# **6. Taming a Credit Boom: Future Challenges**

Generally, it may very difficult to try to tame credit booms in small economies and limit the probability of the boom-and-bust development in certain periods. These are primarily macroeconomic phenomena associated with broad socioeconomic movements reflected in the buildup of excessively optimistic expectations about future income and asset prices growth. In its Financial Stability Reports published in the pre-crisis times, the CNB pursued this particular view: that the growing risks for financial stability were to a large degree determined by the macroeconomic factors and associated primarily with the emergence of excessively optimistic expectations regarding the future development of income and asset prices.<sup>20</sup> For this reason, a macroeconomic, or more precisely, broad macroprudential approach is needed. Monetary policy should constitute an important part of the approach. However, even a well-developed autonomous monetary policy may have a very limited room for maneuver. In small economies, higher interest rates on domestic currency loans may help only if the banks historically have not established markets for mortgages in foreign currencies. In countries with floating, desired monetary tightening can be achieved, but only to some extent, via a combination of currency appreciation and policy rate adjustment, with a simultaneous application of various macroprudential measures, including fiscal ones. Countries with fixed exchange rates or high level of euroization can use less standard monetary policy tools (such as various reserve requirements) only.

The basic recommendation for small and converging economies is to avoid as much as possible the expansionary effects of the foreign banks’ operations and capital inflows by making financial sector work as nearly as possible as if it was a purely domestic one. This means that local banks ideally would use domestic sources for lending activity and carry on their business mainly in domestic currency. A sufficient base of deposits from domestic entities, therefore, seems to be one of the prerequisites for a stability of the banking system. Such a base makes the system resilient to sudden evaporations of resources from abroad or from financial markets. In addition, the strong ability of the domestic banking sector to accumulate domestic savings via deposits secures the long-term funding for the investments so needed for boosting the convergence process. And the currency structure of borrowing is linked to the one of saving. If people have long-term incentive to save in domestic currency, they will also view borrowing in it as natural.

Generally, there is no one-size-fits-all solution available for countries. In any country, the authorities have to search for a specific combination of macro- and microprudential measures to succeed. The efficiency in providing such a combination is critically dependent on the organization of regulation and supervision in a country.

# <u>6.1 The organization of supervision at the national level</u>

The stability of the financial sector in small converging economies very much depends on the ability to establish independent, strong, and respected supervision. Among the key reasons behind recent financial turmoil in mature economies were the deficiencies in financial sector

> 20 An example of the macro view is a statement from 2006 Financial Stability Report (page 13): ―The Czech Republic is currently facing a risk of excessively optimistic expectations regarding its future development, driven by the high GDP growth rates, which, however, may not present a faithful picture of the improvement in household income.‖

19