Jean-Pierre Danthine: Taming the financial cycle
Speech by Mr Jean-Pierre Danthine, Vice Chairman of the Governing Board of the Swiss
National Bank, at the 30th SUERF Colloquium, Zurich, 5 September 2012.
* * *
Introduction
The global financial crisis has been weighing heavily on the world economy since 2007. The
crisis was severe. In most advanced countries, the recovery has been weak in historical
comparison. Many of these economies are struggling hard to regain the jobs lost during the
last four years (slide 1).1
The crisis originated in the bursting of a house price bubble driven by an excessive credit
expansion in the US, which eventually pushed the global financial system to the brink of
collapse. In some countries, such as Spain or Ireland, the crisis was further compounded by
the bursting of their own housing bubbles. In this regard, the current crisis is an excellent
example. Historical evidence shows that the macroeconomic cost of an asset price bubble
that bursts is particularly severe when the property market is affected. Moreover, such events
tend to be more costly when the bubble is financed through credit and when leveraged
financial institutions are directly involved.2
Switzerland has been less affected by the recent crisis and has recovered more quickly from
it. There is no room for complacency, however. The recovery has been boosted by a thriving
housing market and strong credit growth. In the wake of this, the medium-term risk to
financial stability has been increasing. The dismal consequences of the recent global crisis
as well as of our own housing market crisis experience in the early 1990s are stark
reminders that we should not take any chances in this regard. We must ensure that a similar
crisis does not materialise in our country again.
How can we improve our ability to contain risks to system-wide stability knowing that, in case
of adverse shocks, these risks can materialise with devastating consequences for the
broader economy?
In the first part of my speech, I argue that what is referred to as a macroprudential approach
to financial regulation is an important missing link in our quest for a more comprehensive
financial stability framework. It provides the necessary complement to sound microprudential
regulation and supervision as well as to a monetary policy that focuses primarily on price
stability.
I argue, in the second part of my speech, that the case for macroprudential policies applies
strongly in Switzerland. Against a background of persistently strong growth in the Swiss
credit and property markets, the availability of a new macroprudential instrument, a
countercyclical capital buffer (CCB), is an important step forward. I will describe the key
features of this important new instrument.
How to deal with systemic risk: The case for macroprudential regulation
Let me proceed straight to the key problem at hand: the issue of systemic risk in financial
markets.
In general terms, systemic risk arises because an optimising financial institution does not
fully account for the cost that its behaviour imposes on other financial institutions. That is, at
heart, systemic risk originates in a negative externality imposed by individual financial firms
on the system. The underlying sources of systemic risk can be either structural or cyclical.
The structural dimension of systemic risk is linked to spillovers associated with three key
properties of modern banking: high leverage, limited liability and interconnectedness.
On its own, high leverage implies a higher risk of insolvency. Combined with limited liability,
high leverage often leads to excessive risk-taking. This is because, with limited liability, the
diverse set of stakeholders (managers, owners, creditors) benefits from the upside of
risk-taking but does not fully bear the cost when these risks materialise. As a consequence,
there are strong incentives to leverage the balance sheet beyond the level which would be
chosen if the individual stakeholders were fully exposed to the associated increase in the risk
of default.
This problem of socially excessive risk-taking is particularly damaging in the case of large
interconnected institutions whose failure would endanger other institutions, with adverse
consequences for the broader economy. Finally, the issue is further exacerbated if an implicit
or explicit guarantee of state support is extended to such institutions. The chain of distorted
incentives which has just been described, and, in particular, the moral hazard issue implied
by the guarantee of state support, is now well recognised and is being addressed
energetically by the various regulators.3
The second source of systemic risk has a cyclical dimension (slide 2). This is the aspect on
which I would like to focus today. Here, systemic risk arises from the procyclicality of financial
agents' behaviour, leading to the amplification of financial cycles.4 Procyclicality can arise, for
instance, from the tendency to underprice risk during booms and to overprice it in
downswings. Sometimes exacerbated by regulatory requirements, it causes agents to take
similar actions in case of an adverse shock, namely to dispose of risky assets when prices
fall. While this behaviour may be individually rational, the outcome can be socially
devastating. Indeed this collective reaction tends to amplify an initial price movement, thus
leading to another round of asset selling, in particular if the boom is mainly financed through
credit. A financial system facing such strains is forced to retrench further from risk-taking and
eventually from credit intermediation, leading - in extreme cases - to an outright credit
crunch.
How to deal with systemic risk - the traditional approach
While these arguments are not profoundly new, the policy consensus before the current
crisis was dominated by a reluctance to address systemic risk issues directly. This
consensus was based on two key arguments.
First, it was largely assumed that securing the solidity of individual financial institutions would
also grant system-wide stability and thus that regulation at the level of individual
firms - micro-regulation - would suffice. The crisis has shown that this view is clearly
questionable. As just described, risk in a financial system can arise quasi endogenously,
even if individual financial institutions appear to be robust.
The second critical element of the pre-crisis policy consensus is known as the "Greenspan
Doctrine". This states that pricking an asset price bubble is in general more costly than
cleaning up after the bubble has burst. The foundation of this doctrine is that it is simply too
difficult to identify ex ante when a bubble is forming. Specifically, it is inherently difficult to
disentangle situations where a credit or asset-price boom is justified by fundamentals from
those where it is based on misplaced expectations and is thus a threat to financial stability.
As a result, an attempt to prick a bubble may lead to an intervention that puts a halt to "a
good boom" which would have pushed the economy towards a higher level of development.
The cost of such unwarranted interventions in the form of foregone growth could be
substantial.5
How to deal with the cyclical dimension of systemic risk - a macroprudential approach
The immense cost of the global crisis has led to a thorough rethinking of this traditional view
on financial regulation and macroeconomic policy. For instance, estimates have been
provided suggesting that the cumulated output loss incurred by the recent crisis could
amount to 90% of 2009 world GDP.6 Naturally enough, the afore-mentioned approach of
"benign neglect" is no longer seen as an acceptable way to deal with potential excesses
building up through the financial cycle.
Given that the cost of inaction when imbalances develop in the credit market can be huge, a
more precautionary approach is indispensable (slide 3). In general, its goal should be, first, to
enhance the resilience of the financial system to adverse shocks, and second - to the extent
possible - to try and preventively contain the build-up of systemic risk. This is the thrust of
the macroprudential approach. For instance, in order to address the root cause of cyclical
systemic risk directly, the goal of this approach should be to reduce the procyclicality of
financial agents' behaviour.
Can we hope to achieve this with monetary policy instruments, or do we need new
specifically designed instruments?
Monetary policy comes to mind since it is conceivable that we might use the interest rate
instrument more aggressively in the face of mounting cyclical excesses in the credit and real
estate markets. Raising interest rates in the case of a credit boom - leaning against the wind
- is a natural response, as the higher market borrowing rates would exert a dampening effect
on credit demand and - eventually - on real estate prices.7
Using the interest rate to contain asset price growth would, however, regularly lead to
deviations from the interest rate path that would be optimally justified by the pursuit of the
price stability mandate. This is an illustration of the well-known principle according to which
the number of policy tools should equal the number of policy goals.
At a more practical level, empirical evidence suggests that the interest rate may be an
inefficient tool when used single-handedly for the purpose of dampening the financial cycle.
That is, containing a boom may require very large interest rate movements, leading to
commensurate output losses.8
In sum, while interest rate policy may at times be counted on to support efforts to contain
financial stability risks, it is unlikely to suffice as the main, or sole, instrument in doing so.
Thus the deployment of specific macroprudential instruments, targeted directly at the specific
source of systemic risk, seems appropriate. There are several potential candidates - ranging
from capital and liquidity oriented tools, to taxation or outright bans on certain financial
activities.9 Ex ante it is difficult to single out the best instrument, independently of the context
and the targeted source of systemic risk.
I will abstain from an in-depth discussion of the catalogue of proposed tools and rather focus
on a practical case study, namely the macroprudential instrument introduced in Switzerland
earlier this year, the countercyclical capital buffer (CCB).
Macroprudential regulation in Switzerland
Why do we need this instrument?
In Switzerland, the indications of a gradual build-up of cyclical imbalances in the mortgage
and real estate markets have become increasingly evident over the past few years (slide 4).
In the last three years, yearly growth rates of mortgage lending and real estate prices have
amounted to about 5% on average.10 These numbers may not be spectacular compared to
the double-digit growth rates often observed during later build-up stages of a bubble.
However, these growth rates are atypically high when compared to the below average
economic growth observed during the last three years. As a consequence, the
mortgage-lending-to-GDP ratio has reached historical heights while, in some segments and
regions, residential real estate prices exceed levels that can be justified by fundamental
factors such as demographics or income.
Given these developments, Switzerland is facing an increasing risk, both of defaults in the
mortgage market and a sizable correction in property prices, either of which might impair
financial stability in the medium term. Specifically, an adverse shock - such as rising interest
rates, lower growth or increasing unemployment - would leave some borrowers unable to
service their loans, increasing the possibility and number of defaults, and ultimately leading
to a vicious feedback loop of falling property prices and impaired balance sheets throughout
the banking sector.
At the same time, Switzerland currently serves as perfect example for the afore-mentioned
argument that the interest rate is unlikely to suffice as instrument to ensure financial stability
(slide 5). Notably, it is clear that the current exchange rate situation invalidates the interest
rate as an available instrument to dampen the persistently strong growth in credit volumes.
At present, the interest rates required for monetary policy objectives differ considerably from
those required for financial stability policy objectives. This perfectly demonstrates the need
for specific instruments to be able to address both policy objectives - financial and price
stability - simultaneously.
Against this background, the Federal Council announced a package of measures in June
2012 addressing these risks in the mortgage and real estate markets.
In addition to the CCB, this package consists of a structural revision of capital requirements
for residential mortgage lending as well as a revision of the banking industry's self-regulation
guidelines. The first of these measures consists of a permanent increase in the
risk-weighting11 for the loan tranche exceeding the 80% loan-to-value ratio. The second
measure requires a 100% risk-weighting for new mortgage loans which do not meet tighter
minimum requirements stipulated in the banks' revised self-regulation guidelines.12
The CCB, for its part, is a pre-emptive measure that allows authorities to temporarily raise
capital requirements in the banking system as imbalances in the credit market develop.
When activated, banks will be required to gradually build up an additional capital buffer of up
to 2.5% of total domestic risk-weighted assets during the upswing in the credit cycle. The
CCB requirement is a supplement to other capital requirements. Once risks have
materialised, or if the intensity of risk is subsiding, the capital buffer generated from the CCB
is released, either immediately or gradually.
The key features of the CCB
The CCB combines several key features that directly address the problem of cyclical risks to
financial stability.
In particular, when activated, the CCB should help reduce the amplitude and the
consequences of imbalances for financial stability. The CCB should increase resilience by
ensuring that an additional buffer of capital is built up gradually during the boom, a buffer that
can then be released to cushion losses in an eventual downturn. It thus limits the threat of
vicious fire-sale spirals. Moreover, by increasing the relative cost of providing credit, the CCB
should help to lean against the build-up of excesses.
In addition, the buffer is designed in such a way that it can be implemented on a broad basis
or can target specific segments of the credit market only. Currently, for instance, signs of a
build-up of excesses in the Swiss credit market merely relate to the domestic mortgage and
residential real estate markets. Thus, if the buffer were to be activated, it would be aimed
solely at this segment of the credit market.
Not least, a CCB is one of the key components of the reforms of international financial
regulation (Basel III framework). It will be introduced by most countries within the next few
years. In this context, criticism has been raised that an early introduction of the CCB would
cause competitive disadvantages for the Swiss financial sector in international comparison.
For various reasons, this criticism is invalid. First, the CCB will be activated only if deemed
necessary; most of the time, it is likely to remain turned off. Second, if activated, the CCB
would be applicable to Swiss banks and to subsidiaries of foreign banks in Switzerland,
ensuring a level playing field. Third, given the geographical diversification of the two big
banks, an activation of the CCB focused on domestic risk-weighted assets would not have a
material impact on these banks' overall capital situation. Finally, by contributing to financial
stability and hence reducing the risk of domestic banking crises, the CCB should help
increase the overall long-term attractiveness and competitiveness of the Swiss financial
sector.
How the CCB works
Let me now address four key questions pertaining to the functionality of the CCB; and, for
that matter, of any macroprudential instrument targeted at containing the cyclical dimension
of systemic risk.
First, how do we know that imbalances have reached a level such that an activation of the
CCB is warranted?
As mentioned earlier, identifying unsustainable developments in asset and credit markets is
inherently difficult. Thus, the aim cannot, and should not, be to surgically prick bubbles or to
fine tune asset-price or credit market developments.
It is easier, however, although not trivial, to identify situations of intensified financial stability
risk. In such cases, taking precautionary action is fully justified. The question should thus be
rephrased as "How can we identify that the build-up of risk is approaching a critical stage?"
International evidence suggests a palette of quantitative early warning indicators that are
reliable with respect to predicting banking crises and financial instability. For instance, real
estate boom-bust cycles are particularly damaging when associated with increased leverage
in both the real and financial sectors. To obtain a more accurate picture of the intensity of
systemic risk, a combination of indicators should be monitored simultaneously.13
In this spirit, the Swiss approach relies on a combination of indicators to assess whether, and
to what extent, the activation, adjustment or deactivation of the CCB is warranted.14 These
indicators have been chosen based on their past performance as early warning indicators
both for Switzerland and internationally (slide 6).
Still, a purely mechanical response to financial stability risk depicted by a set of indicators,
while providing a certain degree of transparency, is risky. For instance, it would leave no
room for considering the influence of developments not captured by these indicators. As a
consequence, an element of discretion should be embedded in the decision to activate the
CCB, or not, at a given point in time.15
The current situation provides a good example: The medium-term risks to financial stability
remain high, with imbalances in certain segments persisting. Some recent data releases,
however, indicate a possible slowdown in momentum in Swiss mortgage and real estate
markets during the second quarter of 2012. In addition, the effect on credit momentum of the
other measures announced by the Federal Council in June 2012, namely the revision of the
risk-weighting and the self-regulation rules, remains to be seen.16 Taking these issues into
consideration, the SNB decided in August 2012 not to issue an immediate proposal to the
Federal Council for activation of the CCB. It will reassess the situation regularly.
The second key question pertaining to the functioning of the CCB is whether it is an effective
instrument to strengthen the resilience of the financial system and thus help to limit negative
spillovers (slide 7).
The impact of higher capital ratios and more provisions on the resilience of banks is
self-evident. This is also the case from a system-wide perspective. To assess the
effectiveness of the CCB in strengthening resilience, we can draw some lessons from
historical experience, namely the Swiss real estate crisis in the early 1990s. Internal
calculations suggest that, had the proposed CCB regime been in place in the run-up to that
crisis, the resilience of the system as a whole would have increased significantly. From an
aggregate perspective, this additional capital would have absorbed a large portion of the
losses that were reported as a result of the crisis.
The third key question is: To what extent the CCB is able to contain the build-up of
excesses?
Here, international empirical evidence suggests that tighter capital requirements have, on
average, a dampening impact on credit volume. This impact of tighter capital on lending is
greater when the implementation period is shorter.17 Moreover, the increase in capital
requirements may lead to a significant reduction in the likelihood of a systemic crisis.18
Expectations concerning the effectiveness of leaning against the credit cycle must remain
realistic, however. There is no guarantee that activating the CCB will fully eliminate future
imbalances in the Swiss mortgage and real estate markets. Inherent uncertainty regarding
the strength of its impact and hence the appropriate calibration remains. Moreover, if banks
hold significant capital cushions even before the CCB is activated, the desired
countercyclical effect on credit growth may be weakened. We can note, however, that even if
the CCB has no effect on aggregate credit growth, it will nonetheless be useful if lending is
shifted from relatively weak banks (constrained by the CCB) to more resilient banks
(benefitting from a sufficient capital buffer).
Let us now turn to the fourth question pertaining to the functioning of the CCB: How does it
perform with respect to potential side-effects?
The most important concern in this regard is that, if the CCB generates capital constraints at
some banks, these banks will need to decide which sector to keep lending to. It may seem
reasonable that institutions will prefer to keep lending to the booming sector, while cutting
back on lending to other sectors.
The design of the CCB takes such undesired side-effects into account. In particular, the
sectoral approach alleviates this problem to some extent. By increasing the cost of granting
credit to a given sector (real estate lending) relative to others, it should discourage lending to
the former as it is "penalised" in terms of higher capital requirements. And, thanks to its
dynamic nature, the CCB can be flexibly adjusted, should it still have undesired
consequences in other segments of the credit market.
Conclusion
To sum up, the global crisis has clearly stressed the need for a more comprehensive
approach to financial stability. The potential cost of a systemic crisis is significant. Remaining
idle is no alternative. We must insist on addressing systemic risk issues head-on. This is the
intent of macroprudential instruments.
In Switzerland, financial stability risk is currently building up, driven by persistently strong
momentum in the mortgage and real estate markets. Against this background, the availability
of a tool such as the CCB is a significant step forward. The CCB is a "soft", incentive-oriented
instrument based on the principle of prudence. It can and will be used in a balanced and
flexible way to deal with specific cyclical risks to financial stability.
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