Jean-Pierre Danthine: Credit - is the sky the limit?
Introductory remarks by Mr Jean-Pierre Danthine, Vice Chairman of the Governing Board of
the Swiss National Bank, at the International Center for Monetary and Banking Studies,
Geneva, 16 April 2013.
* * *
I would like to thank Claudia Strub and Till Ebner for their very valuable support in drafting this speech and for the
underlying analysis of the topic. I would also like to thank Robert Bichsel for his helpful comments.
1. Introduction
The Swiss Federal Council has recently decided to activate the countercyclical capital buffer
(CCB) acting on a proposal by the Swiss National Bank (SNB). The key feature of this new
tool is to counter the "pro-cyclical" behavior of financial institutions whose collective action
can be a source of systemic risk. To this end it requires banks to temporarily increase the
level of capital they must hold as a backing for mortgage loans on residential property. In
doing this, Switzerland is one of the first countries to make effective use of a tool advocated
by the international community as a means for preemptively dealing with cyclical risks to
financial stability.
What was the motivation for activating this instrument? The main goal of the CCB is to
increase the resilience of financial institutions against the background of imbalances in the
domestic mortgage credit and housing markets that have been building up gradually over the
last several years. In 2012, these imbalances intensified further reaching levels that pose a
risk to the stability of the banking sector, and hence to the Swiss economy. Here, two facts
stand out.
First, real estate prices in Switzerland have been persistently increasing since 2000, at
accelerated speed since 2008, reaching levels estimated to be 40 to 60% higher than
12 years ago (see Figure 1).1 Second, the growth of credit volumes has been significant with
the consequence that credit volumes relative to gross domestic product (GDP) have reached
new historical peaks (see Figure 2a and 2b). The fact that these two developments have
progressed hand in hand spells out conditions that may lead to subsequent financial
instability. Indeed, historical evidence - widely documented by the Bank for International
Settlements (BIS)2 - shows that such a twin development - elevated residential prices and
dynamic credit growth - constitutes the prime advance indicator of financial instability. We
only have to look outside our borders, to the US and various regions of Europe, or back
through Switzerland's own past to get a feel for the devastating consequences on the real
economy of financial crises originating in real estate excesses.
2. Credit: is the sky the limit?
Today I would like to focus on one of the two critical elements mentioned above, the growth
of credit volumes. Figure 2b easily explains the question asked in the title: is the sky the
limit? The answer is just as easy. Clearly the credit-to-GDP ratio cannot grow indefinitely
because otherwise the cost of servicing the debt would end up exhausting the whole of GDP.
In other words: What we observe here cannot be the manifestation of a secular trend! As we
will see, making sense of this development is less trivial. To get a broader perspective on this
question let us enlarge the picture shown in Figure 2b.
Figure 3 provides the international dimension. As is clearly visible, there has been a
substantial built-up of credit relative to GDP on a global scale over the last decades. There
are some notable differences in the size, timing and scope of this development between
individual countries but the general direction is the same. Ominously the upward trend was
particularly steep in the run-up to the recent financial crisis in those countries that were
subsequently most heavily affected (US, Ireland, Spain, UK).
Figure 4 looks at the Swiss data from an earlier starting point. Here one is struck by the fact
that the recent significant upward trend in the credit-to-GDP ratio has been preceded by an
even more spectacular jump during the 1970s and 1980s, pushing the ratio to about 150% -
a high level in international comparison. During the 1990s, it then fluctuated around this
mark. From 2000, we again observe an increase in the ratio3, at accelerated speed since
2009, such that, as of today, the ratio has reached about 170%.4 This more recent upward
trend seems to be continuing unabated.
How can we understand these developments? And can this understanding form a basis for
predicting the likely future evolution of this variable in Switzerland? These are the questions I
would like to focus on in this speech.
To begin with, let me argue that if the dynamics in credit-to-GDP observed since the 1970s
cannot be construed as an ongoing trend, the recent development must either be viewed as
a structural adjustment to a new plateau - which seems to have been the case until 1990 -
or as a cyclical upswing to be followed by a later correction. Schematically one can describe
these possibilities in terms of Figure 5.5 In the first case, the implication is that at some point,
credit volumes will be growing in line with GDP again. This could be either the result of an
acceleration of nominal GDP growth at constant credit volume growth, or of a moderation of
credit growth to adapt to the long run growth rate of nominal GDP. In the second case, that is
if the situation is rather one of a cyclical upswing, then clearly credit growth will have to
undershoot nominal GDP growth for many years in the future. In both cases the present
situation with credit growth significantly exceeding nominal GDP growth is not sustainable.
However, the challenge to the financial industry to adapt to a much lower growth of credit is
clearly larger in the second. This holds even if a harsh backlash in the form of an outright
crisis can be avoided.
Unfortunately it is not possible to precisely ascertain where we stand and what the future
holds in store. Nevertheless, I will try to bring some clarity to the issue by examining - first -
possible explanations for an increasing credit-to-GDP ratio (section 3), then by assessing
their explanatory power in the Swiss case (section 4). Section 5 will conclude.
3. Possible explanations for increasing credit-to-GDP ratios
3.1. Supply side considerations: Financial liberalization, the likely explanation for
the 1970s and 1980s
A first important reason for an increase in credit volumes can be found in an improved
availability of credit. It is well recognized that quantity rationing is prevalent in credit markets.6
Technical innovation and regulatory changes have an impact on the extent of credit rationing
and thus very directly on the volume of allocated credit. The financial liberalization of the
1970s and the 1980s and technical innovation in financial services that resulted are therefore
natural and plausible explanations for the spectacular credit development observed
internationally in the later part of the last century. Here, a permanent adjustment to a new
plateau seems to be a viable explanation. This does not mean that such an adjustment
process is innocuous from the perspective of financial stability, nor does it imply that the
adjustment process cannot overshoot. Indeed, a higher credit-to-GDP ratio means a higher
degree of leverage which, in all cases, is likely to increase the fragility of the financial system.
3.2. Demand side developments
Second, structural changes in the demand for credit are also a conceivable driver of an
increasing credit-to-GDP ratio. For example, an economy-wide perception of improved
growth opportunities justifies a broad increase in borrowing to finance investment projects.
One can thus rationalize an increase in the credit-to-GDP ratio in economies in the process
of catching up with advanced economies. This is a plausible element of explanation for credit
developments in the case of a country such as Japan in the 1960s and 1970s. It is, however,
much less plausible in the case of mature countries such as Switzerland in the latter part of
the period of observation (Figure 3).
Other structural changes in credit demand are also conceivable. For instance, it can be
argued that the financial liberalization of the 1970s and 1980s (together with related
sociological developments) has significantly affected the public attitude towards
indebtedness making it much more socially acceptable, in particular with regard to
consumption financing. Further structural changes on the demand side, such as
demographic transitions or an increase in idiosyncratic income risk could lead to an increase
of credit demand for consumption smoothing purposes. It is difficult, however, to connect
these theoretical considerations with the realities of developed economies in the last
decades. In particular the demographic trends observed in advanced countries (also in
Switzerland) would imply a structural shift towards less rather than more borrowing.
3.3. The role of the interest rate
Third, the role of the interest rate deserves special attention when thinking about credit
developments. The interest rate is of course an endogenous variable when examining the
demand and supply for credit. Yet additional insights are possible when considering it
separately. For instance, a structural low interest rate level such as typically observed in
Switzerland can help explain a relatively high credit-to-GDP ratio in international comparison.
Similarly a prolonged period of exceptionally low rates such as the one we are currently
experiencing is a potential explanation for an increase in credit volumes.
At a superficial level this relation is obvious. Low interest rates reduce the cost of servicing a
given credit which becomes affordable for a broader range of households. Alternatively,
borrowers can afford higher credit lines. Moreover, low interest rates translate into higher
asset prices and higher notional wealth. The increased collateral values support higher credit
lines and decrease the amount of credit rationing. This is, in particular, relevant with
reference to the real estate market where higher house prices imply higher mortgage
volumes to finance the same stock of housing.
The rationality of this explanation has to be relativized, however. This is certainly the case if
we think of credit financing long run projects such as real estate. Here the average interest
rate over the life-time of the credit must be relevant for investment decisions. An exceptional,
prolonged period of low rates might imply a decrease in the lifetime average rate, a form of
"window of opportunity". However, the very fact that interest rates must - eventually - rise
again implies that credit expansion based on low interest rates cannot be viewed as a shift to
a permanent higher credit level. At higher interest rates, credit demand will decline once
again. To the extent that the credit expansion was driven by miscalculations on credit
affordability, this may even lead to a crisis.
3.4. Behavioral biases
The latter remark leads to a fourth potential explanation, that is, credit expansion driven by
behavioral biases. As highlighted by Hyman Minsky7, the credit cycle appears to be driven by
"waves of optimistic and pessimistic sentiment"8. In an upswing, expectations about future
developments may turn erratically exuberant. Observing a long period of price increases,
investors tend to believe that new circumstances justify the perpetuation of the upward trend
and act on this belief. Overconfident lenders and borrowers are increasingly ready to take
higher risks. Ever increasing prices become a necessary condition to enable borrowers to
service their debts. Then the tide turns. A few investors fail to meet their obligations,
confidence crumbles, asset prices stop increasing or begin to fall and optimism turns into a
wave of pessimism. Clearly, credit expansion driven by such erratic beliefs is a cyclical
phenomenon and no viable explanation for a sustainable increase in the credit-to-GDP ratio.
As we have seen, there are various potential explanations for an increase in the
credit-toGDP ratio, some suggesting a permanent, structural increase in this ratio, others hinting at a
temporary, cyclical upswing. Which of those explanations can plausibly contribute to explain
the remarkable development of credit-to-GDP ratio in Switzerland highlighted before?
4. A plausible explanation for the current Swiss developments
As already hinted at, the review of possible structural drivers of an increase in credit volumes
does not seem to provide solid support for arguing in favor of a recent permanent shift in the
case of Switzerland. Switzerland has a highly developed financial system. Economic stability,
a high wealth level - Swiss households' stock of financial assets amounted to about
3.5 times GDP in 2011 (Figure 6) - a high savings rate and structurally low interest rates are
probable reasons for high credit volumes, possibly even a high credit-to-GDP ratio, in
international comparison. It is not clear, however, how one could argue that significant
changes in these structural factors are currently at work.9 By contrast, many of the cyclical
drivers that we have discussed appear highly plausible in the current circumstances.
Specifically, the prolonged current period of ultra-low interest rates feeding into and being
reinforced by rising real estate prices, combined with the potential for some of the
abovementioned behavioral biases, have a higher explanatory power. These developments bear
clear risks for financial stability. Let me go into more detail.
We are currently experiencing a prolonged period of low interest rates (Figure 7a). This holds
globally as well as in Switzerland; it is one of the key consequences of the financial crisis of
2008-09 and the sluggish recovery recorded since 2009. In the fall of 2008, the SNB lowered
the policy rate significantly to counter unwarranted tightening of financial conditions and the
risk of deflation and recession. Since then, the policy rate has been kept close to zero and, in
September 2011, the SNB set a minimum exchange rate for the euro against the Swiss franc
to ensure appropriate monetary conditions for the Swiss economy. In this environment the
interest rate is not available as an instrument for influencing developments in the credit
market. As a consequence of this exceptional period of low rates, Swiss mortgage rates have
fallen substantially over this time period, with advertised rates for 10 year mortgage credits
hitting all-time lows in 2012 at 2.1%, substantially below the pre-crisis average of 4.7%
(Figure 7b).
It thus comes as no surprise that credit growth, mainly driven by the growth of residential
mortgage loans, accelerated from 2009 onwards (as shown before in Figure 2a). Given the
rather rigid Swiss rental market, the decrease in mortgage rates has not been, until recently,
accompanied by a similar decrease in rental rates. This has led to a situation where it may
seem relatively more attractive to buy than to rent.
Such a prolonged period of ultra-low rates is also fertile ground for behavioral biases. It is, for
instance, tempting to compute the cost of home ownership on the basis of a permanently low
rate, a practice which can lead to grossly overestimating the cost advantage of home
ownership. The persistent real estate price increases reported in Figure 1 are also relevant in
this context. This can lead to an overestimation of housing wealth, on the one hand, or to an
underestimation of the riskiness of mortgages granted on the basis of these elevated housing
prices, on the other. A long period of rising prices also tends to feed beliefs that prices can
only go up, contrary to all historical experience ("this time is different"-argument10). At the
same time the low interest rates put pressure on the margins of lenders. This increases their
propensity to compensate lowered margins with increased volumes. All this leads to
increasing fragility and added riskiness. For Switzerland, indications of such a high risk
appetite are found in recent survey data.11
Summing up, the analysis of the Swiss situation suggests that although structural factors can
possibly explain a high level of credit-to-GDP in Switzerland in international comparison, they
are unlikely to rationalize the most recent upward move in this ratio. The latter is likely to be a
cyclical movement that could reverse when interest rates themselves return to more normal
levels at some point in the future.
5. Conclusion: Fasten your seatbelts!
What does this analysis imply for market participants? As observed earlier, credit volume has
gone from around 150% to around 170% of GDP in the past few years. This is the result of
an average growth of credit of nearly 4%, while nominal GDP growth has averaged slightly
above 1% over the same period. For this movement to be fully reversed, credit growth would
have to significantly undershoot nominal GDP growth. The critical question is: could such a
reversal happen smoothly, or in other words, is a soft landing possible? International
experience (Figure 3) suggests this is a significant challenge. Credit-to-GDP ratios often fall
in the wake of a severe crash, with pronounced falls in property prices and large increases in
credit default rates; but this is exactly what we aim to avoid.
While the diagnosis cannot be totally certain until history has run its course, the lessons from
the analysis are, in my mind, crystal clear. The large increase in leverage, presumably of a
cyclical nature, the elevated property prices and the evidence of high risk appetite translate
for the Swiss economy into a state of high vulnerability requiring caution and the exercise of
responsibility by all concerned. The activation of the CCB and the adoption of other
prudential measures have to be seen in this perspective.
References
Borio, C. (2012): The financial cycle and macroeconomics: What have we learnt?
BIS Working Paper No 395
Keynes, J. M. (1936): The General Theory of Employment, Interest and Money, London,
Macmillan; Chapter 12
Minsky, H. P. (1982): Can "it" happen again?, Essays on instability and finance, New York
1982
Reinhart, C. and Rogoff, K. (2009): This time is different: Eight Centuries of Financial Folly,
Princeton University Press
Schularick M., and Taylor, A. (2012): Credit Booms Gone Bust: Monetary Policy, Leverage
Cycles, and Financial Crises, 1870-2008, American Economic Review, American Economic
Association, Vol. 102(2), pp. 1029-61
Stiglitz, J. and Weiss, A. (1981): Credit Rationing in Markets with Imperfect Information, The
American Economic Review, Vol. 71, No. 3, pp. 393-410.