Glenn Hoggarth, Carsten Jung and Dennis Reinhardt.
Supporters of financial globalisation argue that global finance allows investors to diversify risks, it increases efficiency and fosters technology transfer. The critics point to the history of financial crises which were associated with booms and busts in capital inflows. In our recent paper ‘Capital inflows – the good, the bad and the bubbly’, we argue that the risks depend on the type of capital inflow, the type of lender and also the currency denomination of the inflows. We find that equity inflows are more stable than debt, foreign banks are more flighty than non-bank creditors, and flows denominated in local currency are more stable than in foreign currency. We also find evidence that macroprudential policies can make capital inflows more stable.
Ian Webb, David Baumslag and Rupert Read.
One September morning, the Lord Mayor of London was called to inspect a fire that had recently started in the City. Believing that it posed little threat, he refused to permit the demolition of nearby houses, probably due to the expense of compensating the owners. The fire spread and ultimately destroyed most of the city. The Great Fire of London had begun. Only when the fire became too extensive to be readily halted did the full extent of the danger become evident. Financial regulators today face a similar challenge preventing financial crises- action causes significant costs to some but the consequences of inaction are much more uncertain. To combat this, we argue they should apply the precautionary principle.
Philippe Bracke and Silvana Tenreyro.
When someone bought a house turns out to be an important factor in predicting whether the house will be sold again soon, and at what price. People who bought during a boom aim at achieving higher prices when they sell and, as a consequence, move less often. We explore whether this pattern is due to psychological anchoring (whereby the previous purchase price becomes an important reference point) or to the way the mortgage market works (for example, with homebuyers often using proceeds from house sales for down-payments on new properties).
Peter Eckley and Liam Kirwin.
In the world of bank capital regulation, minimum requirements grab all the headlines. But actual capital resources are what absorb unexpected losses. Banks and building societies typically hold resources substantially in excess of requirements – called the capital surplus. One reason is to avoid breaching the minimum due to unforeseen shocks. Another is to build resources in anticipation of requirements arising from growth or regulatory change. The chart shows how capital surpluses (on total requirements including Pillars 1 and 2, and all types of capital) have varied in recent decades. It is based on historical data from regulatory returns.
Saleem Bahaj, Jonathan Bridges, Cian O’Neill & Frederic Malherbe.
It’s not just what you do; it’s when you do it – many decisions in life have “state contingent” costs and benefits. The payoffs from haymaking depend crucially upon the weather. Putting fodder away for a rainy day can be quick, cheap and prudent when skies are blue. But results may take a soggy and unproductive turn, if poorly timed. The financial climate is similarly important when assessing the costs and benefits of macroprudential policy changes. We argue that it is best to build the countercyclical capital buffer when the macroeconomic sun is shining. We find strong empirical evidence to support our claim.
Roy Zilberman and William Tayler.
Last year the Bank organised a research competition to coincide with the launch of the One Bank Research Agenda. In this guest post, the authors of the winning paper in that competition, Roy Zilberman and William Tayler from Lancaster Business School, summarise their work on optimal macroprudential policy.
Can macroprudential regulation go beyond its remit of financial stability and also contain inflation and output fluctuations? We think it can and argue that macroprudential regulation, in the form of countercyclical bank capital requirements, is a superior instrument to both conventional and financially-augmented Taylor (1993) monetary policy rules. This is especially true in responding to financial shocks that drive output and inflation in opposite directions, as also observed at the start of the recent financial crisis (see Gilchrist, Schoenle, Sim and Zakrajsek (2016)). This helps to effectively shield the real economy without the need for a monetary policy interest rate intervention. Put differently, a well-designed simple and implementable bank capital rule can achieve optimal policy associated with zero welfare losses.
Arzu Uluc and Tomasz Wieladek.
Following the global financial crisis of 2007-08, financial reform introduced time-varying capital requirements to raise the resilience of the financial system. But do we really understand how this policy works and the impact it is likely to have on UK banks’ largest activity, mortgage lending? In a recent paper we investigated the UK experience of time-varying microprudential capital requirements before the financial crisis. We found that an increase in this requirement intended to make a bank more resilient actually induced it to shift into riskier mortgage lending.
What do the Cold War powers of the United States and the USSR have in common with modern day asset managers? The capacity for mutually assured destruction. During the 1950s game theorists described a model of strategic interaction to demonstrate how it might be that two nations would choose to annihilate each other in nuclear conflict. Simply put, each nation had an incentive to strike first, as there was no incentive to retaliate. Both would race to push the button. Asset managers face a similar set of incentives.
Paolo Siciliani, Nic Garbarino, Thomas Papavranoussis and Jonathan Stalmann.
Systemically important banks are material providers of critical economic functions. The Global Financial Crisis showed how distress or failure of one of these firms may have a severe impact on the financial system and the real economy. Systemic capital surcharges protect the economy from these negative spillovers by decreasing systemically important firms’ probability of distress or failure. A graduated approach facilitates effective competition to the extent that the capital surcharges faced by firms are more proportionate to the scale of systemic risks that they pose. This post illustrates some of the competition implications with respect to the methodology used to set the number and level of thresholds.
Karen Braun-Munzinger, Zijun Liu and Arthur Turrell.
If a boat is unstable and someone jumps out, does it capsize the boat for everyone else? In a novel application of agent-based modelling, we examine how investors redeeming the corporate bonds held for them by open-ended mutual funds can cause feedback loops in which bond prices fall further, posing risks to financial stability. In our model, reducing the speed with which investors pull out their investments over time helps to keep prices stable and remaining investors’ savings on an even keel.