Never a right moment for central bank to step in

No bank ever made a loan it did not believe would be repaid.

But as the economic and financial cycle matures, lending standards tend to decline. Borrowers stretch themselves, and banks interpret standards more flexibly to accommodate them. The result is that late-cycle loans are more likely to default than those advanced in earlier years.

Now the Bank of England is betting that its new suite of macro-prudential policies can smooth the credit cycle by counteracting the forces that cause lending standards to deteriorate. Maintaining prudent lending standards is at the heart of the Bank’s “low for long” interest rate strategy for reviving Britain’s economy while mitigating the risks of a housing bubble.

The Bank has warned that it could direct lenders to hold more capital and will insist that they check that borrowers will be able to repay even if interest rates rise.

Maintaining underwriting standards is also essential for safely reviving the market for securities backed by mortgages and other assets, as the Bank’s executive director for financial stability Andy Haldane told the Financial Times in a recent interview.

But the Bank may be placing too much faith in its ability to tame the credit cycle. Lending standards are endogenous. The Bank is likely to have no more success in preventing them from deteriorating than it has had in taming other aspects of the boom-bust cycle.

That is no reason not to try. But it is a reason to be cautious about what the macro-prudential policies can achieve, and in particular whether the Bank can rely on them to avoid a destabilising run-up in house prices, other asset values and lending, while it keeps interest rates at historically low levels to support the recovery.

Consider a stylised description of the lending and economic cycle. In the first few years after a recession, lending standards are tight, asset valuations are low and potential borrowers remain chastened by the recent downturn. Loan volumes are low, and the quality of most new loans is high.

But after a few years asset values rise, borrowers become much more optimistic about their ability to repay, and loan standards tend to ease as lenders compete to win business. Loan amounts become much larger, and the average quality of the credit falls.

The endogenous nature of the credit cycle was brilliantly described in Hyman Minsky’s book, “Stabilising an unstable economy”, which became justly famous after the financial crash for its description about why a long period of calm sows the seeds of its own destruction.

The Bank of England believes it can avert the problem in future by interposing its macro-prudential policies into the middle of this process to prevent standards from slipping. But how realistic is it to expect the Bank will act in a timely manner to stem excessively risky lending?

In his Financial Times interview, Haldane promised the Bank would act “sooner rather than later” to forestall the dangerous build-up of debt in sections of the population. “We are popping (bubbles), not mopping (them up afterwards), which means getting on the front foot when risks are building and before they are full built,” he said.

In effect, the Bank will be substituting its own judgement about what constitutes a prudent loan for those of individual banks and borrowers. Some borrowers who would otherwise receive a loan will have to be told they cannot have one, because it would breach standards set by the Bank.

Some lenders who would otherwise be willing to advance credit will be told they cannot do so, because it does not comply with guidance and regulations set by the central bank. The Bank believes it can spot imprudent lending better than the commercial banks or the rating agencies.

But like its counterparts around the world, the Bank was not noticeably successful at identifying the build-up of risks before the financial crisis.

Is it any more likely to identify them and take effective action in future? And there are enormous economic and political risks in trying to spot and pop bubbles in real time, as most central bankers have acknowledged.

In 2010, the Federal Reserve Bank of Kansas City published a slim but deeply insightful volume about banking supervision in the US during the 1980s and 1990s entitled, “Integrity, Fairness and Resolve”.

Of these three qualities, resolve is always in shortest supply among bank supervisors. To be effective, regulators must often take unpopular decisions and face down powerful vested interests among lenders and borrowers, who are also voters and lobbyists with the ear of politicians.

In a boom, central bankers typically delay interest rate increases, in part because of the risk of causing the economy to stall and in part because they are deeply unpopular with powerful politically connected groups. It is easier to dismiss signs of a bubble as “froth” and find rationalisations for “irrational exuberance”.

The Bank will face precisely the same problems when it tries to deploy its macro-prudential toolkit. Enforcing lending standards will mean denying first-time buyers a mortgage or making it harder for a company to complete a corporate takeover. The pressure not to tighten lending standards will be enormous.

Britain’s politicians have already successfully pressed the Bank not to require the commercial banks to hold even more capital because it could restrict lending.

Efforts to force homebuyers to put up more equity before taking out a mortgage have already been reversed, even though it is widely accepted that in the run-up to the financial crisis, borrowers overstretched themselves and loan-to-valuation ratios got very high, in some cases over 100 per cent.

Following intense pressure from house-builders, politically important first-time buyers and homeowners with negative equity, politicians have offered a government guarantee for loans up to 95 per cent of the property’s valuation in order to revive the housing market.

In theory, the Bank has pledged to take tough decisions. But its resolve remains untested. Past experience suggests it will struggle to be bold enough and face down the pressure to let lending standards ease as the cycle proceeds.

Even if the Bank has the courage to take unpopular decisions, commercial banks, borrowers and the real estate industry will appeal over the heads of supervisors to the politicians.

“It is ... important that banks don’t leave conversations with the supervisors and feel that the next step is to telephone (the Treasury) or even (the Prime Minister’s office) and lobby officials or politicians to put pressure on supervisors to back down,” Mervyn King, then governor of the Bank of England, told the House of Commons Treasury Committee in June 2013.

In the past, the Bank has sometimes appeared to hesitate before raising interest rates because of the possible fallout.

Will it really find it easier in future to instruct banks to cut their maximum loan-to-value ratios or hold more capital when the results will be much the same? Just as with monetary policy, the Bank will produce beautifully illustrated reports and give thoughtful speeches detailing the risks to financial stability, and then hesitate, arguing the risks are not yet fully understood, have not crystallised or might go away on their own.

By the time the Bank acts, it will almost certainly be too late.

— Reuters