How to loosen the banks-sovereign nexus

Paolo Angelini, Giuseppe Grande, 8 April 2014



Sovereign debtors and their national banking systems are closely linked through a range of direct and indirect channels.

Topics: EU institutions, Financial markets
Tags: bank capital, bank regulation, capital requirements, home bias

Estimating the impact of changes in aggregate bank capital requirements during an upswing

Joseph Noss, Priscilla Toffano, 6 April 2014



The recent financial crisis and economic contraction that followed highlighted the crucial role that banks play in facilitating the extension of credit and enabling economic growth. This underlies the economic rationale for imposing regulations on the banking industry, including minimum capital requirements designed to mitigate risks banks would not otherwise account for in their behaviour.

Topics: Financial markets
Tags: bank capital, bank regulation, banking, banks, BASEL III, capital requirements, credit, Macroprudential policy, regulations

Bank capital requirements: Risk weights you cannot trust and the implications for Basel III

Jens Hagendorff, Francesco Vallascas, 16 December 2013



One of the primary purposes of bank capital is to absorb losses. Where bank capital holdings are insufficient to absorb losses, banks will either fail or – if bank failure is deemed too costly for the economy – be bailed out. In practice, banks frequently receive public funds where capital holdings are insufficient to cover losses in order to prevent bank failure.

Topics: Financial markets, Microeconomic regulation
Tags: bank capital, Basel, Basel II, BASEL III, capital adequacy, capital requirements, financial crisis, risk weighting

Is a 25% bank equity requirement really a no-brainer?

Charles W Calomiris, 28 November 2013



Professor Allan Meltzer famously quipped that “capitalism without failure is like religion without sin”. If some firms are protected from failure when they cannot pay their bills, then competition is skewed to favour inefficient, protected firms.

Topics: Financial markets, Microeconomic regulation
Tags: bank capital, bank equity, banking, capital requirements, equity requirements, loan supply, risk weighting

The Future of Banking – solving the current crisis while addressing long-term challenges

Thorsten Beck, 25 October 2011



Three years after the Lehman Brothers failure sent shockwaves through financial markets, banks are yet again in the centre of the storm.

Topics: EU institutions, EU policies, Europe's nations and regions, Financial markets, Macroeconomic policy, Politics and economics, Taxation
Tags: banking, capital requirements, euro bonds, Eurozone crisis, financial risks, financial transaction tax, prudential regulation, ring-fencing, sovereign debt crisis

The Dodd-Frank Act, systemic risk and capital requirements

Viral Acharya, Matthew Richardson, 25 October 2011



The economic theory of regulation is clear. Governments should regulate where there is a market failure. It is a positive outcome from the Dodd-Frank legislation that the Act’s primary focus is on the market failure – namely systemic risk – of the recent financial crisis.

Topics: Financial markets, International finance
Tags: capital requirements, Dodd-Frank Act, macroprudential regulation

Ring-fencing is good, but no panacea

Viral Acharya, 25 October 2011



The recent report issued by the UK's Independent Commission on Banking, chaired by Sir John Vickers, provided recommendations on capital requirements and contained a proposal to ring‑fence banks – in particular, their retail versus investment activities.

Topics: Financial markets, International finance
Tags: bank capital regulation, capital requirements, ring-fencing, risk weights, Vickers Commission

Capital, politics and bank weaknesses

Jon Danielsson, 27 June 2011



Bank capital has emerged as a key element in the post-crisis financial regulatory reforms. Basel III is now likely to include a 7% equity-to-risk-weighted-assets capital requirement.

Topics: Financial markets
Tags: banks, capital requirements

Measuring systemic risk and the dismal failure of Basel risk weights

Viral Acharya interviewed by Viv Davies, 17 Jun 2011

Viral Acharya of New York University talks to Viv Davies about capital requirements and measuring systemic risk. Acharya describes the development of the NYU Stern systemic risk rankings of US financial institutions and what he considers to be the dismal failure of the Basel risk-weight approach to addressing systemic risk. He cautions against the blanket call for more capital and instead recommends for more capital against systemic risk contributions of financial firms. He also discusses the shadow banking sector and how banking risk and sovereign risk are becoming dangerously intertwined. The interview was recorded in London on 2 June 2011. [Also read the transcript]


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See Also

"Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance"


View Transcript

Viv Davies: Hello and welcome to "Vox Talks," a series of audio interviews with leading economists from around the world. I'm Viv Davies from CEPR. It's the second of June 2011; and I'm in London, talking to Professor Viral Acharya of the New York University Stern School of Business about measuring systemic risk, Basel III and capital requirements. Professor Acharya describes the Stern systemic risk rankings of US financial institutions and what he considers to be the failure of the Basel III capital requirements in addressing systemic risk. He discusses shadow banking, and also how banking and sovereign risks are becoming intertwined.

I began the interview by asking Professor Acharya to explain how systemic risk arises in the first place.

Professor Viral Acharya: I would say; in order to give a very short but maybe useful definition, systemic risk arises when a significant part of the financial sector gets under capitalized all at once. Another way of saying it would be that, a common shock hits a large part of the financial sector that's being funded with short term debt. Different crises have either more emphasis on the shock, sometimes the emphasis is more on the short term debt aspects of it. But I think the key factor is that it has to hit a large part of the financial sector all at once, so that there is some loss of intermediation.

And through the loss of intermediation, there is either a credit crunch for the real sector, there's a reduction in debt for the household sector, capital markets could freeze up all at once. In the extreme, payment and settlement systems could collapse altogether so that there could even be loss of trade globally as a consequence.

Viv: So systemic risk is one of the main reasons why regulation of financial institutions is so important, yet there has never been a formal or organized method, established by regulators, to measure or quantify systemic risk. Why do you think that is?

Prof. Acharya: It's partly because regulators very often follow the letter of the law that's laid out. And unfortunately, most regulation - at least the way it was formerly written down - had always been about what I would call micro-prudential regulation; focused on supervision of individual banks, ensuring that they don't fail, ensuring that there's no sort of fraud in the accounting, that they're rightly recognizing losses in due course of time, and so on. Systemic risk was often justified as a reason for regulating banks. But as you put it, there hadn't been a good formal attempt to measure or quantify systemic risk in an interesting way.

In the Western economies, I would say there hadn't been an episode of a fully blown banking crisis. Scandinavia had one in early '90s. You could argue savings and loans crisis in the United States was also a systemic crisis in the sense that it cost the taxpayer a lot. A big part of the mortgage industry was at risk at that point.

But I think it was partly really because the Great Depression was followed by a suite of regulations, like the Deposit Insurance, the SEC, the Glass Steagall Act, which seemed to have contained banking crises for a while, until these regulations became anachronistic in one way or the other, so that the government guarantees remained in place, but all the restrictions to ring fence its users became weak over time. Amd then gradually the seeds of a full blown systemic crisis were sown in the Western economies.

Viv: Maybe you could explain for us what you and your colleagues at the NYU Stern School of Business have been doing in relation to measuring systemic risk.

Prof. Acharya: Our measurement of systemic risk is based on publicly available data. It's very close to the definition of systemic risk that I made earlier, which is that systemic risk arises when a big part of the financial sector gets under capitalized all at once. As you can see from this definition, the key ingredients are: first what's the leverage of an institution? Second what is its exposure to some sorts of common shocks out there in the economy? And three its size is going to be important because the larger it is, the greater is going to be its share in the overall under capitalization of the system.

At NYU, we have an academic paper on this. I've co authored this paper with Lasse Pedersen, Thomas Philippon and Matt Richardson. My colleague Rob Engel then has an econometric implementation in there with Christian Brownlees. But as a result of this collaboration ended in a website which is called Vlab - Volatility Lab - something that Rob Engel maintains on his Volatility Institute website.

Here, on a weekly basis, we update our ranking of the systemic risk contributions of the top 100 financial firms in the United States. Now, the idea is not to say that systemic risk contributions change on a week to week basis, but it helps you understand why these measures are moving.

Put simply, what our measure does is the following. It says that “I'm going to define a stress scenario for the economy as a 40% crash in the aggregate market, per se. S&P 500, for example”. Why such a simple scenario? Because we don't have the advantage that regulators have of knowing every single asset that banks are sitting on what's currently the most important asset class.

But by and large, in every crisis, if it is systemically important, you would expect a pretty large correction to the stock market, of the economy as a whole, because a systemic crisis should be something that actually spins over to the real economy to households and so on.

Our criterion is…the question we want to ask is: will firms be well capitalized when there is a large common shock to the economy as a whole? So, the question would be, for example, will Bank of America have a capitalization of not more than $8 of assets per dollar of equity? Conversely, which means its leverage should not exceed 12.5 to 1 in this stress scenario.

Therefore, we are not talking about current leverage. We are talking about leverage in a potentially severe stress scenario down the road. So we need to be able to project, given its current leverage, and given its current equity capitalization, how much of their equity capitalization will erode in a 40% correction to the market?

In a simple sort of market language, this is a concept of what is the downside beta of Bank of America? Beta is more of a linear concept. Probably risk increases somewhat more exponentially on the downside, so we do a more sophisticated estimation of this downside risk.

But we basically come up with a measure, which we call MES, or marginal expected shortfall, which is “what your expected shortfall, or loss, when the market is in a bad scenario this 40% shock?”

For example, if Bank of America's shortfall against market, on a per dollar basis, is, say, two, it means that when market loses 40% of its equity capitalization, Bank of America is going to lose 80% of its market capitalization.

Now, therefore, if I know this downside risk measure, the MES, I can project how much equity Bank of America is going to be left with in the scenario. I know what the liabilities of Bank of America are, based on its current balance sheet. I can project its leverage ratio, therefore, in that systemic stress scenario, and now, most likely, it's going to be short of being at the leverage of 12.5 to 1.

So I can calculate by how many dollars is its equity short of ensuring that its leverage doesn't exceed 12.5 to 1. This we call the capital shortfall of each firm in this case Bank of America. I can repeat this exercise for J P Morgan, for Citigroup, for Goldman Sachs. We do this for the top 100 financial firms.

The important thing is we are subjecting them not to what they believe is their own stress scenario, which is usually different across different players. We are subjecting all of them to a common shock, because we are really interested in the system as whole becoming under capitalized at the same time.

So now we can add up the capital shortfalls of each of these firms, and then the proportion or the percentage of that which Bank of America contributes is its own systemic risk contribution. If Bank of America's capital shortfall is $35 billion, the overall shortfall is $75 billion, then Bank of America's systemic risk contribution in the U.S. economy is about 45%, as per our measure.

We update this measure on an ongoing basis, so it reflects changes in assets that these banks might be undertaking, it reflects changes in their leverage, it reflects changes in market volatility, and so on. Potentially, we could even reflect changes in how likely the scenario is, where the market actually gets a 40% correction in the first place.

Viv: So you update weekly, or monthly?

Prof. Acharya: We update it weekly. I would say it's more interesting to study a long time series than try and understand when big changes take place, and try to add some economic meaning to what really happened around those times. One thing I should stress is, as I said we are not in the regulatory shoes; we can't have the supervisory intelligence that they have on specific assets that they have. So our approach to systemic risk is very top down. We are coming up with a measure of systemic risk at the level of an institution itself, whereas the current regulatory approaches are more bottom up. They try to get a more granular knowledge about their assets. In some sense, for example, the Basel requirements attach risk rates to each asset. They add those up, and then they try to come up with a capital requirement.

Viv: So, would this mean that it could become easier now to design efficient regulation that discourages the build up of excessive risk?

Prof. Acharya: In principle, yes. Let's suppose, for the time being, that our measure has some economically sound properties in reflecting systemic risk. You could think about several ways we could easily transform our measure into a capital requirement, because I'm actually telling you how much short you're going to be in a systemic crisis and that therefore tells me how much capital you need to raise today to ensure that you will not exceed a 12.5 to 1 leverage in a systemic risk scenario. You could even, in principle, design a levy or a surcharge that's based on this contribution. Clearly, there will be something that's about the level of regulation that needs to be decided as to how high the surcharge or the levy is going to be. Or, in principle, regulators could even just ensure that the systemically most important institutions are being supervised better, try and ensure that the resolution authority…whether they have sufficient knowledge of what's going to happen when they need to wind them down, are their living wills good enough in prescribing what set of actions need to get triggered, etc.

Viv: So, to what extent have the Basel III capital requirements been successful, or not, in helping to mitigate systemic risk?

Prof. Acharya: I have mixed feelings about Basel III capital requirements, in the following sense. Clearly, it's reasonable to think about capital requirement as a response to dealing with systemic risk. And this is because, by and large, systemic risk arises when there's loss of intermediation. Loss of intermediation generally happens when there is something like a bank run, or at least significant draw down on liabilities of a bank or a bank like institution. Where I think Basel capital requirements have failed and I would say have failed, in some sense, quite royally is in, really, their approach, which is really this bottom up approach of assigning risk weights to each asset class and then aggregating it up. As we've been discussing, what you really care about is whether the system is resilient to a large, common shock. But, what the Basel risk weights are based on is the individual historical risk profile of asset by asset. What you really want to know is the risk of mortgages is in a recession? What you really want to know is the risk of a corporate loan is in a recession? What is the risk of a credit card receivable in a recession? That common conditioning on a recession or a large financial sector crisis is what the risk weights should be based on. Instead, the risk weights are based on individual assessments of risk of different asset classes, but they are not aggregated upon.
So there are several problems with this, I would say at least three. One you are looking at individual risk of assets rather than their systemic risk. So because you have ignored systemic risk, implicitly, systemically-risky assets are being subsidized relative to their risks that they impose on the system.

Two the risk weights are often historical looking, they're backward looking in their risk assessments. And so, because the Basel risk weights don't change that frequently, they completely miss any dynamic aspects of risk taking in the economy. They miss the fact that an asset class could be emerging to be a systemically important asset class, like mortgages were in the last decade, whereas prior to that they had been, historically, the most stable asset class. And I would argue that, taking my first point, because we gave a lower capital requirement to mortgage backed securities in Basel capital requirements, in one form or the other, implicitly we are subsidizing this asset class by saying, "No, if you want to go and lend more on this asset class, please go and do it."

And that brings me to the third point which is that because you are not conditioning on a common shock, there's no sense in which the Basel risk weights are capturing a risk of build up of concentrated, common exposure across balance sheets of institutions. So, historically, mortgages have been a stable asset class; they weren't as dramatically large part of bank balance sheets as they became in the last decade. But during 2003, 2004, 2005, 2006, this was the biggest source of credit creation that banks were engaged in, either as direct mortgage origination or as holdings of mortgage backed securities or the other.

So Basel risk weights were telling you that, oh, banking sector is extremely safe because its risk weighted assets were very small, because they were loading up on an asset class that had historically been very stable. But of course, because they were loading up so dramatically on one asset class, there was lending down the quality curve; there was a common factor exposure that was building up. And add to all of this that Basel capital requirements don't really distinguish that much between short term debt, long term debt, even though Basel III proposes some liquidity capital requirements to get around it.

So I would say the broad approach of Basel capital requirements is problematic because of risk weights. Risk weights are not inherently about systemic risk, the way I see them.

Basel III, in contrast, put simply, is some liquidity requirements, which I think is going to deal with short term debt issues a little better than it has done in the past. But by and large, I'm not sure if Basel capital requirements are really what is needed to contain systemic risk in the economy. They are capital requirements, but unfortunately they are not capital requirements geared to deal with systemic risk.

Viv: And what about the shadow banking sector? There's been some criticism of Basel III in that, whilst it was designed to make the banking sector more resilient, it has perversely created new risks by favoring the development of the insufficiently regulated shadow banking system. Would you agree with that?

Prof. Acharya: I would say that's probably point number four against Basel capital requirements, but I would say this is actually a broader criticism of the regulation of financial sector in general, which is that it's often by form rather than function. So, for example; we regulate depository banks, but we were not regulating the investment banks, which, increasingly, after the repeal of Glass Steagall, started performing very similar functions under the same jurisdiction. One was under bank holding companies; the others were with SEC. Money market funds seem to be doing maturity transformations, just like depository banks do, but they are being treated sort of as a halfway between a mutual fund and a bank. So, I think there were these special purpose vehicles which were, again, doing maturity transformation, but because they were off balance sheet, they were not recognized as being part of the banking sector in one way or the other.

So there's a sense in which the letter of the law is important, which is that regulators often have a tendency to take what the law requires them to do and then go and then enforce those requirements. If the law doesn't allow them to do something, because unless the regulation is very principle based, they don't really go and actually exert their discretion or judgment about what they should be doing. They sort of tend to go in more of a box ticking approach.

So I think, in some sense, the only way around this is to regularly revisit the architecture of the financial system, see what new forms of financial firms are coming up, what their function is, and if their function is inherently looking to be the same as that of a regulated entity, both in what it does and what its capital structure is, I think there's no reason to call it something else, to just put it in sort of common parlance. I think, if a money market fund or a conduit faces a run, there is something about it which looks like a bank, and let's better regulate them, as we regulate banks.

Viv: Finally, what would be your strap line advice to the G20 with respect to regulatory reform in the banking sector?

Prof. Acharya: I would say ensure that regulation is addressing systemic risk, both in an ex ante sense in terms of charging more capital to those institutions that are likely to become under capitalized in a stress scenario. Ensure that those institutions, there is a good resolution authority for dealing with them when things go bad so that they don't become too big or too systemic to fail. And I think the last piece of advice I would give is that clearly sovereign credit risk is emerging as a big source of systemic risk in its own right. Banks own a big chunk of bonds of their own governments. Governments, when they are in fiscal difficulties, are known to push their debt onto the balance sheets of banks, either implicitly, through moral suasion, or explicitly, through higher statutory liquidity requirements.

Clearly, this means that the banking balance sheets and the sovereign balance sheets are getting quite intertwined. Ireland is a prime example. But to the extent that European banks are exposed to, say, debt of Greek banks, how safe Greek banks are depends upon how safe Greece is as a sovereign in its own right. These risks are becoming intertwined, and I think my bottom line on this would be that it's not clear that just macro prudential of private financial sector going forward is going to be sufficient for ensuring financial stability. We may have to think hard about fiscal prudence on part of the governments, to ensure that their problems don't spill over to the private financial sectors.

Viv: Viral Acharya, thanks very much for speaking to us today.

Prof. Acharya: Thank you, Viv.

Topics: Global governance, International finance
Tags: BASEL III, capital requirements, Dodd-Frank Act, financial reform, shadow banking, stress tests

Monetary policy in extraordinary times

David Miles interviewed by Viv Davies, 25 Feb 2011

David Miles of the Bank of England's Monetary Policy Committee talks to Viv Davies about ‘Monetary Policy in Extraordinary Times’, a speech he delivered in London on 23 February 2011. Two very large shocks have hit the UK economy – the near collapse of the banking system and, more recently, a sharp increase in commodity, energy and food prices. The first shock is deflationary, the second inflationary. Miles discusses how best to set monetary policy in the wake of these shocks and analyses how regulation and monetary policy can most effectively reduce the likelihood of future financial instability. [Also read the transcript]


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Related Publications:

David Miles’ speech Monetary Policy in Extraordinary Times and accompanying slides


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Viv Davies interviews David Miles for Vox

February 2011

Transcription of a VoxEU audio interview []

Viv Davies:  Hello and welcome to Vox Talks. I'm Viv Davies from the Centre for Economic Policy Research. It's the 23rd of February 2011 and I'm talking to Professor David Miles, member of the Bank of England's monetary policy committee, on the subject of a talk he is giving this evening titled "Monetary Policy and Financial Stability in Extraordinary Times". The event is being hosted jointly by the Centre for Economic Policy Research and the London Business School. I began by asking Professor Miles to explain the principal factors that have given rise to what he refers to as “the extraordinary times in which we live.”

Professor David Miles:  Yes, well people use that phrase very frequently, they say, "We're living in extraordinary times" and of course by definition most of the time it's not true. I think in terms of what's happened in the economy right across the Western world, certainly here in the UK, it really is true at the moment. I mean, just in the last few years we've seen a series of really extraordinary events that I think few people could have predicted.

Toward the end of 2008 the banking system in the UK came pretty close to almost complete gridlock and if the banking system had stopped working, and I think it came close to stopping working, it would have been about as serious as the supply of electricity being cut off. And I think in the aftermath of that crisis there was a period when confidence declined and the level of economic activity declined certainly in the UK, and not just in the UK, but certainly in the UK, declined for a period of three or four quarters which was comparable to the decline in output in the first six to twelve months of the Great Depression.

We've also seen an extraordinary roller coaster ride really for commodity prices between maybe the middle of 2008 and the middle of 2009. That is the period just before the near collapse of the banking system, the worst part of the financial crises at the end of 2008, between a few months before that and a few months after that, commodity prices, roughly speaking, halved, and in some cases, in oil prices, more than halved.

Now since then, since the middle of 2009 to now, prices more or less doubled. So they first of all halved and then they doubled so we've had something that has been close to a Great Depression-like trajectory for output in the UK. We've had a situation with the banking sector came pretty close to complete meltdown, and we've had a degree of volatility in commodity prices which is pretty extraordinary. We've also had a huge increase in the scale of the fiscal deficit, and again this is absolutely not unique to the UK, but it's been very serious in the UK, and an increase in the stock of government debt on a scale that's unprecedented outside of world wars.

We also on top of all that had a period in the first few months of 2009 where world trade declined in a way that we've never seen, outside of the outbreak of world wars. So I think this adds up to a truly extraordinary period and it's generated a situation where economic policy, monetary policy and fiscal policy is pretty difficult to set but we've got to try and get through it.

Viv:  The current rate of inflation in the UK is around 4% which is twice the Bank of England's official 2% target and according to the bank's quarterly inflation report, inflation is also likely to rise further in the coming months to 4.5% or even higher perhaps. There's also a widespread expectation that interest rates will go up as soon as May. Does this mean that we can expect rapid interest rate increases through 2011? And, if so, is there a danger that such increases could perhaps harm the economy given that it's still relatively fragile and facing further tax increases and public spending cuts, et cetera?

Professor David:  Well, I think it helps to sit back and try and understand as best as one can why inflation is as high as it is and in some ways it is a very unusual situation. We've had a very deep recession, unemployment has gone up a great deal. Other things equal you would expect that more likely than not that would take inflation lower and inflation might be sitting underneath the Bank of England's 2% target rather than rather uncomfortably above it. I think the reasons inflation is as high as it is are largely to do with the big exchange rate depreciation in 2007, 2008. Probably more important right now has been the enormous increase in commodity prices over the last year or so. Just in the last couple of weeks commodity prices have moved higher again. Over the last year in sterling terms on average commodity prices are up not far off 40%.

Viv:  So they are not where they were two years ago or 2008?

Professor David:  That's right. So commodity prices halved and then doubled and that's caused a great deal of variability in inflation. We've had an increase in VAT, in fact we've had two, one at the beginning of 2010 and another at the beginning of this year 2011. I think it's almost inevitable that when you have such big changes in the level of commodity prices and other imported goods prices and an increase in VAT, it's highly likely that's going to drive measured inflation up for a period after those increases in prices. I think the key thing for us in the monetary policy committee is to try and look through the temporary effects of those price changes and think about where the underlying inflation pressures in the UK are. I think if one focuses on the, what you might call the domestically-generated inflation pressures, you actually get a very different picture for the degree of inflation pressure than simply looking at the headline inflation rate right now. One of the, probably most important indicators of domestically-generated inflation pressure is what's happening to wages and the story there has been an unusual one.

Wage settlements in the UK now, certainly in the private sector, have been running at somewhere around 1.5 ‑ 2% for much of the last few years. In fact for many companies there has been a wage freeze for most of the last couple of years. Now wage settlements are picking up a little bit, but it's plausible that they remain, at least in the near term, at a level far beneath the actual rate of inflation and probably beneath a level consistent with domestically-generated inflation pressures being above the target.

So once we get through, I think, the aftermath of a big increase in commodity prices and a substantial increase in VAT, I think it's more likely than not, I wouldn't put it any stronger than that, but more likely than not, that inflation will move back down toward the target level. Now who knows how things will play out, there's plenty of risks that inflation maybe stays above the target level a bit longer then our best guess, an educated best guess that the monetary policy committee makes, but I think there's plenty of chances that actually inflation moves back to the target level even more quickly than the central forecast that the monetary policy committee came up with just a few weeks ago.

Viv:  This is the 14th month in a row that inflation has exceeded the bank's 2% target. In light of this do you think that criticism of the bank in failing to meet its target is justified and more broadly do you think it has implications for the effectiveness of inflation targeting as a monetary policy framework?

Professor David:  I mean it's certainly true that inflation has been above the target level for an uncomfortably long period of time and indeed for longer than the monetary policy committee had thought likely. I think some of the reasons for that are the very sharp further increases in commodity prices over the last six to twelve months. And we've had increases in the VAT rate that almost inevitably would keep the inflation rate high for a period, maybe not permanently, I don't think permanently, but for a period. Some of those things are easy to see in retrospect but if you go back a year or two it wasn't at all clear that one's best guess 18 months ago would have been that commodity prices would have risen as fast as they actually have risen.

Now, that’s an explanation for why the MPC's own past forecasts have been lower than what's actually happened to inflation. I don't think it's an excuse. I hope it doesn't come across as an excuse. I think it is just the inevitable consequence of things happening that are easy to see in retrospect but difficult to forecast in advance.

The key policy question for the Monetary Policy Committee is, given where we are now, given that inflation has been and for a few more months is likely to stay rather significantly above the target level, what's the best policy to bring it back down to the target level? I don't think it makes a great deal of sense to take the 2% target level and say, we must try by any means possible to bring inflation back to that target over the course of three or four months, because in order to do that, one would need to tighten monetary policy on such a scale as to make it likely that you'd push the economy back into a recession.

So the question, I think, is, what's the right way of balancing the risks of inflation staying above the target for sufficiently long that people get used to it and think that's the new normal against, balance that against the risks of tightening monetary policy so rapidly to bring inflation down very quickly, but that causing the rather fragile recovery we've seen already being essentially knocked on the head and the economy going back into a recession.

I think that's a tricky judgment. It's a judgment that it’s my job as being a member of the Monetary Policy Committee to make, and it's a judgment that I wouldn't want to try and forecast in advance what the best thing to do is. The reason we meet every month rather than meet every six months or 12 months is precisely because you get a lot of information from one month to the next which is relevant to judging what the right setting in monetary policy is.

Viv:  Given the UK government's policy of fiscal tightening, do you anticipate any potential tensions between undertaking that whilst at the same time implementing a tighter monetary policy? Could the two together perhaps serve to hinder an economic recovery?

Professor David:  I think, given what had happened to the size of the deficit and the trajectory of the debt result, it's absolutely essential that there be a period of fiscal consolidation. What we do at Monetary Policy Committee is take the fiscal stance that the government has decided on as a given, we'll assume that that's how fiscal policy will be set, and we set monetary policy in the light of that to bring inflation back toward the target level and try and keep it there. I wouldn't say that there was a tension with those things or that was problematic, it's just the natural, if you like, division of labor, if you will, between a government that sets fiscal policy and an independent Monetary Policy Committee that uses monetary policy to hedge an inflation target. I think there are lots of advantages in doing things that way, and I wouldn't say that that caused enormous tensions or difficulties.

Viv:  OK. The second part of your talk deals more directly with banking and regulation. You say that one way to make the banking sector more robust is to have banks use more equity and less debt to finance their activities. Could you expand on this perhaps?

Professor David:  Yes. One of the unusual things, it certainly looks exceptional and extraordinary, and unusual , in retrospect, of the unusual things about the position major banks have got themselves into before we ran into the financial crisis that began in 2007 and got very bad in 2008, was the degree to which they had very high leverage. In other words, many banks were in a situation where they had a huge balance sheet, a very large stock of assets, a very large amount of debt financing that and very little equity. What that means is that, if people become nervous for whatever reason, good reasons or bad reasons, about the value of the assets, since there's very little equity capital in the institution, it doesn't take much of a fall in the value of the assets or, indeed, a perception that there's a risk of a fall in the value of the assets, for the institution to simply run out of capital and to become insolvent. We had let banks get into that situation.

I think in retrospect that was a mistake. Had banks had far more equity, had their leverage been lower, they would have been far more robust institutions and, even if people had become much more nervous about the true value of assets, if the equity buffer had been very much larger, it wouldn't have led people to believe there was a risk about them not getting their money back if they lent money to a bank.

So I think the primary way, to my mind, of having the banks become much more robust so we don't get in a situation again, is that they have a lot more equity. The reason I think that's the natural response is that having banks hold a lot more equity is probably not really that costly a thing to have them do.

Viv:  It's been suggested that extra equity financing and increased capital requirements means that there's actually less money available for lending, but you maintain that the opposite is, in fact, the case.

Professor David:  Yeah, I think there's a bit of confusion here. There's a view that some people have which is that if you have banks use more equity, have higher capital, that somehow this reduces their ability to lend. I don't think that makes much economic sense, to be honest with you. If a bank goes out and raises more equity capital, and it could do that by issuing some new shares or maybe paying out slightly less of its profits in the form of dividends and retaining it, that would be a form of equity financing, if a bank does that, it's got more money to lend, not less money to lend. That's why I think there's a degree of confusion in the vocabulary people sometimes use here, where they give the impression that having banks hold more capital is somehow tying the money up and there's less money available to lend. Actually, I think that pretty much the opposite to the truth.

Viv:  Finally returning to the theme of extraordinary times, you refer several times in your talk to the idea that what we are currently experiencing is clearly not a standard textbook economic cycle. In your view, does this mean that micro‑economic textbooks probably need to be rewritten?

Professor David:  That's a good question, because with my co‑author, Andrew Scott, I'm actually rewriting a micro‑economics textbook that we wrote a few years ago. I think my point there about this being not a standard economic cycle is merely a way of making the following point: That there are occasions where economies go through a natural downswing and growth is a little bit less than average for a while, and then there's an upswing and there's a period where growth is a bit above average, and it sort of evens out. You could call that a textbook economic cycle. There are plenty of occasions in history where that is a perfectly reasonable description of what economies have gone through.

I do not think it is in any way a good description of what we're going through at the moment. Just to come back to the prototypical example of the UK, output fell by around about 6%, GDP fell 6%, in 2009. The level of output is probably now in the UK about 10% below where you might have expected it to be at the beginning of 2007 if you just thought the next three or four years would be typical, average years of growth. So in some sense we've lost 10% of our growth.

I don't think it's particularly likely, I don't think it's likely at all, to be honest with you, that we over the next three or four years have a period of such strong growth that we get back onto the same trajectory where we were on. And if that's right, then you wouldn't be able to describe what we've gone through as a textbook economic cycle. Now, I'm not saying that there aren't such things as textbook economic cycles, my point is merely the simple one that this isn't one of those things.

Viv:  So we've experienced more than just a blip on the landscape?

Professor David:  I think we have experienced more than a blip on the landscape and I think that if you just look at a picture showing the trajectory of GDP, not just in the UKbut for many economies, this doesn't look like just a blip.

Viv:  David Miles, thanks very much for talking to us today.

Professor David:  Thank you very much. 

Topics: Global crisis, Macroeconomic policy, Monetary policy
Tags: capital requirements, financial reform, financial regulation, inflation targeting, interest rates, monetary policy

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