In many advanced economies, policymakers try to stabilise and support activity while financial and non-financial agents undergo a process of balance sheet repair and deleveraging. The task is challenging. Headwinds borne out of deleveraging explain why – to quote Martin Wolf – "economies stagnate, while policy is aggressive" (2012).
Deleveraging is unavoidable and necessary. It can be, however, more or less costly depending on how it is conducted. The policy mix matters.
We are used to assessing the policy mix in the fiscal-monetary space. Today, it may be necessary to add a third dimension: prudential policies. Decisions taken in the prudential field have significant economic consequences. And, therefore, the mix between monetary and prudential policies may prove important and central in achieving the desired economic outcomes.
Monetary policy is extremely accommodative in all advanced economies. At the same time, prudential standards imposed on banks are being tightened. Those actions are mutually supportive in the long run. In the short term, however, monetary and prudential policies are pulling in opposite directions. Accelerated deleveraging by banks impairs the monetary transmission mechanism. The conjunction of low interest rates and credit constraints distorts portfolio choices and asset prices. Interest rate risk is piling up in balance sheets while bank credit is impaired, especially for small and medium enterprises. Is a better mix is possible?
Deleveraging, uncertainty and growth
Most analyses take a deterministic view of deleveraging. Historical experiences and precedents are used as benchmarks and references to conclude that the process has barely started. The overall spirit is well captured by a column a July 2011 article in the Economist entitled ‘Deleveraging: You ain't seen nothing yet’. A similar message is conveyed in Buiter and Rabati (2012): "there is a lot more private and public debt today in the advanced economies than has been the norm during peacetime periods".
In fact, deleveraging is not deterministic. It is an endogenous process with many interactions and feedback loops between economic agents. The end point is undetermined as "safe levels of leverage are subject to change over time" (Eggertson and Krugman 2010). There are many paths that might lead us there and not all of them will have the same effects. Depending on how deleveraging occurs, the total cost is different. The amount of losses to be taken by the economy is endogenous to the deleveraging process itself.
As emphasised by Buiter, deleveraging is first and foremost a coordination problem. Deleveraging by one agent creates externalities on others. For instance, when households deleverage, firms are worse off and may have to shrink their own balance sheets. Deleveraging by banks impose financing constraints on non-financial agents. With those externalities, the distinction between supply and demand constraints in credit distribution seems rather moot. Supply constraints in one part of the economy translate into weak credit demand in another one.
Because the path is indeterminate and the total amount of losses endogenous, deleveraging generates its own uncertainty. In turn, uncertainty pushes the banks to deleverage more as it deteriorates the quality of their loans' portfolios. This circular – and reciprocal – relationship between deleveraging and uncertainty creates a negative spiral into which many advanced economies, especially in Europe, are currently caught.
To break that spiral, one can think of three possible courses of action:
- First, debt can be grouped in a single balance sheet and centrally managed;
This is what ‘bad banks’ do, thereby taking uncertainty and risk away from the rest of the financial system.
- Second, liquidity provision may alleviate funding constraints and limit fire sale externalities and spillovers;
Liquidity also eases coordination problems. This was highlighted by a fun story circulating the web a few weeks ago: A German tourist checks into an Irish hotel for the night. While she proceeds to her room, she forgets a €100 bank note on the desk. The hotel manager takes it and, while the tourist sleeps, rushes to the grocery store to settle a €100 debt. In turn the grocery shop owner uses that same bank note to pay back a debt to a transport company, which immediately transfers to a cab driver who sends it to a tour operator to extinguish their own debts. Finally, the tour operator, who owes €100 to the hotelier, sends the note back to the hotel where it originated. When the tourist wakes up for breakfast, she finds the €100 waiting for her at reception. In the meantime debts equivalent to €500 have been extinguished and the leverage in the domestic economy has been dramatically reduced. Involuntary, but also non-costly liquidity provision by a third party has allowed leverage to be substantially adjusted.
The biggest contribution that policy can make, however is to reduce uncertainty in the regulatory field.
Financial regulation has been thoroughly reformed over the last years. Regulatory changes have been assessed on the basis of their static advantages, with less consideration given to the dynamics they may create. Basel III offers a good example. Studies concur on its significant long-term benefits but diverge on the short run, depending on assumptions made on the transition process. To avoid unintended effects, it was decided to set ambitious targets and give the banks a long delay to adjust. In fact, that decision opened a period with no precise references to guide markets on the appropriate levels of capital requirements and leverage. It may have created a possible ‘race to the top’ and made the whole process more uncertain and disorderly.
Interest risk is typical of those that macroprudential policy is supposed to address. It is global and non-specific to any institution. It is systemic – think of the consequences of a bond market crash. And it is building progressively, hence offering space for preventive measures.
Interest rates on risk free assets (treasuries) are at an all-time low. Term premiums on government bonds are heavily negative in advanced economies (once inflation and growth expectations have been factored in). Issuance of high yield securities is very high, both in absolute and in proportion of total debt. High yields corporate spreads narrowed to levels last seen prior to the Eurozone debt crisis (BIS 2013).
Making a judgment is difficult. Risks are by no means certain or one sided: "the upside and downside risks to the level of rates are roughly symmetric as of 2017" (Bernanke 2013). Their distribution is unknown although one suspects that banks are holding a large chunk (Turner 2013). Finally, the potential consequences of an increase in long-term rates are difficult to predict. They would be different across institutions, according to their accounting regimes, their hedging strategies and their investment horizons. They would also depend on whether the adjustment is progressive or abrupt.
On the other hand, there is evidence that interest risk has been associated with increased financial fragility with mounting leverage, and maturity transformation. Mutual funds and Exchange Traded Funds are accumulating significant exposures to interest rate risk backed by very short-term claims (Tett 2013). "Such financial structures are known to give rise to amplification and non-linear shocks if positions have to be liquidated quickly to face redemptions" (Stein 2013).
The current policy mix has therefore produced a very contrasted and unbalanced situation.
Market based intermediation is booming. Bubbles may be appearing in some high yield segments of bond markets. At the same time, deleveraging has brought credit distribution by banks to a halt. This contrast may partly explain the increasing divergence in economic performance on both sides of the Atlantic. The euro economy, where banks account for more than 80% of credit, is suffering more than the US, where markets play a dominant role in financial intermediation. Some rebalancing is necessary. The overall level of risk is not an issue, rather, the problem lies in the nature and the distribution of those risks. One objective of non-conventional monetary policies is to encourage risk taking. Introducing indiscriminate frictions would contradict that objective. The macroprudential response should aim at redirecting rather than impeding risk taking in the economy by reducing the incentives to take interest rate risk and increasing credit in the banking sector.
- Interest rate risk: even if the threat is judged not immediate or of great amplitude, there is a case for some preventing action;
The essence of macroprudential policy is to act before imbalances have become so large that they threaten financial stability. In the case of interest risk, prudential action would also free monetary policy from the dangers of ‘financial dominance’ (Hannoun 2012), a situation where so much risk has been piled up in financial intermediaries' balance sheets that central banks may hesitate to raise policy rates, when it becomes necessary.
For banks, the FED has been stress testing some interest rates scenarios and their impact on balance sheets (Bernanke 2013). It is likely that most supervisors are quietly doing the same. It would be prudent to induce institutions to build up specific buffers, which could be drawn upon in times of stress. The systemic aspect is more difficult: building up leveraged positions and maturity mismatches takes place in non-banking institutions, often outside the purview of supervisors. Macroprudential regulators should not shy away from formulating explicit warnings and backing them with specific actions (on margin requirements, for instance) when necessary.
- Deleveraging and capital requirements: to reduce uncertainty, regulators need to express a view (and give a guidance) on the appropriate path and modalities for deleveraging in the financial sector;
In a sense they face a problem identical to the one confronted by Central Banks when they practice ‘flexible’ inflation targeting. And they need to adopt the same mindset. ‘Flexible capital targeting’ would involve taking a view on the appropriate path to return to equilibrium after a shock. As central bankers know, there is a trad-off. Getting back too fast to target involves important losses of output and costs. On the other hand, waiting too long risks endangering the credibility of the ultimate objective. That trade off had been left unexplored in the regulatory field. There would be huge benefits in making the regulators' preferences explicit and transparent.
It would also be necessary to eliminate uncertainty on the future. Prudential regimes are in a constant state of flux. Now that the foundations of Basel III have been solidly established, regulators could consider a moratorium on any change for a few years. That would not prevent discussions and consideration of new measures and improvements to be introduced in the following period. The agenda is full (see Ingves 2013).
- Finally, capital requirements could be significantly reduced on new bank loans;
It makes sense, in the current environment, to differentiate between marginal and average capital requirements. Differentiation of capital requirements, across time and across asset classes is an integral part of the Basel regime. Any forbearance should be excluded and capital requirements on past loans should be maintained and strengthened. By contrast, a favourable regime could be applied to new net exposures, as the UK Financial Services Authority has been doing since 2012 by "ensuring that no bank will be required to hold the additional capital requirements of the increased lending" (2012).
A great deal of international cooperation may be necessary to implement such an agenda. It may be difficult to achieve. Reasonable people may differ in judging on the reality and seriousness of risk. At the same time, it is clear that current circumstances offer an opportunity and present a test for efficient macroprudential policies.
Editor’s note: This column expands on remarks made at a conference organised by the JulisRabinowics Center, Princeton University, on March 1, 2013
Bernanke, B (2013), “Long Term Interest Rates”, speech, 1 March.
BIS (2013), Quarterly Review, March.
Buiter and Rabati (2012), “Debt of Nations”, CITI GPS, November.
Eggertsson, GP, and Krugman, P (2010), “Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo approach” discussion paper.
Financial Service Authority UK (2012), “Adjustments to FSA’s liquidity and capital regime for UK banks and building societies”, 27 September.
Hannoun, H (2012), “Monetary Policy in the Crisis: Testing the Limits of Monetary Policy”, speech, BIS, February.
Ingves, S (2013), “Where to next? Priorities and themes for the Basel Committee”, 12 March.
Stein, J (2013), “Overheating in Credit Markets: Origins, Measurement, and Policy Responses”, speech, 7 February.
The Economist (2011), “Deleveraging: You ain't seen nothing yet”, 7 July.
Tett, G (2013), “Remember lessons of 2007 in rush for junk”, Financial Times, 14 March.
Turner, P (2013), “Benign neglect of the long-term interest rate”, BIS Working Papers 403, February.
Wolf, M (2012), “We still have that sinking feeling”, Financial Times, 10 July.