Financial Stability Needs Credit Creation, Social Optimality
Ensuring greater financial stability may require policy makers to make judgements about the right level of credit in the economy, and about the relative value of different categories of credit created by the banking system, said Adair Turner, chairman of the FSA.
Speaking at a European conference on banking and the economy at Southampton University, Lord Turner said that the financial crisis had partly derived from new features of the financial system, such as trading in complex credit securities and derivatives.
He argued that further regulatory action to address the risks created by these activities was still required. He highlighted further changes to the capital regime for trading activities, and the international Financial Stability Board’s project to identify required actions in relation to “shadow banking”.
But he stressed that banking crises and harmful swings in economic activity can also be produced by volatility in the core functions of the banking system such as extending loans to customers. In the case of the major banks which had failed in the UK, failures in plain old fashioned banking were as important as failures in new trading activities.
Lord Turner said: “Alongside thinking out our response to what was new in the latest crisis, we must ensure that we have thought deeply enough about the drivers of excessive credit growth in the upswing, and the problems created by deficient credit growth in the post-crisis period, and about possible policy responses.”
Lord Turner set out theoretical and empirical reasons that suggest that if credit supply to the economy was left to its own devices it could result in harmful booms and busts in credit extension. He suggests that a combination of static micro-prudential regulation (constant capital and liquidity rules) and interest rate policies cannot be sufficient to ensure the level of credit supplied to sectors of the economy is optimal from a social point of view.
He argues that macro-prudential policy levers, such as those for which the new Financial Policy Committee would be responsible, could therefore be vital in creating the optimal level of credit in the economy.
Lord Turner suggests these tools could include counter-cyclical capital requirements or loan-to-value ratios on mortgages varying over the cycle. While recognising that further detailed design work was required, he argued that it was likely that tools could be developed which would effectively lean against the upswing of credit booms and asset price cycles.
The more difficult question, he suggested, was whether macro-prudential levers could help address the current priority; the need to stimulate the economy rather than to restrain it, or whether macro-prudential policy like interest rates policy was “pushing on a string.”
Lord Turner said: “A crucial issue at this point in the cycle is, therefore, whether macro-prudential policy has a role to play in stimulating rather than constraining credit supply and demand, whether it can be used to ‘push’ as well as to ‘pull’.
“The answer is unclear. But what is clear is that if we are to use macro-prudential policy levers to push, we may need to get far more involved in the details of credit capacity within the economy and even of the sectoral allocation of credit, than we have for several decades.”
Lord Turner concluded: “The fundamental question which I have asked is: how confident can we be that the quantity of credit supplied and demanded will be socially optimal. The answer is not very confident.
“That implies that macro-prudential policy must be based on judgements about the optimal aggregate quantity of credit creation and that we need to consider carefully how far we can and should, make judgements about the economic value of different categories of credit, which in the recent past we have largely avoided.”