David Miles: Leverage and monetary policy
Speech by Mr David Miles, Member of the Monetary Policy Committee of the Bank of
England, at The Economic and Social Research Institute/Foundation for Fiscal Studies
(ESRI/FFS) conference, Dublin, 12 October 2010.
* * *
I would like to thank Jing Yang and Gilberto Marcheggiano for research assistance and to colleagues at the Bank
of England for helpful comments. The views expressed are my own and do not necessarily reflect those of other
members of the Monetary Policy Committee.
You do not need me to stand here in Dublin this morning and tell you what profoundly difficult
economic times we are going through. As an elderly New York friend of mine enquired of me
recently when I offered such a thought "for such pearls we need economists?" I feebly replied
that knowing how much of a mess you were in was of some use and (with rather more
confidence) that thinking how you get out of the mess was something economics could help
with. Today I want to talk about setting monetary policy as we emerge from one mess and
how we can reduce the chances of getting into another one. I am going to focus on the UK
but I think much of what I say has relevance here in Ireland and beyond.
That it has been a very bad mess is clear. From the onset of the financial crisis that started
towards the end of 2007 real output in the UK has fallen about 10% relative to the upward
path it might have been expected to follow. In Ireland the fall in economic activity has been
greater: the level of output is about 13% lower than at the end of 2007; if one had expected
growth of 3% a year - significantly lower than the average in the preceding 10 years - output
is now more than 20% below where it seemed likely to be.
I want to ask two questions about monetary policy prompted by the financial crisis and the
resultant recession. First, should we fundamentally re-think the inflation targeting framework
for monetary policy? Is the focus on a target for consumer price inflation flawed? This is a
long-term issue.
There is a second, in some ways more immediate, question. How should monetary policy be
set now in what I hope it is not too optimistic to call the aftermath of the financial mess? In
considering that issue I will be talking specifically about the UK, as befits a member of the
Monetary Policy Committee (MPC) at the Bank of England.
I want to start with the longer-term issue of the appropriate goals of monetary policy.
The goals of monetary policy
If one looks at the 10 years leading up to the onset of the crisis - which were also the first ten
years of the Bank's MPC - the outcomes for inflation and for aggregate economic growth in
the UK were good. Inflation was - by historical standards - very low, very stable and close to
the target. That had not been achieved at the expense of unusually low growth or high
unemployment. In Ireland growth had been much stronger and inflation a bit higher. The
aggregate outcomes looked good in both countries (Charts 1-4). In the UK there was a
strong consensus that having monetary policy directed at hitting an inflation target was
sensible and that it had been successfully implemented.
But if you now view the mess that we are dealing with after the financial crisis as
substantially reflecting monetary policy decisions, you would take a completely different view
of how well policy had been run.
The charge is that policy in the UK was inappropriate given the huge build-up in many asset
prices, and particularly in debt, or leverage. The fact that monetary policy could be very
successful in terms of hitting an inflation target - and in the UK it was1 - but not prevent a
very serious financial crisis, and one that has been followed by much more variable inflation,
is taken by many as a clear demonstration that the inflation-targeting framework is flawed.
Monetary policy, the argument goes, must be directed at a wider set of goals than controlling
consumer price inflation - a set of goals that includes the preservation of financial stability.
Those who advocate using monetary policy to help preserve financial stability usually argue
that preventing, or at least countering, asset price booms is the most effective means to that
end. For a clear statement of this view see, for example, Wadhwani (2010).
I want to make three points about this argument. First, that not all episodes of rapid asset
price inflation - followed by substantial price falls - are disruptive to the wider economy. But
when big asset price rises are accompanied by very sharp increases in debt they very
frequently are followed by bad economic outcomes. Second, that monetary policy is not the
most effective tool to prevent rapid and simultaneous build-ups in both debt and in asset
prices. Third, that a much more direct and effective tool to counter a potentially dangerous
build-up in debt is limits on the debt-to-asset ratios of financial institutions - that is limits to
leverage, or capital requirements.
Let me try to justify these three claims.
Reinhart and Reinhart (2010) document the facts around the most serious economic
dislocations in modern economic history. They show that big dislocations are almost
invariably preceded by large increases in the amount of debt in the economy. It is the
combination of very substantial rises in asset prices and in debt that has often proved toxic.
Sharp rises, and subsequent falls, in asset prices which have not been preceded (and
fuelled) by large rises in debt have been less disruptive. The contrast between the fallout
from the sharp falls in equity prices in the early 2000s and the fallout from declining asset
prices - most notably US house prices - at the end of the decade is revealing. The run-up in
stock prices at the end of the 1990s ("the dot.com bubble") was an equity market
phenomenon and the investment activity it fuelled and reflected was equity financed. The
American stock market lost nearly half of its value between March 2000 and July 2002. The
fall in asset values wiped out a great deal of the financial wealth of holders of equity, but it
did not bankrupt large financial institutions and the knock-on effect on the wider economy
was limited. In contrast, the falls in asset values that became serious in 2007 have been
followed by financial crises and recessions that have been exceptionally severe in countries
where the build-up in debt had been great. The easing of monetary policy in the wake of the
recent financial crises has been greater than in the wake of the equity crash of 2001 - both in
the US and elsewhere. But the economic outcomes have been dramatically worse.
A key difference here is that property price rises - unlike big rises in equity prices - are
invariably accompanied by big increases in debt. So when property prices fall they are more
likely to create solvency problems - and funding problems associated with heightened
solvency risks - than when equity prices fall. My colleague Adam Posen recently presented
evidence that big falls in equity prices in themselves generally do much less damage than big
falls in house prices. He found that the average output loss after real estate booms
cumulates to over 5% of GDP over five years, and in 75% of cases at least 2% of output is
lost. For equity price booms and busts, there is no output loss on average over five years,
and following them only 25% of economies experience a loss of more than 4% (Posen 2009).
What has happened to the hedge fund sector during this crisis is also illuminating. In
Q4 2007, total assets held by hedge funds were around $5500bn, and aggregate equity
capital (or what the industry refers to as assets under management, AUM) was around
$2000bn. This implies that the hedge fund sector had an average leverage of around 2.8,
compared to typical banking sector leverage ratios at that time of 30 or more. By Q1 2009,
the hedge fund sector had experienced trading losses of around $1000bn amounting to one
fifth of their total assets (He, Khang and Krishnamurthy, 2010), a scale that would have
wiped out almost all banks given their leverage. Yet many hedge funds have survived. And
none has been bailed out with taxpayers' money. Because hedge funds have so much lower
gearing, or leverage, than banks they have been able to absorb much bigger falls in asset
values. Close to 3,000 hedge funds have closed, that is liquidated, since mid-20072 - but
they have done so with a quiet whimper rather than with an alarming bang.
Falls in the value of assets that hit the wealth of institutions - but not their existence - do
much less damage than falls that wipe out firms and cause bankruptcy. So sharp asset price
variability, per se, is not the most serious problem. It is the combination of (and the
interrelation between) high debt - or leverage - and variability in asset prices that is
problematic.
I believe that an important way to help preserve financial stability is to have policy
instruments directed at debt gearing (or leverage) and to be used in the light of what has
happened to asset values. The aim would be to avoid a situation where gearing has gone up
a lot alongside asset values so that subsequent falls in those values threaten the solvency of
institutions and of individuals. But I believe it is unlikely that monetary policy - which most of
the time means variations in the short-term nominal interest rate - is the most natural tool to
use to achieve this.
The reason is that - even when we set aside the issues about how effective interest rates
can be in controlling asset prices and what effect on consumer price inflation and activity
their use for that end would be - monetary policy tools are likely to be pretty poor at affecting
gearing and leverage. And the main reason for this is that changes in the level of interest
rates do not obviously alter incentives to use debt relative to equity. It is likely that factors
other than the level of interest rates most influence the relative attractions of debt and equity:
risk premia, the tax code, regulations (most obviously rules on maximum gearing). Higher
interest rates will mean that the return that needs to be promised by the issuer, and expected
by the provider of funds, needs to be higher. That will affect the cost of funds in general; it is
not so clear how - if at all - it affects the relative cost of debt finance to non-debt finance.
Indeed it is possible that the attractiveness to those seeking funds of debt relative to equity is
greater at higher interest rates. This is because interest payments are tax deductible
whereas dividends are not. The scale of that subsidy to debt gets bigger as debt payments
rise, which will happen as interest rates rise.
A more formal version of this story goes like this: Suppose that nominal interest payments by
issuers of debt, paying an interest rate r, are deductible against corporation tax (levied at
rate tc) but that returns on equity paid by issuers have to come from post-tax income.
Assume that all nominal returns received by holders of debt and equity are taxed at a
common rate - a single rate that is charged on interest received, dividends and nominal
capital gains. Because all receipts of income from financial claims are taxed at the same rate
then the payments that need to be made by companies on debt and equity would, on
average, need to be the same (because we ignore risk considerations). But companies can
deduct interest payments against tax which means that the cost advantage of debt over
equity to the company is measured by the nominal interest rate multiplied by the corporate
tax rate - r x tc. This is increasing in the nominal interest rate. In this case, all else equal, the
tax consideration is likely to lead to an increase in leverage when the nominal interest rate is
higher.
This is not meant to be a realistic model - in fact it isn't even a model, it is simply a set of
stark assumptions. But it illustrates why using interest rates to try to control leverage - at
least for companies - may not be at all effective. And I believe that high leverage has been at
the centre of the financial problems of recent years.
Bean et al (2010) provide some evidence on the impact of monetary policy - that is interest
rates - on credit and asset prices. They find that monetary policy has some effect on asset
price inflation, but little on bank lending. For example, in a counter-factual experiment using
vector auto-regressions, they estimate that for the US if policy rates had started rising in
2003 and peaked at around 7.5% in late 2006, then the peak of the real house prices would
have been around 7.5% lower; real credit growth would have been just 3% lower by the end
of 2006. For the United Kingdom, if Bank Rate would have been around 7% from the end of
2004 to mid-2007, real house prices would have been around a fifth lower at the end of 2006,
while the stock of real credit would have been only 4% lower, trivial compared to the almost
50% increase in the stock of credit seen over the period.
Leverage and financial stability
The fundamental problem in the financial crisis was that the ability of many highly-geared
financial institutions to withstand substantial - but by no means unprecedented - falls in the
value of their assets was rightly perceived to be low. Much of the debt of the highly leveraged
institutions was wholesale funding - some of which proved footloose when there was
increased concern about asset values. It was reasonable to have concerns over the strength
of banks because leverage was so high. Between 2005 and 2007 major UK banks - which
were by no means the most highly geared - had leverage ratios that averaged slightly
above 30. The highest ratios - and this was for major banks - were close to 60 (Chart 5-6).
By leverage I mean total bank assets (netted for derivatives and minus cash at the central
banks and goodwill) relative to shareholder equity (also net of goodwill and excluding
minority interest). So true equity capital was often barely 2% of total assets.
The vulnerability that high gearing brought to financial institutions meant that even relatively
modest falls in asset values triggered concerns about solvency that in turn led to funding
problems that threatened to be - and in some cases became - self-fulfilling as sources of
funding dried up and some assets needed to be sold because they could no longer be
financed. It has not been the declines in asset values in the recent financial crisis that have
been unprecedented (charts 7-14) - it is the scale of bank leverage and financial problems
in the banking sector. Equity prices fell by up to 35% in the UK and 45% in the US during the
current financial crisis. During the previous century both countries had experienced similar
falls, at least four and three times respectively. Investment grade corporate bond yields in the
UK and US rose by over 300bps in the twelve months to October 2008; both countries had
experienced at least three similar episodes within the last hundred years. Falls in residential
property prices in the UK have not been exceptional - though the falls in commercial
property values have been, as have declines in US house prices.
At the risk of over-simplifying - I would say that declines in asset values leading up to (and
during) the financial crisis have generally been on the scale of a once-in-every-25-year
event; but the financial mess has been (at least) on a once-every-century scale. Had gearing
of financial institutions - and specifically of banks - not been so high (Chart 15) the strains
that falls in asset value brought would surely have been substantially lower, as would have
been the falls in asset values themselves.
A bad equilibrium path for the financial sector - or in more everyday language a vicious cycle -
is much more likely to exist in a world where financial firms that hold large amounts of risky
assets, such as banks, have small equity cushions. The smaller bank capital is the greater will
be the concern over bank solvency from a given fall in the value of bank assets. That can
trigger a drying up in funding for banks causing a sale of some bank assets that drives their
values lower, exacerbating the concerns about the ability of banks to survive. There need be
nothing irrational about this process. Indeed, there are many examples of bad, but rational,
equilibrium paths that markets - and whole economies - can follow.
The idea that this is news to economists who use formal models expressed in maths is
completely wrong-headed. Yet there is a current view that economists who use mathematical
models to analyse outcomes where people behave rationally are always led to the
Panglossian conclusion that things will work out just fine. It would come as a surprise to
those who hold this view that two of the most famous economic articles in the last forty years
which are routinely taught to economics undergraduates - by George Akerlof (1970) and by
Diamond and Dybvig (1983) - draw entirely non-Panglossian conclusions from formal
(mathematically expressed) models of collective rational behaviour.
I was struck by a trivial example of where a bad equilibrium path can lead on a recent visit to
the US. I opened the mini bar in my hotel room to find it empty save for a small slip of paper.
Here is what it said:
"A personal note to you....
We have made a renewing change to our heavenly guest rooms.
Our refreshment centers will no longer be pre-stocked.
Please be aware the refreshment center cooler is not intended as a refrigeration device"
The empty-mini-bar equilibrium is not a good one. How do you get there? I think the story is
this: mini-bar prices are high; they are high because some people conveniently tend to forget
how much they may have used their mini-bar when they come to pay the bill and that
forgetfulness gets worse the higher are prices; but then the mini bar prices need to be even
higher as the forgetfulness seems to get worse. This vicious cycle ends up with mini bars
that are empty save for a "personal note to you".
Good economic policies can help prevent bad equilibria and reduce the chances of vicious
circles. For banks, I believe the most direct way to do this is to prevent an initial (limited) fall
in the value of assets triggering sharply higher concerns about their solvency. It seems to me
the natural way to do that is to make sure they can withstand falls in asset values by having
sufficient loss-absorbing capital rather than to expect monetary policy - moves in interest
rates - to substantially reduce asset price variability, much of which might be warranted. The
short-term nominal interest rate is a very blunt instrument to use to try to limit gearing of
financial institutions. Capital requirements, and explicit limits on gearing, are more direct
means to control leverage.
This is why I think the direction of the policy emerging from the Basel III process - which will
put in place higher capital requirements on banks - is right. It is also why time-varying limits
on gearing of financial firms - limits that might vary with asset prices and with the economic
cycle - are likely to be useful in helping maintain financial stability.
I believe that is a much more fruitful way forward than abandoning inflation targeting. But
while I think this is plausible, the case is not proved. Simply because they are a more direct
means to control leverage does not prove that capital requirements or limits to gearing are a
far more effective tool to preserve financial stability than changing interest rates. Indeed
there are at least two situations where the use of capital controls and limits on gearing might
not be a very effective means of maintaining financial stability, namely if either:
1. the link between an institution's leverage and its robustness to real (or imagined)
risks to the value of its assets were very weak.....OR...
2. there were great sensitivity of the overall cost of funding to changes in equity capital -
so that requiring an institution to hold much more capital came at a very high price.
If either of these things were true it would strengthen the case for using monetary policy
directly to help preserve financial stability. But I think there is strong evidence that neither of
these things are very likely.
The only reason why a financial firm's leverage (the ratio of assets to equity capital) would be
irrelevant to robustness is if that equity were not truly loss-absorbing or if it was already so
large relative to assets that the chances of losses being that great becomes virtually zero.
But in fact bank equity capital that is truly loss absorbing has been 10% or less for most
banks, and generally a great deal less. That is certainly not so high that chances of losses
this big are of negligible probability. Value-at-Risk (VAR) models might have suggested
otherwise. But those models have weaknesses that reflect the difficulty of accurately
assessing risks.
Assessing the probabilities of losses on bank assets is not easy. Many bank assets are not
marketable - or only became so a few years before the crisis. And where prices do exist,
using their recent volatility and assuming price changes follow a normal distribution is
unlikely to be reliable. Yet that is what most VAR models do (or at least did).
We do have long runs of data on total incomes for economies - that is GDP. Since the value
of bank assets - most of which are loans - ultimately depends upon the incomes of
households and companies, variability in GDP is at least some guide to variability in their true
value. Analysing changes in annual GDP for a large sample of countries over long periods
reveals two characteristics: changes in annual GDP do not follow a normal distribution (they
have much bigger chances of extreme movements) and the chances of big falls are much
greater than the chances of big rises (there is clear downwards skew). The table below
shows the proportion of occasions when annual GDP fell by various amounts in one year3.
The sample is for around 40 (mainly developed) countries and in many cases goes back well
over 100 years creating a total sample size of annual observations of around 4000.
In thinking about variations in the value of the assets held by a bank with a diversified
portfolio of loans then variation in real aggregate income is arguably a much better guide
than volatility in particular asset classes (eg property, equities). In some simple asset price
models the real value of assets which are a claim on a stream of income is proportional to
aggregate incomes (see, for example, Barro 2006). If we use that as a rough rule of thumb
the Table suggests that occasions when generalised falls in real asset values might be 5% or
more occur roughly once every 15 years. Falls in value in excess of 10% might be about
once every 40 year events. Declines of 15% or more are once-every-80-year events. This
suggests that banks would need far more capital than has been usual in recent years to be
truly robust.
Why bank capital might not be expensive?
Of course if having quite substantially more capital generated much higher cost in
intermediating funds through banks - and there are no close alternatives for bank financing -
that extra robustness would come at a high price. But calculations undertaken by the Bank of
England (2010), the BIS (2010) and academics (Kashyap 2009, and Admati et al 2010)
suggest this is not the case. It is worth considering why.
A natural way to gauge the cost of higher capital requirements on banks is to estimate how
much lower economic activity - GDP - might be as a result. I want to illustrate the cost of
higher capital for banks using a very similar method to that used in the studies mentioned
above. The calculation proceeds in steps. First, estimate how much the average interest rate
charged by banks would have to increase to recoup any cost of an increase in their equity
financing relative to use of debt. Then estimate how much a rise in the cost of borrowing from
banks might change the required rate of return (or cost of capital) of investors. Finally use a
production function to estimate the impact of such an increase in the cost of capital on
desired capital and output. We can then express the cost of having banks hold more equity
capital in terms of the present value of all future falls in output. This is the methodology used
in the calculations reported in the Bank of England's 2010 Financial Stability Review (FSR).
Those calculations were based on conservative assumptions - understandably so, for fear of
under-estimating the cost to the wider economy of imposing substantially higher capital
requirements on banks. I will start from that FSR baseline estimate of the present value of
output lost as a result of a 1pp increase in the capital ratio, which is 4.25% of current annual
GDP. That estimate becomes very substantially smaller if we make less conservative
assumptions and allow for several offsetting impacts from banks holding more capital.
Specifically:
1. Allowing for a partial offset because as a bank holds more equity capital, its equity
becomes less risky, and therefore requires a lower return. (A Modigliani-Miller effect -
which I will assume is not zero but only 30% as big as it would be under perfect
markets)
2. Allowing for the value to the government of the extra tax revenue received as a
result of banks having more equity capital which is less tax sheltered than is debt.
3. Allowing for a somewhat lower use of bank funding for investment than in the
baseline.
4. Allowing for a lower sensitivity of investment and the capital stock to a rise in the
cost of funds to non-financial firms.
Table 2 shows how rapidly the estimated long-run economic cost of requiring higher bank
capital falls as we sequentially allow for each of these offsets.
I conclude from this that the long-run costs of having banks hold more capital is likely to be
small - plausibly it is negligible. If that is so then the benefits of having much more robust
banks would far exceed its costs.
If it is right that the benefits of raising capital requirements to much higher levels far outweigh
their economic cost, how we did we get into a situation that bank capital was so low relative
to total assets? I think this is because banks and regulators came to believe capital was very
costly. In particular the Modigliani-Miller (M-M) offset (that equity becomes less risky, and so
less expensive, as gearing falls) was ignored. A failure to understand the exact details of the
M-M theorem is of course understandable - it is a theoretical result and one which was
originally described in an academic article. But it was - and remains - surprising to me that
the most basic bit of the story - that if a bank has less debt gearing then the volatility of the
returns on its equity will be lower and that this will have an impact on the required rate of
return on it - seems to have been largely ignored by many people running banks4. Anyone
who says "equity capital is very expensive to a bank" appears not to understand this. It might
be fine for most people not to understand this - just as it is fine that most people do not
understand what tensile strength materials need to have to be suitable to build a bridge with.
But it is not fine if those that run banks, or regulate them, don't understand it, any more than
if engineers who design bridges don't know about the strengths of building materials.
In retrospect I believe a huge mistake was made in letting banks come to hold much less
equity capital - relative to un-weighted assets - than was normal in earlier times. To my mind
this was because regulators and governments bought completely the view that "equity capital
is scarce and very expensive" - which in some ways is a proposition remarkable in its total
incoherence (as shown with clarity and precision by Admati, De Marzo, Hellwig and
Pfleiderer (2010) and with wit and humour by Merton Miller (1995)).
I believe there is a need to break out of the way of thinking that leads to the "equity is scarce
and expensive" conclusion. That would help us get to a situation where it will be normal to
have banks hold very much more capital that had been assumed in recent decades to be
acceptable. And that change would be a return to the past.
Having higher bank capital will make the job of monetary policy (which has now to deal with
the after-effects of massive instability in financial markets) much easier. Using limits on
gearing to help maintain financial stability and monetary policy to help maintain price stability
is an efficient allocation of instruments to goals.
But it makes little sense to expect this extra bank capital to be in place immediately. Curbing
lending and dealing with a debt-fuelled asset price boom is not the problem for today. Higher
capital needs to be in place by the time that does emerge as a problem. The difficulty today
is one that monetary policy must address - this is to balance the risks of removing the
stimulus from the expansionary monetary policy too soon, starving a recovery while it is still
immature, against the risk of allowing inflation and inflation expectations to become stuck at
above the target level. Balancing those risks in the UK is not easy. That is the issue the
Monetary Policy Committee at the Bank of England faces today and the one I now want to
explore.
The immediate monetary policy problem
The financial crisis dealt a huge blow to the financial infrastructure in most of the developed
world. In the UK, and here in Ireland, the financial system came close to total breakdown. It
would
was not so much that virtually no-one thought this sort of thing happen. It was worse
than that; virtually no-one thought this sort of thing could happen. But it did happen. As a
result the supply of credit to businesses and to households was - and continues to be -
seriously affected. The confidence of businesses and households has been severely dented.
Fiscal deficits have exploded; private sector investment has imploded.
Whatever the aftermath of this event is - and we will not know that for many years - I very
much doubt it will be a normal cyclical recovery after a downturn. If we were facing a typical
pattern of cyclical fluctuations of the sort we have often seen over the past 60 years - albeit
a bit more bumpy - then I think the time to remove some of the extraordinary monetary
stimulus would already have come. In the UK inflation is above the target level - despite
some recent falls, inflation is around 1 percentage point above the 2% target level.
Employment has been rising and so has GDP. If that clearly meant we were on the upswing
of a typical cycle then I do not think that keeping interest rates at effectively zero and holding
on to a stock of £200 billion of assets bought to ease monetary conditions further would be
right.
But to me this does not seem like the typical recovery phase following an above average
cyclical downturn. A typical downturn is not one in which the financial sector all but stopped
working for a while. A typical cycle for the UK is not one in which the exchange rate
depreciates by about 25% ahead of the downturn.
UK inflation now sits uncomfortably above the target (see Chart 2). But I believe that this tells
us rather little about the cyclical position of the economy or where inflation will be in the
future. Underlying forces that were created by the financial crisis and that would themselves
keep inflation low have been offset by other factors that have kept inflation above target for
much of the past year. These factors are well known but it is important not to forget the likely
scale of their impact. Around one quarter of the goods that enter the basket for calculating
the UK CPI are imported. The 25% depreciation seen since 2007 would - given that
imported goods and services account for around a quarter of the consumer price basket -
add a bit above 6% to the level of the CPI. Over a three-year-period that would generate 2%
a year higher inflation. We have also seen the VAT rate cut and then increased. When the
cut was having its largest impact on the annual rate of inflation last year the CPI inflation rate
fell to 1.1%. The subsequent rise in VAT at the start of this year has helped push inflation
back above the target by about the same amount. At the start of next year there will be
another VAT rate increase - and that is likely to keep inflation above the target a bit longer. I
am not blasé about that. That is why I said that I thought we face a risk in the UK of not doing
enough to bear down on inflation. But there is also a risk of tightening monetary policy too
soon. This second ri