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E. Philip Davis*
National Institute of Economic and Social Research
In providing commentary on this topic, we begin with a National
Institute perspective, highlighting work done partly for the UK
regulator, the Financial Services Authority, and now emerging in
Our research shows that OECD banking crises differ from
emerging market ones. OECD crises were absent up to 1973, but
since then they have been very common, albeit with a gap for
most datasets from 1995 to 2007. In our work looking at predictors
of such crises using logit models (Barrell et al., 2010a, b), we found
a role for bank capital ratios and bank liquidity ratios in determining those crises, and apart from that, house price bubbles and
current account deficits. Our results contrast with those from the
World Bank and IMF, with global samples of crises dominated by
emerging market crises that highlight variables such as GDP
growth, M2 as a proportion of reserves, and credit growth as crisis predictors. One reason for this is that data for bank capital and
liquidity are unavailable for emerging markets, nor for the most
* E. Philip Davis is a Senior Research Fellow at the UK’s National Institute of
Economic and Social Research and an Associate Professor at Brunel University,
West London.
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part are house prices. But we would argue that we are also detecting fundamental differences in crisis determination for OECD
countries, which are less vulnerable to banking crises driven by
currency crises than are emerging market countries.
In other work for the FSA, we used a crisis model to generate
estimates of benefits from tighter regulation to offset against the
wider spreads that you get from increasing capital ratios (Barrell
et al., 2009). This then gave a suggested optimal degree of regulatory tightening.
The paper I want to talk about mainly in my commentary is
called “Calibrating Macroprudential Surveillance” (Barrell et al.,
2010c). Basically, what we did in that paper was to look at variables that have been used in the past in crisis models (e.g.,
Demirgüç-Kunt and Detragiache, 2005), testing down to a simplest model possible and using a short data period from 1980 to
1997, a long way before the subprime crisis. What we found is, as
was mentioned earlier, that variables such as credit growth, output growth, and M2 to reserves are not significant; instead, our
specification search ends with the four variables that I mentioned
earlier, namely bank leverage (unweighted capital adequacy), net
liquidity ratios, house price growth, and the current balance. We
did a number of robustness checks to see whether it was justified
to exclude credit growth and GDP growth, such as additional lags.
But in each case, they dropped out.
Our economic argument for this result is that credit growth
may accompany a favorable as well as an unfavorable period for
financial stability. Credit growth may be rapid during a period
when the output gap is not growing and when supply is growing
with demand, but equally in a period when there are major imbalances and excess demand. What distinguishes such a more
difficult period for financial stability are trends like rapid house
price growth and a large deficit in the current balance. They show
when rapid credit growth is likely to lead to a financial crisis.
Our model works well; we get 75% of crises correct and 72% of
non-crisis periods. As an illustration of the model’s use in macroprudential surveillance, we are able to use the model to forecast
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Commentary on Macroprudential and Other Policies
up to 2008 (using actual values for right-hand side variables), and
we find that it was flagging the subprime crisis quite strongly for
the UK, US, France, and Belgium. It also highlights risk in Spain.
Possibly the reason Spain didn’t have a full-blown banking crisis
was that the authorities had introduced dynamic provisioning
that protected the banks from the losses they incurred.
There are also relevant results for macroprudential regulation. Because the model includes policy variables, namely
liquidity and leverage on the right-hand side, we can invert it and
then calculate what levels of those variables would be needed to
get the crisis probability down to 1% for each country, i.e., a crisis every 100 years (as compared to every 16 years in the sample).
We show, on average, over 1998 to 2008, i.e., out-of-sample, what
level of leverage and liquidity would be needed to get us down
to this 1%. The key result is that a rise in leverage and liquidity
of 3.7% points would be sufficient to get 1% on average across
the OECD.
However, there are differences between countries in the
degree of tightening that is warranted. A number of countries
need much more extra capital than 3.7% in order to get their maximum crisis probability down to 1%. That relates in turn to
different levels of macroeconomic volatility, different levels of crisis risk, as well as the initial positions in terms of leverage and
liquidity. This aspect has not been discussed much yet in policy
circles, but it implies potential externalities from more risky to
less risky countries if all have the same Basel III level. Some countries, including the UK and US, need more capital and liquidity
than the OECD average to get their crisis probabilities to 1%, and
in turn to avoid externalities to other countries when effects of
their crises spill over.
As was mentioned earlier, we find credit insignificant as a
crisis predictor, and we argue that countercyclical provisioning
should be based on house prices and the current account. In
Barrell et al. (2010c), we show calculations of extra capital needs
based on 5% higher house prices and show that the need for extra
capital in order to keep the crisis probability down does build
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up over 1998–2008, but in a very non-linear way. It, of course,
depends on all the variables in the model and there is no scope for
a simple “rule.” This is an area of interest for further research.
With the above as background, we can address now the topic
of the session directly — looking first at the interaction of macroprudential with monetary policy. We’ve shown that the overall
country adjustment in prudential policy to reduce crisis probabilities depends partly on macroeconomic volatility. So one
argument one can make is that if monetary policy can reduce
house price bubbles and imbalances in the current account, it
impacts on macroprudential adjustment.
On the other hand, it is more doubtful that macroprudential
regulation will significantly affect the macro economy, and hence
the demands on monetary policy. I’m referring here to our own calculations, but also the Basel calculations that were made in FSB
(2010). According to simulations with macroeconomic models in
various countries, 1% more capital and liquidity seems to take
around 0.1% off GDP, which is not huge, and only 0.03% if all countries moved together. So in other words, the effect of regulatory
tightening on the macro economy is small so long as the tightening
is gradual, which I think is a point relevant to monetary policy.
As the BIS point out in their recent Annual Report, there are
some benefits to monetary policy of a more active macroprudential policy. Less financial crises imply less economic fluctuation. If
crisis risk can be reduced, interest rates are less likely to become
ineffective due to financial distress, and also there will be less
need to cut interest rates for financial stability reasons in the
downturn with possible inflation risks.
Conflict between monetary and macroprudential seems most
likely if it’s an ex-post issue i.e., there is already a crisis. In
advance of the crisis, the optimal policies move in the same direction — to avoid bubbles that threaten financial instability and
that are also going to be inflationary at some point. So both
macroprudential and monetary policies should be tightened.
There is also notable interaction of macroprudential policy
with microprudential regulation in that crisis probabilities depend
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on the stringency of microprudential regulation. The weaker the
regulation, the more adjustment needed for macroprudential
aims. As mentioned, some countries will need tighter average regulation than the OECD/Basel III average. Whether or not that is
the case, the macroprudential stance of a country is a benchmark
for all banks, but there would also be a need for discretionary
adjustment at a micro level for riskier banks and the larger banks.
Finally, we argue that the use of estimated credit-to-GDP gaps as
recommended by the BIS is not necessary for calculation of the
need for countercyclical buffers as credit is not significant as a crisis predictor — and does not even Granger-cause property prices
in most countries, according to our research.
There are also some points to raise on competition policy.
Systemic institutions that are of concern to macroprudential policy as being “too big to fail” (Haldane, 2010) are also likely to have
market dominance. This suggests a synergy with competition policy, notably in recommending the unwinding of some of the
mergers that took place under duress in the crisis (the UK example
is Lloyds/HBOS). What I think is more questionable is whether
proposals for dividing universal banks have a competition policy
justification, unless they dominate both commercial and investment banking. Equally, it is not clear that the outcome of the
subprime crisis shows the universal bank model’s weakness —
Northern Rock and Lehman’s were “specialized” institutions.
We now comment briefly on the papers. The Reichlin and Pill
paper is an excellent analysis of the ECB’s extraordinary monetary
policy and its impact on interest rates in lending.
One technical point is that it would have been helpful to have
the standard error bands in the first part of the paper as well as
the second part because it was not clear whether the effects were
Turning to some more substantive points, a first is on wholesale funding. The paper takes the dependence of banks on
wholesale funding as given. That’s been a big issue for central
banks to provide liquidity to compensate for the dependence
of banks on the wholesale funding markets that have been
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chronically unavailable. The question one has to raise is whether
the banks should have been in that position in the first place, and
therefore, is the microprudential regulation of liquidity actually
sufficient? There’s an argument that there should have been
tighter regulation of the dependence on wholesale funding. Banks
could have been prevented from taking on such a high proportion
of non-customer funding and that should also have been viewed
at the macroprudential level (for example, the aggregate customer funding gap of the banking system). The wholesale funding
of the whole system should’ve been looked at and it could be
looked at countercyclically. So that’s a substantive suggestion
drawing from the paper.
Equally, the paper assumes that the interbank spread of zero
prior to the crisis was in some way normal. All the central banks
assumed that as well, but economic logic states that a zero LIBOR
versus Central Bank rate spread implies gross underpricing of
risk. Why wasn’t there always a positive spread? Was it perhaps
because the expectations of the market that the banks would
always be bailed out and therefore, a zero LIBOR spread was in
some sense rational? Or does it also show disaster myopia both in
banks and in policy circles — that a risky position with large proportions of wholesale funding and a zero spread is somehow seen
as normal. We need to view such patterns from first principles in
There’s a further issue of unwinding of extraordinary ECB policies. Banks have become dependent on central bank funding and
need incentives to adjust balance sheets away from wholesale
funding. Can exit from extraordinary policies be accomplished
without a major credit contraction?
Then there’s the broader issue of integrating central bank
liquidity policy and bank regulation. Do money market desks talk
to regulators enough? How can one gauge the overall stance of
macroprudential policy? Is the tradeoff limited? How was the liquidity support integrated with inflation concerns of central bank?
The nature of ECB’s extraordinary measures deserves further
attention. Why did they not buy up government bonds (as in
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Commentary on Macroprudential and Other Policies
the UK) or also private sector assets (US) as more effective means
of reducing long rates and supplying credit directly than buying
long-term money market instruments? Our work at NIESR suggests that as a consequence, the ECB got a lower impact on GDP
for its special measures. Has any counterfactual work been done
to see if this was more or less effective to stick to such assets,
given the differing financial structure in the Eurozone? And
finally, how different would the outcome have been if Basel
III/countercyclical macroprudential policies were already in
place? Would the conclusion be that it was a liquidity and not a
capital crisis for most Eurozone countries, so it would have made
little difference?
In the Király paper, it was good to highlight the needs for
cross-country coordination of macroprudential policies, and one
only has to consider the crisis in Iceland to show how important
those things can be. The local example of Austria and Hungary
was very helpful. But the question arises — why wasn’t product
regulation, banning foreign currency mortgages, used to complement macroprudential? Arguably, they should have never been
allowed to have been sold in Hungary in the first place.
Their suggestion that we need global credit growth based
macroprudential policy is harder to sustain. Countries with slow
economic growth and very little cross-border lending would consider themselves penalized. They would say, why should we
suddenly have this buffer based on global credit growth? The
focus needs to be on the countries where the cross-border lending is coming from.
This paper also raises the issue of cross-border wholesale
funding. In the UK, this rose from around zero in 2000 to around
£400 billion in 2008. This points again to the need for macroprudential regulation on the liability side of liquidity, not just on the
asset side, which seems to me to be the major focus at present.
On the other hand, it’s worth adding that in our research at
NIESR we tried very hard to get wholesale funding into our crisis
models, and we found that it couldn’t readily be found to be a
stable predictor.
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In the paper, it is argued that loan to value limits need to be
fixed. We suggest they should be flexible over the cycle, lowered,
for example, during periods of house price boom as is the case in
emerging market countries that use such ratios actively.
The authors talk about the need for measuring a macroprudential stance. I would argue that our work at NIESR cited above
gives at least an initial approach to that. Our models generate
probabilities of crises in each period that in effect measure how
tight the stance of macroprudential policy is. For example, using
a rolling probabilities model, we can forecast one year ahead;
then the indicator of the stance is the excess of the crisis probability in the next year over an acceptable level of risk. The model
also shows how it could be reduced (albeit not immediately).
The authors discuss the fiscal rules of the stability and growth
pact, but they didn’t elaborate on that. We would contend that
there’s an important role of fiscal coordination in macroprudential, notably in terms of a need for fiscal flexibility to respond to
future banking problems. This is an important argument for the
fiscal consolidation that’s underway at present; we need to be
ready for any future financial crises and that consolidation can be
helped by coordination. The Greek example shows the risk of
contagion from uncontrolled fiscal policies with cross-border
lending, and is another argument for coordination.
To illustrate their argument further, I want to highlight
Barrell et al. (2010d) on cross-border effects of crises. What we
did was to look at the weighted incidence of ongoing crises elsewhere in our crisis model and see what the effect is on our
probabilities elsewhere. We came up with a table which unsurprisingly shows that a crisis in the United States has a big impact
globally. Its impact depends not only on the size of the country,
of course, but on all the other coefficients and variables within
the other countries. So that’s an indicator of induced changes to
crises probabilities that are affected by crises elsewhere, and that
seems to me very relevant to this discussion about cross-border
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Barrell, R., E. P. Davis, T. Fic, D. Holland, S. Kirby and I. Liadze (2009).
Optimal regulation of bank capital and liquidity: How to calibrate
new international standards. FSA Occasional Paper, No. 38, October.
Barrell, R., E. P. Davis, D. Karim and I. Liadze (2010a). Bank regulation,
property prices and early warning systems for banking crises in
OECD countries. Journal of Banking and Finance, 34, 2255–2264.
Barrell, R., E. P. Davis, D. Karim and I. Liadze (2010b). How unique was
the subprime crisis? Discussion paper, No. 351, National Institute of
Economic and Social Research.
Barrell, R., E. P. Davis, D. Karim and I. Liadze (2010c). Calibrating macroprudential policy. Discussion paper, No. 354, National Institute of
Economic and Social Research.
Barrell, R., E. P. Davis, D. Karim and I. Liadze (2010d). Contagious effects
of banking crises in OECD countries. Mimeo, National Institute of
Economic and Social Research.
Demirgüç-Kunt, A. and E. Detragiache (2005). Cross-country empirical
studies of systemic bank distress: A survey. IMF working papers
05/96, International Monetary Fund.
Financial Stability Board (2010). An assessment of the long-term economic impact of stronger capital and liquidity requirements. Basel,
Haldane, A. (2010). The $100 billion question. Speech, Institute of
Regulation and Risk, Hong Kong, March 30.
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