrowers and their individual properties. Arguments about the ‘greater good’ or the ‘market’ should be summarily dismissed as being irrelevant.

    If you make the opening assumption that individual borrowers are as financially naive and naked as Adam and Eve – apart from their cash fig leaf, then it should not be beyond the capacity of our legislators to provide individual borrowers ith a protective cage against those Great White predators. Our couple can now swim in the Money Ocean and enjoy a survival rate of 99.4%. It may come as somewhat of a shock to ordinary folk when it is explained to them that lenders can gain more from a defaulting mortgage than they can if the mortgage abides to maturity. CMOs anyone? So who’s got the Moral Hazard then?

    Three of the more salient arguments (contra caps) are; (i) the likely affect of the ‘economic cycle’ on the application of caps; (ii) the likelihood of the dilution of upward price levels; and (iii) the likely (negative) impact on residential housing construction. Each of these arguments are actually irrelevant to the protection of the individual borrower and should simply be dismissed out of hand. And please spare me the ‘ladder’ bit. Its shameless, politically motivated sentimental nonsense: good psychology though.

    The ‘economic cycle’ has effectively being abolished – well, according to Bernanke. And many governments have put a solid floor under loan default and liquidation risks.

    Financial protections for individual borrowers are independent of property prices, which are much more likely to be influenced by local supply, local demand and individual-based credit scores. The private residential ‘market is neither national nor homogenous – its sectoral and local. More like Farmers’ Markets.

    LTV + LTI caps do not hinder credit availability – they control the allocation of the credit which financial providers are willing and able to allocate. For the present anyhow, credit availability is more a function of the state of regional and international financial centres and the availability of CB credit lines.

    New housing construction is a function of commercial capital allocation which is primarily speculator driven, as these latter search for yield. This sector is much more under the influence of international capital flows.

    Its not a settled matter whether or not social or local authority housing should even be included in the PPR sector. I suspect not. Sure, the purpose is to provide housing, but under a completely different financial model. I’d separate them.

    One crucial matter is the re-introduction of the complete legal and administrative separation of mortgage lending for PPRs from all other forms of credit allocation. I know that the Free Marketeers would be apoplectic at this ‘totally regressive’ move. But again, its not about providing a competitive environment, but ensuring robust financial protection to income vulnerable borrowers who have volunteered to assume a very large, fixed, contractual financial burden without any monetary backstop other than their initial cash deposit. These individuals are not competing with anyone, except themselves. And just keep in mind who actually provides them with the credit.

    The larger an individual’s cash backstop: the greater their downstream protection. The greater their protection: the less likelihood of financial disaster. That’s the objective of the LTV+LTI caps: financial and social stability: predictable outcomes.

  2. @BW Snr
    I agree with you that LTI and LTV are absolutely essential. In some countries LTV value can be as low as 60% which lessens the importance of LTI since the borrower is absorbing more risk. The run of the mill 80% LTV and 37% of net monthly income to cover monthly payments seems to be quite efficient.

  3. In parallel it’d be nice to see reform in tenants’ rights.

    And the costs imposed on new building do seem excessive, from VAT and development levies to what seem like over-the-top building regulations. All with no land tax meaning that low density housing is – indirectly- subsidised.

    On the prudential policies themselves, both LTI and LTV seem to have a place. While Karl Whelan’s point about LTV limitations hardly seeming needed in Ireland has some validity, it’s going to be even politically harder to take away that punchbowl if another boom party gets going. Might as well do it now, alongside LTV limits.

    Perhaps you could allow higher limits, but with different recourse T&Cs, e.g. “lend as much as you like but it’s all non-recourse”. It might keep loan values down in line with rents pretty effectively.

  4. @ MH: Thanks for reminding me about the ‘outer limit’ of % of income needed for ALL home costs (mortgage, car, cards, household taxes, charges, insurances, etc. etc.) I would have put the outer limit at 32% of disposable income – assuming a min of 6% mortgage charge.

    The big problem – its like discussing BO or smelly feet, is the current lowish mortgage interest rates and the fact that variable rates are the default programme. And we use recouse mortgage lending. And ‘defaulting’ is one nightmareish hassle. Odds are clearly stacked! How far can the tower cant over before it collapses?

    Lets assume a mortgage rate range of 6% – 8% – what would be monthly repayments on say: 90K, 110K, 130K, …. if the downpayment was fixed at 20% cash – and- the purchaser had the additional cash to pay the transaction costs? How are term-contract employments to be considered? Individual income or combined incomes? What happens if #2 gets ‘hump’ or pregnant, or sick or fired? Some very inconvenient questions: lots of ‘assumy’ and ‘iffy’ answers!

    I reckon it would need a 1-2 hour interview to de-brief a potential borrower about ALL their financial affairs. Then at least 2 weeks to assemble all the documentation to verify the aforementioned. This protocol could (should?) be standardized across all mortgage originators and lenders, with a cc. to the ICB.

    This residential mortgage issue needs a scruff-of-the neck (aka: Lugs Brannigan) solution. The lenders – and their useful idiot shills and spokesmodel enablers will play dirty to keep their advantage. Our politicians are running scared at the mo. So, chances of any positive outcome in favour of borrowers must be low – or perhaps zero.

    @HS: I have KW’s paper on my desk – will read it to-day and see what he has to say. Thanks. B.

  5. @Gregory Connor

    Your response to the CBI , in support of LTV and LTI, is very well argued and put together.
    There appears to be little disagreement in the papers linked (with the exception of the ESRI) on the issue of LTV limits. The speed of implementation is raised as a concern by Karl Whelan.

    Ronan Lyons, makes some very valid points against LTI restrictions, particularly the one that households could be forced to make what are uneconomic decisions for themselves, by buying further away from work locations and thereby incurring additional transport costs etc.
    Yet LTI, to my knowledge, is the one that banks have been using down the years.

    The ESRI response is difficult to determine, appearing to argue that as house prices are not high LTV limits are inappropriate, and that we should wait until things get out of hand, or nearly out of hand, or until builders can earn so much profit (a la the ‘boom’ era) that supply would increase again.
    The ESRI seem to ignore that the last supply side increase in housing was accompanied by by massive price increases, not price reductions.

    However, I find your the following quote from your letter as being far more persuasive than that of the ESRI argument.

    “Many have argued against the caps based on the likelihood that they will dilute the upward trend in Irish property prices, and the argument that this might hinder badly needed housing construction. It seems a bad idea to sacrifice prudential financial regulation to encourage property price trends or as a bulwark against high construction costs.”

  6. In the Republic of Rent,rent is the symptom,Irish property lease law is the disease.
    Ireland has the most anti-tenant property lease law in the world. This encouraged the property speculators and played a substantial role in the property bubble. The BTL speculators knew residential tenants had no rights and the commercial property speculators knew they could lock up tenants for 25/35 years with five yearly ratchet rent review. The rest is history.

  7. Laissez-faire in different sectors of our economy

    Gregory wrote,

    Should regulators take account of market imperfections, such as the poor performance of the Irish property development industry and the high costs of new housing construction in Ireland, in setting constraints on credit growth?

    What we didn’t do in Ireland, I can remember (because I was absolutely glued, to this conversation in Irish public life), in 2009, 2010, in the immediate aftermath of the turmoil in finances in Ireland, . . . was no one ever did the cost benefit analysis, . . to try and guess, what it would mean in Ireland, if we did nothing about loss of output from sectors such as construction, . . . as opposed to doing something, in terms of public policy, to set those sectors of the economy right, and get them operating at some capacity, and in a manner that could be of benefit to the nation.

    In that area, at least, we do exercise a very laissez-faire, approach, it would appear to me – either correctly, or incorrectly.

    One can contrast it for instance, with the very pro-active, very dynamic and focused efforts that we exercise in Irish public administration in sectors of the economy, like agriculture, foreign direct investment, national road building and infrastructure to attract further FDI etc.

    Obviously, in the past, the attitude would have been taken, that in promoting foreign direct investment, that that kind of develop, would necessarily cover the need to address policy for things like construction, property, urban re-development and so on, . . . as well.

    But I think, in Ireland, that after five decades of using this approach, . . . we may have gotten to the end, of where we can just allow housing policy, healthcare, education and other investment and building construction policies to sort of take care of themselves. We could be a lot more pro-active in these areas, like we decided to become in areas such as foreign direct investment, from the end of the 1950’s decade on wards.

    If that means, doing more, as David McWilliams etc may have suggested, to alter behaviors in the middle of boom cycles, as well as more in down cycles, then so be it.

    I would humbly suggest though, that our emphasis, in Ireland in relation to property development, . . . should be more on maintaining levels of output, and quality of end-result, . . . and less, as it used to be, until recently, in being astonished with ourselves, by how a margin of profit, that we can cream out of things like property development, and dump into things like surpluses in our national current account, via taxation nets on same transactions.

    I mean, the money making machine, that we created in Ireland, that generated the national pension reserve fund, in such a short amount of time, was nothing short of astonishing. But a huge part of the problem, was the extent of our level of astonishment with that, . . . and the lack of our astonishment now, . . . that construction and development output has disappeared.

    An American professor, Richard Buchanan at Ohio’s Case Western Reserve, Weatherhead school of management, referenced Herbert A. Simon’s writings about management lately, . . . and also, a reference that was made by Simon in his writings to a writer named Chester I. Barnard, who authored a couple of titles in 1948 and early 1950’s (moving into the era in America that became known as the McCarthy era).

    Barnard made some comments at that time, that may have been considered very un-American, by the senator who led the various investigations in the 1950’s, . . . such as, the purpose of the organisation, is not to make profits, it is to deliver goods and services. Profit is what enables organisations to do the same.

    Output in construction and infrastructure development, in Great Britain, for example has not dropped one iota, from my reading of the numbers. What has entirely evaporated in Great Britain since 2008, is the margin of profit, from the activity of providing the goods and service, but these are things which have continued to be produced by organisations in Great Britain, over the space of the last five years at least.

    It takes enormous skill and organisational management expertise to operate at 50 billion British pounds worth of construction industry turnover, per annum, in Great Britain, at zero percent profit margin, as they have managed to do so since 2008. It isn’t sustainable obviously, in the longer or even medium term, but it is impressive that Britain has managed this, nonetheless, and it indicates a deeply different structure, and driving force of the industry,/i> over there, than is the case here, in Ireland.

    We need to learn something from that particular fact, here in Ireland, and it needs to become woven into our public policy making effort. Instead we had a minister for the environment, who blamed the construction industry, for having ruined the country. That was wrong. That was a mistake. It’s a mistake, or a liberty that was taken, and one that we are paying for at the moment, I dare suggest. BOH.

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