Philip R Lane: Macro-financial risk management
Speech by Mr Philip R Lane, Governor of the Central Bank of Ireland, at the Central Bank of
Ireland Economics Roundtable, Dublin, 8 September 2017.
* * *
It is a pleasure to welcome you to the Bank for the annual economics roundtable. Our
interactions with the external economics community help us in shaping our analysis and policy
positions; I hope the roundtable also enables the participants to gain an improved understanding
of the work of the Bank. This afternoon's thematic sessions promise to provide new insights on
the topics of labour market conditions, non-performing loans, and the European monetary
environment.
In these opening remarks, I will first review current macro-financial conditions. Subsequently, I
will discuss some current policy issues in relation to macro-financial risk management, focusing
on the potential stabilising contributions from counter-cyclical macroprudential and fiscal
policies. My discussion of fiscal policy reflects the content of the pre-Budget letter that I recently
sent to the Minister of Finance, which is published today.
The macro-financial environment
The near-term and medium-term projections for the Irish economy are for significant expansion.
The economy continues to grow at a strong pace, supported by the buoyancy of domestic
economic activity. Underpinning the recovery has been broad-based growth in employment,
which has helped incomes recover and supported solid growth in consumer spending, while
domestic investment has gained traction. Modified domestic demand, a measure of domestic
spending which excludes investment in intangibles and aircraft leasing, grew by 4.7 per cent in
2016.
Looking ahead, the outlook is favourable, although external uncertainty persists. The main
impetus to growth will continue to come from domestic demand, driven by continuing gains in
employment and incomes. Reflecting this, prospects for consumption and investment remain
positive and modified domestic demand is forecast to grow by 4.5 per cent this year and by 4.0
per cent next year. Although the pace of employment growth is projected to moderate,
unemployment is set to fall towards 5 per cent, with growth in compensation likely to average
around 3 per cent.
At the same time, there are clear downside risks to the growth outlook at both global and
domestic levels. At a generic level, Ireland is especially exposed due to the sensitivity of small,
highly-open economies to international shocks. In particular, the state of global economic and
trading conditions and the configuration of major exchange rates are important determinants of
Irish economic performance, given the dominant role of global firms in our tradable sector.
In addition, the legacy of high public and private sector debt levels means that Ireland is
vulnerable to shifts in funding conditions. The low interest rate environment that has persisted in
recent years has generated a positive financial terms of trade shock for debtors. In the other
direction, any upward shifts in policy rates, term premia or risk premia will pose adjustment
challenges for indebted sectors and may have a material impact on asset valuations.
Finally, disorderly versions of Brexit would disproportionately affect Ireland relative to other
European economies. As the EU-UK negotiations proceed, scenarios in which trading frictions
between the EU and UK are increased would be damaging for the productivity of the Irish
economy.
Macro-financial risk management: policy issues
There are two basic elements in macro-financial risk management. First, the capacity to
withstand adverse shocks is enhanced by improving the resilience of the macro-financial system
through the strengthening of sectoral balance sheets and the design of a legal and regulatory
architecture that lowers the costs associated with dealing with unsustainable debts and failing
institutions. Second, counter-cyclical policy measures can dampen cyclical fluctuations in
conditions.
At global, European and domestic levels, financial regulatory reforms in recent years have been
directed at improving the resilience of banking systems. Banks are now required to satisfy
tougher capital and liquidity requirements, while recovery and resolution regimes have been
introduced to make it easier to deal with distressed institutions. These regulatory reforms are
backed by a more intrusive supervisory system, including more extensive on-site inspections
and enhanced enforcement powers. Legal systems have also been reformed to improve
insolvency frameworks, even if much remains to be done.
In addition, under the domestic implementation of the European macroprudential policy
framework, the Central Bank of Ireland now sets additional capital buffers for banks and also
specifies borrower-based measures to mitigate the risks associated with boom-bust financial
cycles.
In relation to capital ratios, the Bank sets an additional buffer for each systemically-important
1
institution (the so-called O-SII buffer). In addition, the counter-cyclical capital buffer (CCyB) is a
policy tool that can be activated in response to cyclical credit dynamics by raising the minimum
capital ratio for banks during periods of above-normal credit growth and lowering it during periods
of below-normal credit growth. A primary objective is to increase the resilience of banks to
unexpected reversals in credit dynamics; in addition, depending on circumstances, it is possible
that the credit cycle might also be dampened by such counter-cyclical measures.
While new lending is picking up, our assessment is that the credit cycle remains subdued, which
is reflected in the current zero value for the counter-cyclical capital buffer. Still, since the
counter-cyclical capital buffer is reviewed on a quarterly basis, this policy tool provides a
highfrequency (compared to the typical duration of financial cycles) mechanism to respond to cyclical
shifts in credit conditions. A small but increasing number of EU countries have raised the
counter-cyclical capital buffer in recent times.
Of course, the bedrock of our macroprudential policy framework is formed by the
borrowerbased measures we have introduced in relation to mortgage loans. We view our mortgage
measures that put ceilings on loan-to-income (LTI) and loan-to-value (LTV) ratios as essential in
limiting systemic financial risk emanating from the mortgage market, while acting to protect
consumers from the risks associated with overborrowing.
Such borrower-based measures are intended to improve the resilience of the financial system
and the overall economy by improving the sustainability of mortgage loans, leading to a lower
probability of default and smaller losses in the event of defaults. Moreover, such measures are
reinforced by the higher capital requirements facing banks, which improves their capacity to
absorb loan losses.
An important property of the mortgage measures is that the LTI rule acts as an automatic
stabiliser in relation to house price dynamics: house prices cannot persistently rise faster than
the income levels among the pool of potential purchasers. In addition, the differential LTV ratios
for first-time and second-and-subsequent buyers recognises the asymmetric impact of house
price increases on these different groups: whereas a rise in house prices requires extra savings
to meet the deposit requirement for a first-time buyer, an incumbent house owner experiences a
decline in the LTV ratio on her existing property which expands her borrowing capacity in further
housing market transactions.
In similar vein, the additional LTV requirement for buy-to-let (BTL) investors limits the feedback
loop between house price rises and the conversion of increases in home equity values into
borrowing capacity in the BTL category. The operation of these mechanisms means that the
combination of the LTI ceiling and the ladder of differentiated LTV ceilings provides some in-built
brakes in housing price dynamics.
A further stabilising mechanism is that our macroprudential regulations can be tightened if there
is evidence of materially-elevated risks in the mortgage market, especially in relation to adverse
feedback loops between the rate of credit growth and house price increases. Our commitment to
an annual review process ensures that a rigorous evaluation of the mortgage measures is
conducted each year, such that indicators of a combination of excess credit growth and
unsustainable house price levels can be met by a revision in the rules. Given this policy regime,
participants in the housing market can be confident that the feedback loop between credit growth
and house prices will no longer operate in an unbounded fashion.
It is critically important to appreciate that our framework sets limits on the size of mortgages: the
LTI and LTV ratios are not targets but ceilings. In buying a home, a household should take into
account the protections offered by putting down a higher deposit in terms of limiting repayment
burden and risks associated with excessive debt levels. Equally, lenders are required to assess
the loan-bearing capacity of each mortgage customer and restrict the size of the mortgage if
indicated by the analysis of the borrower's credit risk.
While the November 2016 revisions to the mortgage rules did raise the maximum loan size for
first-time buyers seeking to buy homes above €220,000 in value, it is important to take into
account several considerations. First, borrowers also have to satisfy the LTI requirement, which
remains unchanged at a cap on loans of 3.5 times income. For many households, this will limit
the capacity to increase the mortgage size. Second, the scope for exemptions to the LTV limit for
first-time buyers has been restricted to just 5 percent of lending to this group, whereas the
previous regime allowed 15 percent of lending above the LTV ceilings and did not restrict the
allocation of exemptions between the first-time and second-and-subsequent buyer pools: in our
analysis, many first-time buyers above the €220,000 threshold were receiving exemptions (or
were looking for loans below the LTV ceiling) so that previous rule was not fully binding. Third, to
the extent that the revision is contributing to an increase in aggregate mortgage credit volumes,
this should be interpreted in the context of the subdued level of lending in recent years.
Finally, it is important to appreciate that many factors influence the dynamics of house prices.
Moreover, there is no fixed relation between credit conditions and the evolution of house prices:
the importance of credit conditions is clearly diminished in settings in which a significant
proportion of purchasers do not require mortgage finance.
While rising incomes, low interest rates, high rents and post-crisis adjustment dynamics are
currently contributing to significant house price pressures, the prospect of future expansion in
housing supply should restrain house prices over the medium term. In particular, an expansion
in the housing stock would simultaneously relieve pressure in both the rental and home
ownership categories.
In addition, as discussed earlier, the highly-open nature of the Irish economy means that income
and employment levels are highly sensitive to external shocks. For instance, slowdowns in
global output growth, major currency movements, adverse shifts in international trading regimes
and a tightening in funding conditions could trigger a reversal in the currently benign growth and
employment environment. Given these considerations, there are no one-way bets in the housing
market and our macroprudential framework is fundamental to mitigating these risks.
A resilient macro-financial system also depends on stable public finances, especially in view of
the feedback loops between fiscal stability, financial stability and macroeconomic stability. In
terms of the public finances, a long-term public debt target can provide an important anchor.
Indeed, the greater the commitment to attaining a long-term debt target, the more is it possible to
run a flexible, counter-cyclical fiscal policy in response to temporary shocks. The case for a
prudent target for public debt is further reinforced by the trend implications of an ageing
population for expenditure on pensions and healthcare.
While the European fiscal framework prescribes a target ceiling for the stock of public debt (at 60
percent of GDP), there are compelling reasons to develop a national target for the stock of public
debt. In this respect, I welcome the commitment in the Summer Economic Statement to
maintain a long-term debt target of 45 percent of GDP. At the most basic level, the new CSO
calculations indicate that the underlying size of the Irish economy (as captured by GNI*) is about
one-third smaller than GDP, such that a debt ratio of 60 percent of GNI* maps to a debt ratio of
40 percent of GDP. More generally, the prudent stock of public debt naturally varies across
countries in line with different risk exposures: the volatile nature of the Irish macro-financial
system and the history of crises suggests a debt target that should be materially below the
appropriate level for a larger, more stable economy. Of course, a target for the stock of public
debt should be appropriately interpreted in the context of the wider public sector balance sheet,
with due allowances for the dynamics of various types of financial and non-financial assets
(including public capital) and the range of contingent and implicit liabilities.
In relation to the cyclical budgetary stance, the pursuit of macro-financial stability requires that
the government runs a counter-cyclical fiscal policy. In addition to the mechanical operation of
the automatic stabilisers that are embedded in the dynamics of tax revenues and transfers, a
government may need to take further discretionary measures to tighten budgetary policy during
phases of robust economic growth. The development of a counter-cyclical fiscal strategy should
also strike the balance in the allocation of surplus revenues between the proposed rainy day fund
and reducing the gross stock of public debt. In addition to ensuring that the fiscal balance is set
at a cyclically-appropriate level, the government can use additional tools to mitigate overheating
pressures, including the deployment of cyclically-varying expenditure taxes.
Determining the optimal counter-cyclical fiscal stance may soon be quite relevant for budgetary
policy if the economy hits full employment. For instance, the macroeconomic implications of the
projected further expansion in public investment during 2019-2021 that is signalled in the
Summer Economic Statement depend on whether and when the economy attains full
employment. While additions to the public capital stock can be expected to raise the productive
capacity of the economy and/or assist in the attainment of social objectives over the medium
term, the process of public investment acts to raise aggregate demand in the near term. While
the demand-raising impact of public investment can be stimulative during periods of economic
slack, a surge in public investment under conditions of full employment requires counter-vailing
measures to limit the risk of costly over-heating dynamics. Alternatively, stretching out a planned
public investment programme over a longer horizon can limit pressures on the absorptive
capacity of the economy.
Finally, it is important to note the complementarities between counter-cyclical macroprudential
2
and fiscal policies. In one direction, a robust macroprudential policy framework mitigates
creditdriven cyclical shocks, easing the burden on fiscal policy. In the other direction, counter-cyclical
fiscal policy moderates the income volatility that is an important source of credit shocks,
reducing the strain on the macroprudential stance.
Conclusions
At the current juncture, Ireland faces two types of risks. In one direction, there remain many
legacy issues from the crisis, with the elevated stocks of private and public debt implying
significant vulnerability to adverse shocks to incomes or interest rates. In the other direction,
upside shocks may provide a new type of challenge in addressing potential overheating risks in
the economy. The responsibility of policymakers is to maintain a vigilant and agile stance in
order to ensure that Ireland can cope with either type of shock.
1
The acronym O-SII stands for Other Systemically Important Institutions.
2
See Philippe Martin and Thomas Philippon (2017), "Inspecting the Mechanism: Leverage and the Great
Recession in the Eurozone," American Economic Review 107(7), 1904-1937.