Sharon Donnery: Lessons from the past, safeguarding stability for the
future
Address by Ms Sharon Donnery, Deputy Governor of the Central Bank of Ireland, at the
Centre for Economic Policy Research (CEPR) Economic History Symposium, Dublin, 9 June
2016.
* * *
I would like to thank Mark Cassidy, Yvonne McCarthy, Mícheál O'Keeffe and Rebecca Stuart for their
contributions to this speech.
Introduction
Good morning. On behalf of the Central Bank of Ireland, I am delighted to welcome you to
the fourth Centre for Economic Policy Research Economic History Symposium. The
conference has a fascinating and varied programme and the Central Bank of Ireland
welcomes the chance to be involved. Unfortunately the Governor is unable to be here and
sends his best wishes.
Both economic history and the history of economic thought provide valuable lessons for
policymakers today, not least central bankers in our quest to safeguard price and financial
stability. And yet, despite the numerous experiences of financial crises over the past two
centuries, recent events highlighted starkly the lack of both analytical frameworks to assess
the risks associated with the build-up of financial imbalances, and the policy tools to mitigate
them.
For my introductory remarks, I would like to reflect briefly on the recent actions taken by the
Central Bank to contribute to financial stability in Ireland through the introduction of
macroprudential policies.
Lessons from the past
The term "macroprudential" only surfaced in public documents in the mid-1980s.1 However,
throughout much of the twentieth century, and particularly during the post-war period, there
were numerous examples of central bank interventions in the financial system that can, in
retrospect, be considered "macroprudential". During this time, many central banks in Europe,
and the US, used quantitative controls rather than interest rates to steer the economy and
maintain bank stability. Measures such as credit controls, reserve ratios and liquidity ratios
were used in Europe, and loan-to-value and repayment caps in the US.2
Such measures were largely implemented at a time when the boundaries between fiscal,
monetary, industrial and prudential policies were less clearly defined. Financial market
deregulation and increasing central bank independence led to the clearer delineation of
these policy functions. At the same time, the rise of inflation targeting meant central banks
used these non-interest rate policies less and less. In Ireland, credit, capital, and interest rate
controls were progressively dismantled from the 1980s.3
In the 2000s many suggested the best contribution monetary policy could make to financial
stability was to keep inflation low and stable, and if imbalances did emerge, the central bank
could always "clean up" afterwards.4 The effective microprudential supervision of individual
banks would, it was thought, also safeguard financial stability.
The recent crisis provided a clear demonstration that such an approach is not sufficient.
Recent evidence shows that in the post-war period, real estate credit has become an
increasingly important predictor of fragility in the financial sector.5 Financial imbalances
resulting from the unsustainable expansion in asset and credit prices, or contagion across
the financial sector due to interconnectedness and strategic complementarities such as
"herding" behaviour among market participants, can lead to the build-up of systemic risk.
Since such imbalances have very serious consequences for the real economy and price
stability, one response is for the central bank to use interest rates to "lean against the wind",
and that may be appropriate in episodes of severe financial exuberance.6 However, it is very
challenging for central banks to manage their price stability objective and address concerns
about systemic risks with just one tool; namely interest rates. Any central bank aiming to cool
off systemic risk by hiking rates might risk disrupting the business cycle to the detriment of its
price stability objective, or vice versa. That is why independent policy instruments are
needed to address each policy objective.7
Macroprudential policies are now commonplace. They are generally regulatory policies or
instruments with the specific objective of mitigating risks to financial stability. They
complement monetary policy in two key ways.8 First they can be used to target regional
imbalances, which is crucial in jurisdictions like the euro area where monetary policy
decisions are taken for the area as a whole. Second, while monetary policy affects all
segments of the economy, macroprudential policies can be used to temper sector-specific
imbalances in a more granular manner.
Looking to more recent Irish history, our own experience shows very clearly why both
dimensions are important. We have seen the damage that can result from loose financing
conditions and excessive leverage, and our economists in the Bank have published a body of
analytical work confirming this. The research shows a positive relationship between higher
loan-to-value and loan-to-income ratios and subsequent mortgage defaults. It also shows a
relationship between higher loan-to-value ratios and banks' losses from defaults.9 The
evidence highlights that lending at high multiples of income was one of the main causes of
(2004), "Financial Liberalisation and Economic Growth in Ireland", Central Bank of Ireland Quarterly Bulletin,
Autumn 2004.
4
Bernanke, Ben and Mark Gertler (1999), "Monetary Policy and Asset Price Volatility." In New Challenges for
Monetary Policy, 77-128. Proceedings of the Federal Reserve Bank of Kansas Economic Symposium,
Jackson Hole, Wyoming, August 26-28.
5
Jorda, Oscar, Alan Taylor and Moritz Schularick, (2016), "The great mortgaging: housing finance, crises and
business cycles", Economic Policy 2016 pp. 107-152.
6
See, for example, Bordo, Michael D. and Olivier Jeanne, (2002) "Monetary Policy and Asset Prices: Does
"Benign Neglect" Make Sense?", International Finance, 5(2): 139-64.
7
This follows the so-called 'Tinbergen rule' (see Tinbergen, Jan, (1952), "On the Theory of Economic Policy",
North-Holland Pub. Co., Holland).
8
They also complement existing microprudential supervision and banks' own risk management practices.
9
See Hallissey, Niamh, Robert Kelly and Terry O'Malley (2014), "Macro-prudential tools and credit risk of
property lending of Irish Banks", Central Bank of Ireland, Economic Letter Vol. 2014, No. 10, or McCarthy,
Yvonne (2014), "Disentangling the Mortgage Arrears Crisis: The Role of the Labour Market, Income Volatility
and Negative Equity", The Journal of the Statistical and Social Inquiry Society of Ireland, Vol.43, pp. 71 - 90.
increases in property prices during the first part of the last decade and was also a significant
reason for the sharp contraction in the downturn.10
From a policy perspective, looking back, one of the main conclusions of the Honohan Report
- and criticisms of the Central Bank - was that the Bank had "an unwillingness ... to take on
board sufficiently the real risk of a looming problem and act with sufficient decision and force
to head it off in time. Rocking the boat and swimming against the tide of public opinion would
have required a particularly strong sense of the independent role of a central bank in being
prepared to spoil the party and withstand possible strong adverse public reaction".11
We at the Bank have learnt many lessons from the crisis and over recent years, very
substantial progress has been made at national and European level, towards establishing
robust frameworks for identifying emerging risks and taking forceful decisions to counteract
these.
Strengthening the resilience of the financial system
The mission of the Central Bank is to safeguard stability and protect consumers. In this
context, our objective, as the independent authority responsible for macroprudential policy, is
to strengthen the resilience of households and the banking system so that both can
withstand adverse movements in credit and property prices, and other economic shocks.12
This, unpopular as it may sometimes appear, also involves introducing policies to reduce the
potential for imbalances to build up in the first place given that they can lead to financial
distress.
Given the importance of real estate asset prices in driving the financial cycle, in February
2015, the Central Bank introduced macroprudential measures to limit the amount of new
mortgage lending that can take place at high loan-to-value and loan-to-income ratios. This
followed a public consultation process, which received widespread support.13 Ireland,
however, is not alone in introducing such measures. Whilst the calibration and impact differ
greatly, sixteen Member States of the European Union have introduced some form of
loanto-value, loan-to-income, or debt service-to-income (DSTI) measure to enhance the
resilience of their respective domestic financial systems.14
The threshold for the loan-to-income ratio in Ireland is set at 3.5 times gross income. This
acts as a restraint on excessive repayment burdens and unsustainable increases in
household debt. Recognising the difficult situation first-time buyers can face in entering the
market (and indeed the lower credit risk among this cohort of borrowers), the loan-to-value
ratios that were introduced distinguish between first-time buyers and other mortgage
borrowers.15
10
McCarthy, Yvonne and Kieran McQuinn (2013), "Credit conditions in a boom and bust property market",
Central Bank of Ireland Research Technical Paper, No 8/RT/13.
11
See Honohan Patrick (2010, 16), "The Irish Banking Crisis Regulatory and Financial Stability Policy 2003-2008:
A Report to the Minister for Finance by the Governor of the Central Bank".
12
Under Council Regulation (EU) No 1024/2013 ('SSMR') and Regulation (EU) No 468/2014 of the ECB
('SSMFR'), macroprudential powers, including the capital buffer provisions as transposed into S.I. 158/ of
2014, are shared between the ECB and the national authorities; meaning, inter alia, that the ECB is capable of
setting higher macroprudential (including buffer) requirements than those set by National Designated
Authorities (NDAs). This includes an ECB power to set a capital buffer rate where a national authority has not
set any rate.
13
See Feedback Statement on CP87: Macro -prudential policy for residential 2015 mortgage lending.
14
An overview of national measures is published by the European Systemic Risk Board and can be found
https://www.esrb.europa.eu/national_policy/html/index.en.html.
15
See Kelly, Robert, Terry O'Malley and Conor O'Toole (2015), "Designing Macroprudential Policy in Mortgage
Lending: Do First Time Buyers Default Less?", Research Technical Paper, 02RT15, Central Bank of Ireland.
The latest data available to the Central Bank on house purchase prices for first-time buyers
nationally suggests the median house price was €200,000 for the first half of 2015.16 This is
associated with a deposit requirement of 10 per cent of the purchase price. For first-time
buyers in Dublin, the median purchase price over the period was €262,000; the deposit
requirement in this case is 11.6 per cent.
An additional important feature of the measures is that a certain amount of new lending is
allowed above the specified thresholds.17 These allowances recognise that higher
loan-tovalue or loan-to-income mortgages can be appropriate in certain circumstances, as laid out
in the banks' own credit policies, and can help to ease some valid concerns about market
access difficulties, without permitting excessive leverage or credit risk to build up across the
system as a whole.
In addition, in December 2015, the Bank announced the first settings of both the
countercyclical capital buffer and other-systemically important institutions (or O-SII) capital
buffer.18 These measures are part of the Capital Requirements Regulation toolkit which is
applicable in all EU Member States.
The countercyclical capital buffer is a prudential tool designed to respond to fluctuations in
the economic cycle and stabilise lending activity. When credit growth picks up, banks will be
required to hold additional capital. When the economic cycle turns, banks will be able to
release this, allowing stable lending to the real economy, through the cycle. Although at
present, following the Central Bank's assessment, we have set this buffer at zero per cent for
Irish exposures.
The O-SII buffer is an additional capital buffer applied to banks that are systemically
important for the domestic economy. The Central Bank has set this buffer at 1.5 per cent for
its systemic institutions, to be phased in over the period 1 July 2019 to 1 July 2021.
It is very clear to me that if these measures had been in place fifteen years ago, the scale of
financial crisis experienced in Ireland would have been much more limited. This time, our
measures have been introduced early in the cyclical recovery in the market in order to
prevent the recovery from becoming destabilised by excessive leverage being taken on by
households.
The mortgage rules in particular are designed to limit the risk of a house price - credit cycle
emerging once again. While the parameters may in the future be amended, either tightened
or loosened, in response to cyclical conditions, these measures, which seek to underpin
prudent lending standards, have been introduced as permanent, structural features of the
Irish mortgage market. Moreover, the evidence threshold to justify adjustments to these rules
is significant.
The loan-to-value measures include a maximum loan-to-value ratio of 80 per cent for non-first-time buyers of a
primary residence, while for first-time buyers a higher cap of 90 per cent applies for the first €220,000 of the
value of the house and the 80 per cent loan-to-value then applies to the part of the value of the house above
€220,000. The maximum loan-to-value ratio is set at 70 per cent for buy-to-let borrowers.
16
Figures are from a loan-level dataset held at the Central Bank of Ireland.
17
20 per cent of the value of new mortgage lending is allowed above 3.5 times gross income, 15 per cent is
allowed at loan-to-value ratios above the thresholds for primary dwelling homes and 10 per cent of lending at
loan-to-values above the threshold for BTL properties. A number of exemptions from the measures are also
included in the regulations, reflecting specific circumstances of the Irish mortgage market at the time of
introduction. Borrowers in negative equity, for example, are exempt from the loan-to-value restrictions while
mortgage holders switching between lenders, without an increase in principal (i.e. switchers), are exempt from
both the loan-to-value and loan-to-income restrictions.
18
See http://www.centralbank.ie/stability/MacroprudentialPol/Pages/default.aspx for further details.
Review of the measures
The macroprudential measures introduced by the Central Bank will be reviewed on a regular
basis. Specifically, the countercyclical capital buffer will be reviewed on a quarterly basis,
while the O-SII buffer and the mortgage regulations will be reviewed annually. These reviews
should not be seen as an indication that we intend to change the measures. Rather because
they are structural, that we periodically evaluate and monitor these measures is crucial.19
In November this year, the Central Bank will publish a report examining the impact and
effectiveness of the loan-to-value and loan-to-income measures since their introduction.
However, it is important to remember that it is still quite early in the life of the measures,
which have a medium-term focus. Nevertheless, the report will bring together an in-depth
analysis on their early performance against their stated objectives, as well as analysis on the
potential side effects of the measures. More specifically, the review will draw on analytical
projects covering household resilience and borrower types, banking resilience and bank
lending practices, house price and credit dynamics, in addition to insights on the rental
market, housing supply and unsecured lending. In addition, the review will encompass the
utilisation of allowances which operate as part of the mortgage regulations.
The review will also be informed by a public call for evidence on the impact of the measures.
This call for evidence will be detailed at the launch of the Central Bank's Macro-Financial
Review on 14 June. The call for evidence will remain open from 15 June to 10 August.
In the years ahead, much attention will be paid to enhancing knowledge on the impact and
effectiveness of macroprudential policies, and on strengthening macroprudential frameworks.
I hope that the analytical work undertaken at the Central Bank of Ireland can contribute to the
development of ideas and methodologies in this area.
We acknowledge that our measures impact individuals' ability to access credit and purchase
houses. However, these policies are designed to enhance household and banking sector
resilience and protect the system as a whole. And in this context, we must take a medium to
long term view. In time, I believe history will look favourably upon these policies.
Let me finish by thanking you once again for the opportunity to speak to you today and I
hope you have a stimulating conference.
Thank you.