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A toolkit with a difference

On Friday the interim-Financial Policy Committee will publish proposals for a macroeconomic toolkit to go about its business of protecting the stability of the UK’s financial system from threats domestic and foreign.

When the committee proper begins operating next year, it could have control over capital buffers, leverage limits or even loan-to-value ratios

This week, Treasury financial secretary Mark Hoban called on other authorities to put together similar bodies with similar goals and help develop the “embryonic” policy area.

The FPC’s cousin, the rate setting Monetary Policy Committee has come in for criticism for the impact of its tools – interest rates and quantitative easing – on the real economy in particular annuity rates. So, what could the Bank’s officials ask for? The Treasury set out some possibilities in the very first consultation paper in July 2010 on the long road to the Financial Services Bill currently before Parliament.

Countercyclical capital requirements: These would add a ’buffer’ to capital requirements based on the current cyclical position of the economy. For example, when private sector credit is growing rapidly, banks might be forced to hold additional levels of capital. This should increase the resilience of the banking sector by giving it more capital to absorb losses in any subsequent downturn, and may also damp the cycle by reducing lending in the upswing. This is highly likely to be recommended – it takes the punchbowl away and forces banks to mend the roof while the sun is shining.

Variable risk weights: This would involve raising capital requirements against specific types of lending. If the authorities felt financial institutions’ exposure to a certain asset class was too great, they could try to discourage it in this way.

Leverage limits: This would impose an overall limit on the amount of leverage financial institutions can hold. It would act as a ’backstop’ to capital requirements, which are typically risk-weighted.

Forward-looking loss provisioning: Banks would be forced to set aside provisions against prospective future losses on their lending. There are various ways this could be used as a macro-prudential tool, with Spain’s ’dynamic provisioning’ system offering a useful practical example. This system links loss provisions to the credit
cycle, so banks are forced to hold higher provisions when credit is growing strongly. Any such approach should respect the integrity of international accounting standards.

Collateral requirements: These would limit specific types of lending by imposing higher collateral restrictions during times of unsustainable growth in that lending. Possible examples include loan-to-value limits on secured lending, margin requirements on stocks/purchases or the imposition of haircuts on repurchase transactions for investment banks.

Quantitative credit controls and reserve requirements: These would limit lending by imposing limits on lenders and/or increasing financial institutions’ short-term liquidity requirements. Such a system was used in the UK until the early 1980s, but is likely to lead to distortions if applied over an extended period.

Not on the Treasury’s list are two possibilities that would ruffle feathers in the mortgage market: loan to value ratios and loan to income to ratios. The first would demand deposits of borrowers they may not be able to afford, the second will restrict how much they can borrow in relation to earnings. The result would inevitably be fewer borrowers. That is the point.

But, here we come back to Hoban’s “embryonic” policy area and the controversy around the MPC. The UK is the guinea pig for an unprecedented economic experiment and it seems, reasonably enough, unlikely the novice FPC’s use of the tools will be flawless. That may be the cost of making advances in the vital response to the financial crisis, but the country has enough costs.

Concerns the tools would be legislated for as statutory instruments and so without Parliamentary debate were scotched last month when Hoban accepted a call for a debate from his shadow minister Chris Leslie.

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