Pentti Hakkarainen: Finance cycles and macroprudential tools - the case
of Finland within the euro area
Speech by Mr Pentti Hakkarainen, Deputy Governor of the Bank of Finland, at the Seventh
High-Level Policy Dialogue of the Eurosystem and Latin American Central Banks, Madrid,
11 November 2015.
* * *
Accompanying slides can be found on the Bank of Finland's website.
First let me thank the organisers for inviting me to this panel with a very topical theme. I am
glad to share some experiences Finland as a small country has had relating to financial
cycles and how we see the macroprudential policy and its tools to be implemented.
What do we know about financial cycles?
What does economics tell us about credit cycles, and their impact on the real economy? The
topic is not new. We can find these issues already in late 19th century writings by Knut
Wicksell the famous Swedish monetary economist. Later, Milton Friedman and other
monetarists emphasized the impact of banking panics on the U.S. Great Recession in the
1930s. However, these contributions did not see the financial cycle as a regular phenomenon
that would be different from the business cycle.
In the Post World War II era, many economists discussed phenomena very similar to what
we now call financial cycles. Minsky's financial instability hypothesis and the way it sees
financial markets as a self-destabilizing process is a narrative approach to the financial cycle
phenomenon.
However, until recently macroeconomics paid little attention to the special role of financial
markets. Many simulation and forecasting models had few if any financial markets related
variables apart from the short-term interest rate. Such models are still being used by many
central banks, although it has become commonplace to include financial frictions in them.
Financial liberalization in the late 1970s and throughout the 1980s was followed by extreme
cyclical swings in many countries, for example in Finland, Sweden and Norway. First, there
was a credit boom almost immediately after the liberalization. A serious banking crisis
followed a few years later. This boom-bust type of instability in Northern Europe was
obviously something else than a mere normal business cycle.
It may not be a random coincidence that the first academic publications that used the
concepts "credit cycle" and "financial cycle" were published in the late 1980s and early
1990s, i.e. when a handful of advanced countries had reached the crisis phase of their
boom-bust experiences after financial deregulation. This field of research has been mostly
empirical. Theory has been slow to explain destabilizing behaviour in a way that would be
applicable in practice.
Banking crises can be interpreted an extreme manifestation of the financial cycle
phenomenon. There is a lot of empirical literature on their early warning indicators. Because
no country has had enough banking crises to have a representative sample of them, this
literature is almost exclusively based on panel data. For instance, recent working papers
published by the European Systemic Risk Board and the Bank of Finland have systematically
tested the predictive power of different early warning indicators.
Banking crises are in most cases preceded by three parallel phenomena, namely excessive
credit growth, house price bubbles and large current account deficits. These three
phenomena preceded the Scandinavian crises more than 20 years ago, as well as the most
extreme recent crises in Europe and the Great Recession of the U.S. Banks' increasing
reliance on money market funding other than retail deposits is also observed quite regularly
in the development before crises.
Therefore, the archetypal banking crisis is preceded by a phase when banks finance the
current account deficit by borrowing in international wholesale markets and channel this
funding to the domestic economy by granting loans to customers who buy real estate.
Although business loans are more likely to be written off as loan losses, macro level studies
have found housing loans more destabilizing than corporate loans. (Detken et al 2014,
Kalatie & al 2015)
According to Claudio Borio, we can measure the credit cycle phenomenon pretty well just by
focusing on credit volumes and property prices. Judging by the results from standard filtering
techniques, the credit cycle seems much longer than the ordinary business cycle, possibly
about 15 years. If anything, financial cycles are becoming longer and more pronounced.
Some academics, including Martin Hellwig and Charles Goodhart, have even argued that the
capital requirements have actually amplified the financial cycle; banks restrict lending when
capital adequacy requirements are about to be violated, which slows down economic growth
and puts downwards pressure on asset prices, worsening credit risks.
Financial cycles in Finland (slide 2)
What has Finland learnt on the financial cycles as a small country and a member of the
monetary union? At the moment, it seems that being a member of the monetary union has
had a rather limited direct impact on the cycle in Finland. The Finnish financial sector has
been rather well insulated from the instability experienced in some other member countries.
Three Bank of Finland economists, Adam Gulan, Markus Haavio and Juha Kilponen, have
presented a decomposition of the fluctuations of the Finnish GDP since the 1980s. They
analyzed which factors - financial or real, domestic or external - have moved the Finnish
GDP. According to their results, the era of monetary union has been characterized by
relatively stable domestic financial markets. Loan supply had a moderate stimulating impact
on the economy in the mid- 2000s, but we cannot blame domestic financial instability for the
deep recession that hit our economy in 2009. The reduction in export demand in particular
and direct negative influences from global financial markets had a strong adverse impact on
output, but these effects were direct, not transmitted through the national financial market.
These results obtained with sophisticated econometric techniques are consistent with what
one can easily observe. The recession of 2009 hardly affected our domestic banking market,
and e.g. loan losses remained at a historically low level. The solvency of banks was hardly
affected. Simultaneously, the banking systems of some other countries within the monetary
union were on the verge of collapse.
The stability of the Finnish financial sector is in strong contrast to the experience during the
Nordic banking crisis 20 years earlier. We had in Finland a very pronounced financial cycle
overheating in the late 1980s. Banks' lending grew too rapidly. Something needed to be
done, but there were few previous examples of what we would now call countercyclical
macroprudential policies. However, it was discussed back then that the problem could be
solved with Pigouvian tax; lending growth could be subject to a tax to be paid by banks.
In March 1989, a new system of additional reserve requirements was introduced. The
requirement was conditional on the lending growth rate of each bank. No interest was paid
on these extra central bank reserves. During an era of high interest rates, this was a
substantial cost burden for a bank that preferred to continue its expansion. Most banks kept
the growth of their loan stocks below the threshold that would have triggered the extra
requirement. The measure obviously helped to slow down credit growth, but in retrospect, it
is easy to say that it should have been implemented earlier.
Finland experienced one of the worst banking crises in history only a few years later.
Unsurprisingly, banks that chose to continue granting more and more loans despite of the
costly extra reserve requirement were the first to end up in nightmarish problems a couple of
years later. With hindsight, a sufficient macroprudential toolkit should have been created
already when times were calm and their activation was not immediately not required.
Macroprudential policy in the euro area
Along with single banking supervision within the banking union, the European Central Bank
was also given a mandate in macroprudential policy. The ECB can impose more - but not
less - stringent requirements than the actions taken at national level on the basis of EU
legislation.
(Slide 3)
The purpose of these asymmetric powers of the ECB is to prevent what is called the inaction
bias in the conduct of macroprudential policy by national policy-makers. This bias towards
inaction might arise because the deployment of macroprudential instruments is unpopular
and tends to meet with opposition from the banks and their customers alike.
In the euro area, Governing Council of the ECB has an important, although a shared
responsibility in the macroprudential field. This has the advantage that national analysis is
complemented with independent ECB analysis and the state of the euro area as a whole
being reflected in policy actions.
For example: In a monetary union where monetary policy is designed for the area as a
whole, it may be unable to temper national credit cycles.Nationally targeted macroprudential
policy is useful and it needs to take the limitations of monetary policy into account.
National credit cycles vary both in frequency and amplitude. For this reason, the
development of macroprudential policy is of particular importance for the euro area countries.
National authorities' role is very important in the conduct of macroprudential policy within a
monetary union. The analysis of the macroeconomic situation and the local conditions is the
foundation for policy making. One function of national macroprudential policy is also to act as
first line of defense against systemic risks. That benefits a country's neighbours as well: in
integrated markets, systemic risks and problems spread rapidly across sectors and borders.
The macroprudential framework in Finland (slide 4)
The Finnish macroprudential framework is pragmatic. In a small country the framework was
built on within the existing institutional structures. A close co-operation between the relevant
institutions is of key importance and in particular the synergies between the central bank's
maroeconomic expertise, [macroprudential analysis] and supervisor's regulatory and
institution-specific expertise.
The decision making body is the Board of the Finnish Supervisory Authority (Fin-FSA),
chaired by the Deputy Governor of the Bank of Finland. The Fin-FSA is the national
macroprudential authority. Staff analysis and policy proposal, serving the decision making,
are prepared jointly by the Fin-FSA and the Bank of Finland. The Bank of Finland, the
Ministry of Finance as well as the Ministry of Social Affairs & Health are asked to express
their opinions on the Fin-FSA Director General's regular quarterly policy proposals. All these
institutions have also possibility to make initiatives of their own for the consideration of the
Board of the Fin-FSA regarding the use of macroprudential tools.
Finnish economy and its outlook
Finland is a small open economy with a very good growth record in the long term. However,
economic growth in Finland has now been slow for a prolonged period, both historically and
by international comparison. Finnish exports have suffered a considerable loss of market
share since 2009, the most severe year of the recession.
According to the last Bank of Finland forecast Finland will not soon catch up with the
recovery foreseen in the other euro area countries.
Growth has been depressed by cyclical, sectoral and structural problems. The labour market
situation has deteriorated rapidly during the past year. Unemployment is now higher than in
the recession year 2009, the unemployment rate standing at around 9.5 %.
Over the past 5 years there has been a soft, if lengthy landing in the Finnish housing market,
reflecting the protracted period of slow economic growth. The regional divergence, driven by
both demand and supply-side factors, in house prices and household indebtedness is wide.
Growth areas, mainly the biggest cities with universities, are characterised by increasing
population, younger residents, a better employment situation and higher household income
than the national average. This is also reflected in housing markets, as higher house prices
and larger housing loans in these areas.
At current juncture, our financial cycle is lackluster. As required by legislation, we have made
quarterly decisions on countercyclical capital buffer since the beginning of 2015. This has
enabled us to gain some practical lessons on how macroprudential analysis is done and how
the decision making with respect to financial cycles is managed.
Lessons learned
The diversity in economic history, the economic outlook and in the local conditions justifies
the importance of national discretion in macroprudential policy making also in a monetary
union.
However, one should go even deeper than the national level into the regional and sectoral
differences. For example, we could foresee that urbanization drives housing demand to the
extent that regional housing bubbles can become a systemic risk, with negative percussions
on real economy, unless problems are appropriately addressed in time.
In addition, we have the well-known problems with data. Namely, the data is in many cases
lagging, often revised afterwards and therefore backward looking. We should not make policy
by looking at the rear-view mirror. Therefore, judgment, discretion and a holistic approach
are essential in policy making.
Macroprudential policy is a new field of economic policy. Its creation is an outcome of the
global financial crises. Monetary policy and good supervision were not sufficient for financial
stability. One needs to see the forest from trees.
We need to learn the lessons of the crisis, while not fighting the last war. No crisis exactly
repeats the previous one. Some more recent phenomena require also particular attention:
increased importance of the debt securities market, re-emergence of shadow banking and
the phenomenon digitalization.
To conclude, what is the biggest challenge for authorities? We have some new powers and a
range of instruments for the conduct of macroprudential policy. We know that the direction is
correct but we should also remember that these instruments are not properly tested yet. We
do not know yet enough about their potential consequences and side effects. This advices
caution. However, despite these difficulties, I believe these new powers and tools given to
authorities are necessary. We are on a right track.