John Gieve: The impact of the financial market disruption on the UK
economy
Speech by Sir John Gieve, Deputy Governor of the Bank of England, to the London Chamber
of Commerce and Industry, London, 17 January 2008.
* * *
Introduction
These are testing times for the MPC.
The latest official figures for growth confirm the strength of the economy in Q3 with above
trend growth in domestic demand and a growing current account deficit. But the evidence
from surveys and other timely indicators is that growth is slowing quite sharply now, in part
because of the rises in interest rates last year. That in itself might justify a progressive shift in
policy - from restrictive to a more neutral stance. And the case for easing has been greatly
strengthened by the disruption in global credit markets and in our own banking system which
brings a risk of a deeper downturn.
However we have also seen a big rise in the world prices of oil and food. That is being
amplified in the UK by a fall in sterling and is now coming through in our food, petrol, gas and
electricity prices. These are likely to raise our inflation rate well above target in the coming
months at a time when short term inflation expectations remain uncomfortably high.
This combination of upside and downside risks complicates our task of keeping inflation on
track to meet the 2% target.
Financial market disruption
The disruption of credit and money markets was set off by a deterioration in the US
subprime housing market. This started to show up in increasing provisions in the 2006 accounts
of banks which held them on balance sheet in a traditional way. But impairment charges of
that sort would not have occasioned such ferment in international markets. That was the
result of the impact on the new markets for structured credit such as Collateralised Debt
Obligations (CDO's)1 (Chart 1), which had developed to meet investors' demand for higher
yield. As forecasts of US sub-prime defaults mounted, it became clear that such products
had introduced opacity and uncertainty into both the distribution and scale of losses.
The crisis played itself out in number of "lurches", which were reflected in the movements in
the ABX indices2 (Chart 2):
•
Although the problems of the sub-prime market were obvious in mid-2006, it wasn't
until January/February 2007 that the rising defaults led to mark downs in indices
valuing the riskier tranches of the structured products and difficulties at a number of
US sub-prime originators;
•
in June, as losses began to appear in highly-rated tranches of so-called mezzanine
CDOs, two heavily exposed Bear Stearns hedge funds collapsed; the rating
agencies began to review their methodologies and started to downgrade securities,
some by several notches;
• at the end of July, a SIV3 sponsored by IKB reported losses on sub-prime mortgage
exposures and failed to raise funding in the commercial paper market, and in early
August BNP Paribas temporarily suspended redemptions from a number of money
market funds because of valuation problems; this provoked an "investors" strike' on
mortgage-backed securities and the commercial paper that funded off-balance sheet
vehicles holding them; in turn this led banks to hoard liquidity against potential calls
on their committed lines, to a marked tightening of inter-bank markets and funding
pressures on banks, including, of course, Northern Rock;
• after a brief lull in October, renewed doubts about the scale of the losses in the big
international banks led to concerns about counterparty risk and sparked a renewed
squeeze in the money markets with LIBOR spreads climbing back to levels
experienced in August.
There are many lessons for markets and the authorities from this turmoil. First it underlined
the critical importance of liquidity in managing and regulating banks. Second it showed up
the limitations of the models which underpin the valuation and rating of structured products
and the excessive weight that had been given to them not just by the naive or unwary, but by
some of the most sophisticated players in financial markets (including many of the
sponsoring banks who underestimated the risks they were running in retaining super senior
tranches). Third, it illuminated the adverse incentives that had been allowed to develop in the
distribution chain for credit products including the strong incentives for originators to put
quantity above quality, for the rating agencies to expand their scope as widely as possible,
and for banks to use off-balance-sheet vehicles to finance structured credits. It may also
reveal some flaws in the compensation schemes in banks. In some cases these incentives
arose despite regulation, in others they were the consequence of faults in the regulatory
system. Finally it showed again how measures of risk used by companies and regulators can
be pro-cyclical, encouraging more risk taking at the top of the cycle and potentially
exacerbating the downswing.
In the last few weeks, markets have been calmer. Liquidity pressures in short-term funding
markets have eased, helped in part by the co-ordinated action by central banks to address
elevated funding rates over the year end (Chart 3). And, as losses have been declared it has
proved possible for a number of firms such as UBS, Merrill Lynch and Citigroup to attract
new capital including from Sovereign Wealth Funds.
It is too early to declare the problem solved. The longer term bank funding markets remain
relatively illiquid, many securitisation markets remain effectively closed (Chart 4), and
general market sentiment remains fragile. Only a part of the total losses on sub-prime have
yet been declared and not all the questions about the future of SIVs or the capitalisation of
monoline insurers have yet been answered. The sub-prime chapter will not be closed for
some months yet and there are still risks of re-ignition of the acute money market conditions
we saw last month.
But there are grounds for hope that we are reaching the end of the beginning at least and
that the key challenge is moving from stabilising the financial markets themselves to dealing
with the impact on the wider economy.
Macroeconomic impact
Judging that impact is not easy. Banking crises have typically reflected macroeconomic
difficulties at home. Banks have lent too much and too cheaply at the top of the cycle and
have then suffered from defaults when policy tightened and unemployment and failures
increased. The most recent example in the UK banking sector was during the recession of
the early 1990s when the major banks wrote off about 2.5%of their domestic loan book and
tightened credit conditions, thus exacerbating the fall in property prices and in confidence. It
has been estimated that the effect of the tightening of credit conditions was to reduce UK
output in 1991 by almost 2% relative to what it would otherwise have been.4 Of course, there
was little monetary policy could do at that time to offset these effects because of Sterling's
ERM membership.
But the current crisis does not follow that pattern. It has come at a time when the
performance of the UK economy has been unusually good. Over the past fifteen years the
economy has experienced the most stable macroeconomic conditions on record with steady
growth, low inflation and a declining trend in unemployment.5 For the most part the
underlying balance sheet position of households and firms is robust and most indicators of
financial fragility such as mortgage arrears, repossessions and corporate insolvencies are at
low levels (Chart 5).
So the question is whether we can reverse into macroeconomic trouble starting from a
banking crisis with its origins in the US housing market. Of course a marked slowdown in the
US will diminish directly part of our exports. But two domestic transmission channels to
consumption and investment will determine the size of the overall impact on our economy:
• the effects of credit constraints; and
•
impact on expectations and confidence.
Credit constraints
With their own funding rates increasing and a reduction in their ability to distribute risk
through securitisation, there is now clear evidence that UK lenders have begun to tighten
lending conditions for households and firms. The Bank's Credit Conditions Survey (CCS) of
major UK lenders has identified a change in behaviour since the summer.6 Contrary to earlier
expectations, lenders reported that the availability of secured credit to households had
reduced noticeably over the three months to mid-December (Chart 6). Corporate credit
availability was also reported to have been reduced significantly over the same period. A
further reduction in the general availability of credit was expected over the next three months.
The survey suggests that lenders are both raising the price of borrowing and reducing the
range of people and firms they are prepared to lend to. There has been a pick up in the
average spread of quoted mortgage rates over the appropriate funding rate in recent months
(Chart 7). There has also been a fall in the number of mortgage products available for
creditimpaired borrowers (Chart 8).
The first impact of the tightening in secured credit conditions is being felt in the property
markets and lower demand for assets but there will also be direct effects on activity.
Although only a minority of households may be credit constrained they are probably sufficient
in number to depress household spending somewhat, possibly reversing a little of the decline
in the saving ratio seen since the early 1990s (Chart 9). In a similar way a tightening of
corporate lending conditions will affect some companies' investment. The Deloitte CFO
survey taken in early December finds that 20% of firms expect the recent credit market
events to have a negative impact on their capital spending in 2008.7
This tightening of credit conditions would be exacerbated by any further weakening in the
financial position of banks due to a slowdown in the wider economy. Slower growth and a
rise in unemployment in particular would lead to higher loan defaults. There are signs that
this is already happening in consumer lending in the US. Weakening property prices would
reduce the amount that lenders could realise in the event of default. With pressures on their
capital and new capital expensive where it is available, banks are likely to attempt to
increase their margins and to slow down new lending, thereby reducing their capital
requirements, for example by tightening non-price terms and conditions on new loans.
One factor which regulators are watching carefully at present is the impact of the shift this
month to the Basle II system of capital requirements for European banks. While Basle II
improves on its predecessor and removes many undesirable incentives, it retains some
procyclical features and any transition needs to be managed carefully.8
The impact on expectations and confidence
The other channel by which the financial market turbulence is likely to have macroeconomic
effects is by prompting more cautious behaviour by households and firms. This might simply
reflect uncertainty about the future. Firms may temporarily postpone investment because of
greater uncertainty about the future path of demand. We saw an effect like this after 9/11 for
example. But it might also reflect a revision by households and firms about the sustainable
path of income and wealth in the coming years. The change in expectations may reflect the
higher costs of borrowing and a higher risk of unemployment.
Again a reduction in confidence about future growth may lead directly to lower consumption
and investment. It is also likely to affect equity and property markets. Potential buyers may
decide to wait before purchasing if they sense that there is a chance that prices may fall.
Such behaviour can be self-fulfilling.
There is no doubt that the housing market has been weakening significantly in recent months
and the trend is more advanced still in commercial property markets where prices are falling
rapidly. It is widely assumed that weakening property prices will also depress consumption.
The Bank has tended to be sceptical of this mechanism.9 While property prices and spending
tend to move together, that doesn't prove that one causes the other. Both may result from
changes in income and expectations of future income.10 Indeed, in the same way as you
can't have your cake and eat it, it is not clear that a general increase in house prices does
create extra spending power for the population as a whole. Owners who expect to remain in
their current house for a long time cannot also spend their housing wealth and the benefits to
those trading down are broadly offset by the costs to those trading up. While older owners
may be richer and believe they can support a more expensive lifestyle, the rise in prices will
show through in higher rents and larger deposits for those wanting to get on the ladder.
But even if there is not a strong causal connection between house prices and consumption
through a wealth channel, there may nevertheless be a significant collateral channel. When
house prices fall, the amount of housing equity and hence collateral at homeowners' disposal
decreases. This will tend to delay spending as lenders are willing to lend less or lend on less
favourable terms to those who have little or no housing equity. That channel should have
become less important in recent years. This is because most homeowners have substantial
equity in their homes which would not be materially affected by relatively modest changes in
house prices.11 This may help to account for a decline in the correlation between real house
price growth and consumption since the beginning of the decade (Chart 10).
An analogous collateral channel may operate in the corporate sector. Declines in commercial
property prices will weaken corporate balance sheets and this could affect corporate
spending if lenders raise the cost of borrowing to affected companies. This effect is likely to
be particularly pronounced among commercial real estate companies.
Inflation and energy prices
In these ways the losses in credit markets are already contributing to slowing growth; the
questions are by how much and for how long? The danger that they could turn a necessary
modest slowdown into a deeper and more painful downturn is clear and, of course, that
would dampen inflationary pressures. That was a key factor in my decision to vote for a cut in
rates in November and December.
But the current situation is complicated by emerging upside pressures on prices. This
inflationary pressure is coming largely from outside the UK, reflecting in part increased
demand from countries like China where output growth has been both rapid and commodity
intensive. That has led to renewed strength in commodity prices (Chart 11), with oil rising as
high as $100 a barrel and some agricultural foods reaching record highs in dollar terms. This
has already increased the prices of imported goods, and that effect has been amplified
recently by the fall in sterling. In turn, it is putting upward pressure on the sterling prices set
by domestic producers for crude oil and wholesale gas and electricity. And, in contrast to the
past, demand from emerging economies may mean that commodity prices prove resilient to
slowing growth in the industrialised economies.
The appropriate monetary policy reaction to upside pressures on prices coming from outside
the economy (such as an energy price shock) depends on how households and businesses
react to that shock - in other words, on so-called "second-round" effects. A key determinant
of those effects will be the impact on inflation expectations. If households' and businesses'
expectations of future inflation rise following the initial price shock, pressures for
compensating rises in wages and prices are much more likely. Inflation expectations are
difficult to measure, but surveys of households' expectations have picked up since early
2005 (Chart 12). This partly reflects the rise in inflation during 2005-06. But expectations
have remained elevated during 2007 despite the easing in inflation in the second half of the
year.
Conclusion
After a long period of stability, we have experienced a major financial shock that has
reverberated through the banking sector in all the advanced economies. It has calmed
recently, but we should expect a prolonged period of discomfort for individual banks and the
financial system as a whole. Unusually, this shock was not the result of bad loans at home
but it will have an impact on growth through tighter credit constraints and by influencing
expectations and confidence. We cannot be sure how large those effects will be but they
pose a serious downside risk to growth. To make matters more difficult, we face a sharp rise
in inflation in coming months as a result of rising commodity prices worldwide and a fall in our
exchange rate.
In reaching our decisions, the MPC always looks not just at the central projection for the
economy but at the risks on either side. That will require not just difficult judgements but
careful explanation in the months ahead.
Chart 1: ABS CDO issuance Chart 2: Prices of US sub-prime mortgage
credit default swaps(a)
$ billion
US$
225
110
100
200
CDO^2
90
Mezz ABS CDO 175
80
HG ABS CDO
150
70
125 60
50
AAA
100
40
75
AAA
30
50
BBB
20
BBB-
10
25
0
0
Jan Apr Jul Oct Jan
1999 2000 2001 2002 2003 2004 2005 2006 2007
2007 2008
Source: Citi Source: Bank calculations.
(a) ABX.HE 2006 H2. Each index references 20 home equity
loan (HEL) ABS of indicated rating issued in 2006 H1.
Subprime loans form the vast majority of the collateral backing
HEL ABS.
Chart 3: 3-month LIBOR spreads over Chart 4: RMBS issuance by all UK resident
expected policy rates issuers
Basis points
£ blns
120
(b) (three month rolling sum)
60
Sterling
100
50
US dollar
Euro 80
40
60
30
20
40
10
20
0
0
00 01 02 03 04 05 06 07
Apr Jul Oct Jan
Dec 2007).
BIS Review 7/2008
Chart 5: Mortgage arrears and possessions Chart 6: Household secured and corporate
rates credit availability
Net percentage balances(a) Easier
Percent Percentage greater than 3 months in arrears
credit
Household 30
0.9 7
Corporate
Secured
20
0.8
6
10
0.7
5
0
0.6
4
-10
0.5
-20
0.4
3
Possessions (LHS)
-30
0.3
2
-40
0.2
Arrears (RHS)
Tighter
1
-50
0.1
credit
-60
0 0
Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1
1990 1993 1995 1998 2001 2004 2006
Source: CML
Back cast data before 1994 Reported change, past three months
Expected change, next three months
Source: Bank of England Credit Conditions Survey
Chart 7: Quoted mortgage spreads Chart 8: Mortgage product availability
(a)
Thousands
Basis point spread to funding rate
250
10
Credit impaired
SVR
200
Prime
150
Bank Rate Tracker
100
5 yr fixed
50
0
2 yr fixed
9876543210
-50
Feb Mar AprMay Jun Jul Aug Sep Oct Nov Dec End
2001 2002 2003 2004 2005 2006 2007
Dec
Source: Bank of England. Source: MoneyFacts.
(a) SVR mortgages spread over one month lag of Bank
Rate; Tracker mortgages spread over Bank Rate; 2 yr, and
5 yr fixed rate mortgages spread over one month lag of 2
and 5 year swap rates.
Chart 9: Household saving ratio Chart 10: Correlation between growth in house
prices and consumption
Rolling ten-year correlation coefficient between real
16%
1.0
annual house price inflation and consumption growth
14% 0.9
0.8
12%
0.7
10%
0.6
0.5
8%
0.4
6%
0.3
0.2
4%
0.1
2%
0.0
1966 1971 1976 1981 1986 1991 1996 2001 2006
0%
1970 1975 1980 1985 1990 1995 2000 2005
Source: ONS Source: Bank calculations.
Chart 11: Commodity prices Chart 12: General public inflation expectations
US dollars per barrel Index, 2000=100
3.2
120 350
Economist food index (rhs)
Bank/NOP
3.0
Economist metals index (rhs)
300
100
2.8
Brent oil spot prices (lhs)
250
80 2.6
200
2.4
60
150
2.2
40
100
2.0
20
50
1.8
0 0 1.6
2000 2001 2002 2003 2004 2005 2006 2007 2008
Feb00 Feb01 Feb02 Feb03 Feb04 Feb05 Feb06 Feb07
Source: datastream and bank calculations Source: Bank of England/NOP public attitudes to inflation
survey.