Mounir Kenaissi and Mariana Gimpelewicz.
A key feature of the post-crisis regulatory reform agenda has been the introduction of a leverage ratio to complement the risk-weighted framework. The FPC designed the UK leverage ratio to mirror risk-weighted capital requirements so the two frameworks move in lock-step over time and across firms. For the sake of simplicity however, the FPC did not reflect Pillar 2 capital charges, which aim to capture risks that cannot be modelled adequately in the risk-weighted framework, in the leverage ratio framework. In this post we explore what happens to leverage and risk-weighted requirements once Pillar 2 are taken into account. We find that in keeping the leverage ratio simple, the perfect lock-step interaction with risk-weighted requirements no longer holds, which could prompt riskier banks to take on more risk.
Sebastian J A de-Ramon, William Francis and Qun Harris
Shakespeare first coined the term ‘sea change’ in The Tempest to describe King Alonso’s lasting transformation after his mystical death by drowning. Resting five fathoms deep, Alonso suffers a sea change into something rich and strange, with coral for bones and pearls for eyes. In a recent working paper, we explore for evidence of a possible sea change in UK banks’ balance sheets using data spanning the 2007-09 crisis. Our initial dive into the still murky, post-crisis waters shows signs of something strange and unrecognizable, with UK banks, in response to higher capital requirements, increasing the level and in particular the quality of capital more after the crisis. This post describes our dive and its findings.
Matteo Benetton, Peter Eckley, Nicola Garbarino, Liam Kirwin and Georgia Latsi.
Do financial regulations change bank behaviour? Does this create new risks? Under Basel II, some banks set capital requirements based on their internal risk models; others use an off-the-shelf standardised approach. These two methodologies can produce very different capital requirements for similar assets. See Figure 1, which displays a snapshot of recent risk weights for UK mortgages. In a new working paper we show empirically that this discrepancy causes lenders to adjust their interest rates and to specialise in which borrowers they target.
Jon Frost and Julia Giese.
A seismic shift is occurring in the European financial system. Since 2008, the aggregate size of bank balance sheets in the EU is essentially flat, while market-based financing has nearly doubled. This shift presents challenges for macroprudential policy, which has a mandate for the stability of the financial system as a whole, but is still focused mostly on banks. As such, macroprudential policymakers are focusing increasing attention on potential systemic risks beyond the banking sector. Drawing from a European Systemic Risk Board (ESRB) strategy paper which we helped write along with five others, we take a step back and set out a policy strategy to address risks to financial stability wherever they arise in the financial system.
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.