Jaime Caruana: Asset price bubbles - implications for monetary, regulatory
and international policies
Speech by Mr Jaime Caruana, Governor of the Bank of Spain, at the Federal Reserve Bank of
Chicago, Chicago, 24 April 2002.
* * *
One of the central topics of debate among economists has traditionally been the reasons for economic
cycles, the factors that may amplify or smooth them, whether the authorities should aim to iron them
out and, if so, how this can be done. More recently, the role of the financial sector in the dynamics of
economic cycles has emerged as a key question in this debate.
I would like to focus today on some problems posed to regulators and policy-makers by asset price
bubbles and the credit cycle, and to share with you some thoughts on a regulatory device we have
recently introduced in Spain to deal with some of these problems: the so-called forward-looking
provisioning, also referred to as the dynamic or statistical provision.
The pro-cyclical behaviour of the banking sector, which is now generally accepted in the literature, is
receiving increasing attention by academics, policymakers and market participants. There is a growing
feeling that the financial sector contributes to the swings in real activity and may even intensify and
accelerate them. Feedback effects between credit growth and rises in asset prices are increasingly
evident, although not yet well understood. Transmission channels from the financial sector to the real
sector are becoming more and more flexible, rapid and complex. This is particularly clear for industrial
countries, whose financial markets are more sophisticated, but it is also affecting emerging markets,
as a logical consequence of their rapid integration into global financial markets.
I will focus on these issues in the first part of my speech, in particular on whether the recent behaviour
of financial markets is exacerbating the volatility and cyclicality of the real economy. Insofar as this is
the case, the next question we regulators should ask ourselves is whether this might be a result of the
increasing weight of the financial sector in the economy or spontaneous financial market
developments, such as new risk management techniques by market participants and/or a by-product
of prudential regulations which might unintendedly amplify financial cycles.
This debate has gained momentum recently in the context of the discussions for a new Basel Capital
Accord. One of the issues identified in the discussions was precisely to what extent there are factors in
the old or new regulations favouring excessive pro-cyclicality. But we should not overemphasise this
point. It is true that a certain degree of cyclicality in risk management techniques and regulations is not
only unavoidable but also sensible. We regulators ask banks to be more risk-sensitive and
risk-sensitive usually means pro-cyclical behaviour.
The second part of my address will deal with the forward-looking provisioning system recently adopted
in Spain. The merit of this regulation is that it introduces incentives for better risk management by
banks, while at the same time attenuating the cyclicality of the financial sector and, thereby, swings in
the real economy.
In my concluding remarks I will try to summarise the main lessons we have learned in discussing,
designing and implementing the new system, with an emphasis on the broader economic view rather
than on the purely supervisory one. Let me bring forward my main conclusion: there are regulatory
mechanisms, like dynamic provisioning, that provide incentives for sound risk management and are
anti-cyclical by nature and can therefore moderate cyclical swings.
* * * * *
Recent experience in a number of countries shows that credit expansion and asset price increases
(see Graph 1). Asset prices may start to rise in
- and bubbles - are mutually reinforcing processes
an economy because new investment opportunities appear or simply because of overly lax financial
conditions. When asset prices rise so does the value of collateral, which makes financing easier,
increasing the demand for assets. That in turn pushes asset prices upward. In the downturn, as the
value of collateral drops, financing possibilities decline, as does thus credit growth, a process often
reinforced by financial institutions pursuing much more cautious credit policies as they are incurring
losses or making smaller profits in this phase of the cycle. Tighter credit policies reinforce recessionary
forces and provoke additional reductions in asset prices.
This sequence affects different categories of assets (commercial property, residential property, equity),
whose impact on the real economy and transmission channels differ. Commercial property seems
particularly linked to the business cycle, while residential property has a larger impact on consumption.
Equity prices are intertwined with business profits and investment but are also related to spending
through wealth effects, depending on the role equity plays in the determination of financial wealth.
This interaction between credit cycles and asset price bubbles poses a number of challenges for the
authorities and regulators, both in the monetary policy and financial stability domains. In the upswing,
inflationary pressures related to excessive credit growth are compounded by financial imbalances
resulting from unwarranted optimism on the part of corporations and households and excessive
risktaking on the part of financial institutions. In the downturn, recessionary and deflationary forces are
aggravated by credit contraction as a result of excessive risk aversion by lenders.
in the financial sector
The possible explanatory factors of this potential amplification of the cycle
are many-faceted and complex. First, heightened competition in the banking sector and in financial
markets leads in an upturn to riskier strategies that are only corrected when the rise in bad debts
becomes evident in the downturn. Second, there seems to be a tendency for economic agents to
overreact to changes in their environment, leading to over-optimism in times of plenty and
over-pessimism in bad times. Third, herding usually reinforces existing trends and causes
overshooting. Fourth, the use of common assessment and risk management tools by market
participants, and finally an excessive and shortsighted focus on "shareholder value" may also amplify
swings. Prudential regulations may also occasionally have proven conducive to an excessive
emphasis on the short term when assessing risks.
Debate among academics,
What can the authorities do to counter these tendencies?
policymakers and market participants has been intense in recent years, and is far from settled. This is
an area particularly open to discussion, where new ideas and new evidence are forthcoming. Indeed,
the way monetary stability and financial stability interact with each other seems a particularly complex
topic, and the impact of specific measures on both fields is uncertain.
As far as monetary policy is concerned, the debate on whether it should react to asset prices has
been one of the most interesting of recent years. Insofar as asset prices contain useful information that
helps predict future price -and output- developments, they should clearly be included in the set of
indicators the central bank uses for decision-making. This is not, however, as easy as it may sound.
First, because empirical evidence on the usefulness of asset prices in predicting future price and
output developments is not conclusive. And second, because the integration of asset prices in
macroeconomic models poses a series of practical difficulties.
Going one step further, a related question is whether monetary policy should react directly to asset
prices, over and above the impact of the latter on inflationary prospects. The argument would be that
deflating an asset price bubble at an early stage contributes "per se" to long-term financial and
monetary stability. Against this view, I tend to share the position of those arguing that asset price
bubbles are very difficult to identify in practice and, even assuming that they were correctly
recognised, there is a lot of uncertainty as to how asset markets would react to policy changes.
Furthermore, this strategy may prove difficult to communicate to the public.
As concerns financial policy, the regulators' task of ensuring the long-term soundness of the financial
system entails creating the right incentives for market participants not reacting in excess in a given
cyclical position and avoiding excessive misalignments. To this end it is essential, first, to encourage
better knowledge of the risks assumed, a long-term orientation to analyses and, consequently, more
prudent management within financial institutions. Second, a greater heterogeneity among financial
market players to avoid mimetic behaviour seems desirable, although this is something the markets
would normally develop by themselves. Third, greater transparency and disclosure by the authorities
and private institutions would help market participants to focus on fundamentals. Fourth, a better
understanding and evaluation of liquidity patterns in financial markets is called for, on the part of both
market participants and supervisors. Finally, the regulatory authorities should obviously not introduce
rules promoting short-term strategies.
Let me focus now on the relationship between bank credit, loan losses and provisions for loan
losses. There is ample international evidence on the cyclical pattern of credit, which is very strongly
correlated to GDP growth, as shown in Graph 2 for the case of Spain (with an elasticity higher than
one, meaning that when real product grows, credit tends to grow more, and when real product falls,
credit likewise tends to fall even more). Demand and supply effects are difficult to disentangle in credit
cyclical dynamics. On the one hand, more economic activity tends to cause more credit demand. At
the same time, credit rationing tends to diminish when the economy is booming and tightens when the
economy is in recession. Both demand and supply seem to account therefore for credit cyclical
swings.
Competition is a key factor in explaining credit supply dynamics. Strong competitive pressures may
exacerbate the trend towards looser credit conditions in the upturn, because the fight for a market
share coincides with the observation of low non-performing loans, leading towards an over-optimistic
perception of low risk.
The probability of losses exists from the moment the loan is granted, but it will only become apparent
ex-post, with the emergence of default problems. Most credit risk mistakes are actually made during
the expansionary phase, when optimism is prevailing, although only in the downturn will they become
evident.
Empirical estimates show that there is a strong correlation between credit growth and bad loans, with
an average lag of around three years (see upper part of Graph 3). This means that a credit expansion
process is likely to lead to some credit quality problems in roughly that time horizon. The average
duration of the economic cycle (from boom to bust) is similar. This implies that if banks only look at
contemporary bad loans to determine their credit risk policies, they will restrain credit and increase risk
premia in the downturn. The higher cost of funding for bank-dependent borrowers will feed back to
activity, reinforcing recessionary forces.
I turn now to provisions. In Spain, until year 2000, loan loss provisions were strongly pro-cyclical (as
in many other countries), because they were largely linked to the volume of contemporaneous problem
assets. This static provisions are backward-looking, they are based on past events. Only are
accounted for loan by loan when borrowers fail to repay or in some cases when the situation of the
borrower deteriorates significantly.
As a consequence, the ratio of provisions to total loans fell therefore during periods of economic
growth and tended to rise considerably during downturns (see lower part of Graph 3). As a result of
this, the latent risk of loan portfolios was not properly recognised in the profit and loss account under
the old system. In periods of economic expansion the fall in doubtful loans went hand in hand with the
decrease in provisions, which in turn allowed bank managers to improve bottom-line profits.
However, one can argue that there is something wrong in the level of profits shown if the latent credit
risk in the loan portfolio is not properly taken into account. Intrinsically every loan has an expected (or
potential) loss that should be recognised as a cost by means of an early provision. Otherwise, the
picture of the true profitability and solvency of the bank over time could be distorted. More
dangerously, the overvaluation of profits might lead to an increase in dividends that could undermine
the solvency of the bank. Therefore, the acknowledgement of latent losses is a prudent valuation
principle (similar to the mathematical reserves set aside by insurance companies) that contributes to
correcting the cyclical bias that currently exists in the profit and loss account. The management of
credit risk in the banking sector has perhaps something to learn from insurance practices.
Theoretical papers on bank credit risk management also go in the same direction, stressing the
importance of proper pricing (i.e. the interest rate charged should cover expected losses as well as the
cost of holding capital for unexpected losses). Estimating expected losses when the bank assesses
the borrower is the first step for sound risk management.
Proper risk management is obviously a primary task of bank managers and shareholders. But we, as
bank supervisors, should evaluate the effectiveness of a bank's policies and practices for assessment
of loan quality and provisioning practices. The ability of a bank's loan review system to identify,
classify, monitor and address loans with credit quality problems in a timely manner should be
assessed by the supervisor on a regular basis as part of its risk-based approach. A misclassification of
assets (and the corresponding under-provisioning) is always present in banks heading for profitability
and solvency difficulties.
Sound credit risk management practices at the banks' level, including acknowledgement of expected
losses in due time, collide to a certain extent with the current accounting framework. The problem
stems from the fact that this framework does not support the notion of provisions on the basis of
expected losses, with the result that the recognition of losses is frequently delayed. Some of the
answers given by accounting-rules setters to this problem (i.e. full fair value accounting) may have
other important drawbacks. I will touch upon this later.
Let me briefly In December 1999, the Bank of
summarise the content of our dynamic provision.
Spain introduced a new solvency provision, the so-called statistical or dynamic provision, focusing on
the statistical risk embedded in the unimpaired portfolio. It started to apply in July 2000.
The main idea behind this provision is to try to capture, together with the other provisions of the
Spanish system, expected losses. From the very moment that a loan is granted, and before any
impairment on this specific loan appears, there is a positive default probability (no matter how low it
might be) following a statistical distribution with an expected loss. The expected loss is known in a
statistical sense but not yet identified in a specific loan operation or borrower. As the risk appears at
the beginning of the operation, so does the statistical provision requirement. With this system,
provisions run in parallel to revenues and are therefore distributed through the cycle allowing for a
better mapping between income and costs in the profit and loss account.
The statistical provision that we have established works in practice as an addition to the "old" existing
provisions: when "old" provisions are well below expected losses, the "new" dynamic provision is
added. In good years the net "specific" provisions are very low (or even negative, if there are
substantial recoveries), so the new provision accumulates. But in bad years the "specific" provisions
increase sharply, eventually exceeding the gross burden of the statistical provision. The net result is
that with this system provisions are distributed over the cycle, providing a better recognition of
expected losses.
More specifically, the amount of the statistical provision is the difference between the measure of
latent risk (i.e. expected losses) and the specific provision (that covering impaired assets). In good
times the specific provision is low and the statistical provision is positive. However, in a slowdown, as
the impaired assets rise, the specific provision requirements increase and the statistical provision
becomes negative. This means that the statistical fund (accumulated in previous years) starts being
used, its proceeds (the difference between the latent risk and the specific provision) being credited to
the profit and loss account. Therefore, thanks to the mechanism of the statistical provision, the burden
of credit risk on the profits of banking institutions is better spread over the cycle and more in
accordance with the evolution of expected losses.
The new scheme offers banks two options. First, to use their own internal measurements of the
statistical credit risk and second, to use a standard method. The Bank of Spain expects that in the
future an increasing number of institutions will be able to show robust computations, in the framework
of an integrated credit risk management system. However, probably in the next year or two, most
banks will use the standard method.
In the standard system the supervisor sets the parameters. The portfolio is distributed in six blocks,
according to the relative riskiness of the different assets, or off-balance sheet items with credit risk. A
vector of coefficients (ranging from 0 to 1.5%) is applied to the exposures contained in the six blocks.
The resulting figure is the estimated expected loss for the bank portfolio.
The computation produces an aggregate annual gross burden (i.e. the expected loss) that, in relative
terms, should equal the average annual net insolvency burden borne by the Spanish banking system
in the last fourteen years. This time span covers more than a full economic cycle.
You might note that the internal approach to calculate the expected losses or the latent risk squares
perfectly with Basel II developments.
The new provision has started with a vector of coefficients that will result in a burden lower than this
average. This takes account of the improvements in risk management since the last cyclical peak
(93/94), and facilitates acceptability of the scheme among institutions. Probably the scheme will be
adjusted in the coming years, on the basis of the experience gained with its application.
A limit of three times the annual gross burden has been put on the accumulated statistical provision, to
avoid an unnecessary or excessive accumulation of funds in the event of a prolonged cyclical
bonanza.
At present, the impairment of assets and other credit risk is at an historical low in Spain; and it will
remain so in the foreseeable future, due to good economic conditions. The new provision should thus
accumulate a significant amount of funds, with a reasonable, acceptable impact on the bottom line of
the profit and loss account. Those funds should allow extra solvency losses to be covered when the
tide turns.
Technically, the new provision is considered a value adjustment. In the published accounts it will be
deducted from the book value of the credit items that produce it. It is not considered a reserve to be
integrated in the regulatory own funds. The annual accounts shall report the various solvency
provisions (or value adjustments), and their method of computation.
The statistical provision is not a tax-deductible expense although banks can use an asset account of
anticipated taxes (i.e. the impact on the profit and loss is neutral but still negative in terms of cash
flows).
Finally, given the considerable internationalisation of our banking system in recent years, it is
important to keep in mind that the statistical provision is required on an individual level of all the
members of a consolidated banking group. It is not possible to counter a positive statistical provision
requirement in one bank with a negative one in another bank of the same group. This individual bank
approach reinforces the statistical provision requirement and squares well with the fact that expected
losses arise at an individual bank portfolio level.
By now, you are probably wondering about the real impact of the statistical provision in the Spanish
banking system. As far as the profit and loss account is concerned, the statistical provision for
depository institutions represents around 12% of 2001 total operating margin. At the end of 2000 the
statistical fund reached 15% of its maximum amount (remember there is a cap of three times the latent
risk) and at the end of 2001 it stands at 27%. At current rates, the statistical fund will reach its peak at
the end of 2004.
As far as the cyclical behaviour of banks, it is too soon to say, but we tend to think that the anti-cyclical
nature of the statistical provision is influencing bank behaviour.
I must confess that gaining acceptance among banking institutions for our new provisioning scheme
was not easy. Banks were reluctant to see their bottom line profits indented, arguing that the Spanish
provisioning system was already demanding (tight asset classification rules plus on-site monitoring
and enforcement by Bank of Spain inspectors, not to mention high solvency ratios by international
standards).
Apart from banks' initial, and understandable, criticism, some other voices have been raised, although
not very loudly, against dynamic provisioning. Some of them can be readily refuted. Others merit
careful discussion because the alternatives they propose may affect financial stability.
The most obvious criticism is that a system of dynamic provisioning smoothes bank profits. It is true
that the statistical provision tends to smooth profits over the course of the cycle. But it is no less true
that the current ex post provisioning system (i.e. setting aside a specific provision when the impaired
asset appears) artificially increases the volatility of banks' profits. And what is more important, this
increased volatility in the latter case has less to do with economic fundamentals (I. e. expected losses)
than with accounting rules. If expected losses appear from the beginning of the operation, banks
should start to provision them at the very outset. This means an increase in provisions and a decline in
bank profits during expansionary periods, just when credit risk expands the most. When the downturn
arrived and expected losses turn into real losses, the impact of provisions on profits would be lower
since a significant amount of the expected loss had been previously acknowledged.
To the extent that the extra volatility of bank profits is the result of an insufficient recognition of
expected losses, dynamic provisioning only restores part of the distortion created.
From a prudential point of view, it is clear that dynamic provisioning limits dangerous capital erosions
in times of plenty, requiring banks to provision expected losses and avoid paying out dividends
(remember the insurance case). Some observers mention that there is no need for ex ante
provisioning since future margin income is enough to cover expected losses. For supervisors,
however, to rely on future margin income might be an overly adventurous stance.
Let me expand more on this. First of all, experience has painfully shown us that the pricing of a loan is
not always properly adjusted to the risk involved in the operation (even taking into account fees and
future customer relationships). I have already talked about strong competition for market share or
over-optimism. Secondly, even if the risk is properly priced, the proceeds from a high margin could
have been paid out to shareholders by the time the impairment appears. Moreover, dynamic
provisioning allows for a timely recognition of both the income and costs stemming from bank loan
portfolios.
An alternative to the current accounting framework is being promoted at some international fora. I am
talking about full fair value accounting (FFVA), I would like underline the word "full". It is quite clear to
me that FFVA has, for the time being, insurmountable drawbacks for commercial banks both of
theoretical and practical nature. I would place a big question mark over FFVA feasibility.
Dynamic provisioning is a reasonable approach to the fair value of a loan without the numerous
drawbacks of FFVA. The statistical provision does not increase volatility of profits and facilitates
prudent risk management.
To conclude, let me emphasise that this provisioning regulation in Spain was introduced for prudential
reasons. It has three main advantages: First, it provides banks with incentives for better risk
management (i.e. risk appraisal, pricing, internal models, etc.). Second, it reconciles good risk
management with sound and prudent accounting practices. And finally, it is anti-cyclical in nature
(therefore mitigating the tendency to reinforce cycles). Overall, these three advantages can be
summarised as one: they reinforce the soundness of each single banking institution and of the whole
system.
My answer to the first question posed at the beginning of this speech is that, although risk
management techniques may induce risk-sensitive behaviour, and risk-sensitive usually means
pro-cyclical, that is not necessarily the case when some good regulatory practices, such as dynamic
provisioning, are adopted, contributing to taming economic and financial cycles.
Let me finish by adding a word of caution. Regulatory devices per se do not suffice to attain a safe and
sound banking system. A proper risk management culture deeply ingrained in banks' practices is also
a necessary condition to reach that goal. Consequently, banks and regulators should work hand in
hand to improve financial stability.