Goodhart, Crockett on UK mortgage rules

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First a brief discussion of what the public purpose might be for the banking sector:

In early American non monetary farming communities the community would come together to build one home at a time until each member had a house. Working together like this was more efficient than building the homes at the same time with only the owner’s family doing the work on his own house.

Individuals had to be willing to defer construction of their home and wait their turn while building a neighbor’s home.

Bank lending serves much the same function- to facilitate deferred consumption and investment across an indefinite period of time. By taking out a mortgage and paying workers to build your house, your getting to use more than your own output while the other workers don’t get to use any of their outputs.

Instead, the workers are satisfied to get paid in funds that they believe they can use in the future to hire you to enact the reverse- they get to then use more than their output of that period of time, and you don’t get to use any of your output in that future period.

Bank lending also serves to facilitate deferred use of output within a given period of time. In non monetary society, workers would work together to produce output in return for a share of that output.

With today’s monetary society, business borrow from banks to pay workers who can not consume the output until it is produced and offered for sale, at which time they can buy their share as represented by the amount they get paid.

That is the essence of the public purpose behind bank lending- to allow for sellers of real goods and services to forgo current use of their outputs in return for future use of other’s outputs.

Additionally, and also as a matter of public purpose, banks serve to facilitate payment in general. This entails safety and accuracy of reporting.

On the basis of public purpose, therefore, I would judge the success or failure of the of banking along the following lines:

Assuming the public purpose of mortgage lending was to promote housing construction and allowing people to move from one house to another, up until 2006 it was a success.

Assuming the public purpose regarding distribution was to grant housing to those who could afford it, this was not the case, as many homes wound up in the hands of owners who could not afford their monthly payments.

After 2006 these results reversed, and public purpose was no longer being served.

While there were several reasons for the sudden fall in the promotion of presumed public purpose, including the discovery of lender fraud and a budget deficit that was too small to sustain aggregate demand, the greatest attention as fallen on the issues and remedies raised by Goodhart, Crockett, and their co authors who recommend the following modifications for the banking system:

  1. Larger down payments
  2. Removal of credit ratings from the ratings agencies
  3. Capital ratios and enforcement

Clearly these measures will not restore new home construction or aggregate demand in general.

Restoring housing construction, output, and employment requires a fiscal adjustment.

So the question is what public purpose is served by these three recommendations.

Larger down payments addresses the distribution issue, and serves to direct housing to those with available funds for down payments.

Removal of credit ratings obtained from the ratings agencies also addresses the distribution issue, as presumably better credit analysis can be obtained by internal analysis and therefore some of those less able statistically to afford housing will be excluded.

Higher capital ratios are a real cost and require banks to raise rates for borrowers to make sufficient returns on equity to attract shareholders. So this is also a distributional issue, as the higher rates again exclude lower income individuals. The same question arises- is this the intended public purpose?

The additional public purpose, and undoubtedly the one given the highest weight by the authors, is the sustainability of the banking system when things go wrong.

These measures do address the sustainability issue of banking, and allow banks to perhaps survive as solvent institutions should aggregate demand again fall. And while they do not prevent the fall of real output when aggregate demand falls, including the rate of construction of new homes, these measures presumably could be instrumental in not allowing a fall of aggregate demand to accelerate as it can do when banks fail to stay open for business.

However, as banks are necessarily pro cyclical as a matter of good business practice, it may matter little whether a bank ceases to stay open for business to fund mortgages and businesses because it is afraid of loss, or whether it ceases to function due to insolvency. This is evident today where even the most solvent banks are acting pro cyclically and have greatly tightened lending standards.

Again, it takes a fiscal adjustment to restore output and employment under current circumstances. And with each passing day the automatic stabilizers grow as transfer payments rise and tax revenue falls, as more jobs and incomes are lost. The federal deficit keeps going up that ugly way until it gets to where it’s large enough to add the net financial assets the private sector needs to again support output and employment.

Any proactive deficit spending will cut this process short. Hopefully we get a fiscal adjustment soon and of sufficient magnitude to reverse the slide.

The more conservative banking practices as outlined by the authors would likely result in fewer bank failures for a given size downturn, and most would agree that less of that type of disruption does serve public purpose.

The question that arises, however is whether requiring more conservative banking practices that result in higher interest rates for borrowers also supports the return of the disintermediation that funds non bank lenders. For example, we are already seeing the return of the wholesale markets including the commercial paper markets, that connect borrowers with lenders who have investors and shareholders that are willing to price risk lower than banks are legally allowed to do and still earn a high risk adjusted rate of return.

So while the authors can surely create a ‘safe and sound’ banking system by legislating a higher price of risk, if they price risk too high, lending will again flow outside the banking system and reintroduce the instability of the business cycle.

To conclude, while I support the measures recommended by Goodhart/Crockett, they do not eliminate the business cycle, but by stabilizing banking and reducing disruptive banking insolvencies they do facilitate the fiscal adjustments needed to continuously sustain output and employment.

Goodhart, Crockett Say Central Banks Should Set Mortgage Rules

by Svenja O’Donnell

Jan 27 (Bloomberg) — Central banks should require mortgage lenders to set a minimum size for loan deposits as part of a package of measures to contain asset bubbles and prevent future financial crises, former policy makers said.

“The epicenter of the financial crisis occurred in the housing market,” economists including former Bank of England policy maker Charles Goodhart and former Bank for International Settlements General Manager Andrew Crockett said in a report. “We advocate the central bank setting maximum loan-to-value ratios for residential mortgages.’

British Prime Minister Gordon Brown says he’s angry at the role banks played in triggering the crisis by writing risky loans, which included mortgages requiring little or no down payment. The suggestions today aim to influence global debate among policy makers about how to rewrite the regulation of banks in areas from lending to capital requirements and pay policies.

“We propose that supervisors should formulate a set of remuneration guidelines,” the economists said. Banking regulators should “adjust capital ratios according to the degree of compliance.”

Other measures suggested include the removal of credit ratings as a formal factor in banking regulation.

“The greater problem is that the ratings provided by (fallible) credit ratings agencies, using fallible models, have been placed at the centre of the regulatory process itself,” the report said.

Capital Ratios

The economists said there’s a need to reform the way regulators set minimum capital ratio requirements for banks, and called for capital level targets which trigger sanctions set by law if they aren’t met.

The report suggests a maximum loan-to-value ratio on mortgages of 90 percent which can be decreased, “should house- price increases appear to be getting out of hand.”

“The boom/bust cycle was exacerbated by the conditions for mortgage lending becoming ever easier in the boom and tightening in the bust,” the authors said. “This was particularly so for loan-to-value ratios.”

Markus Brunnermeier and Hyun Shin at Princeton University and Avinash Persaud of Intelligence Capital also co-authored the report on the reform of financial regulation, published by the Centre for Economics and Policy Research.