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Macroprudential policy Risky business

 THE new big hope of central banks is called macroprudential policy. During the boom, central banks used the fairly blunt instrument of interest rates as their main weapon. But since inflationary pressures were low, thanks to the deflationary shock stemming from China and eastern Europe, rates were kept low. This led to a splurge of asset-backed lending. Meanwhile, banks found easy ways to exploit the rules of the Basle accords – designed to ensure the system was well-capitalised. As a result, when mortgage-backed securities started to plunge in value in 2007, the banks were much less robust than was previously thought.

The Bank of England has set up a financial policy committee, which is just starting the arduous task of sorting out which principles it should follow and which policy buttons it can push. In a paper out today, it sets out its options. It starts by discussing the potential flaws in financial markets such as

incentive distortions which can, for example, arise from contracts that reward short-term performance excessively

informational distortions such as those linked to buyers doubting the quality of assets (adverse selection) or less than fully rational processing of information

co-ordination problems, where collective action, for example to step away from lending in a boom, may be in the interests of individual banks but there is no way to co-ordinate on this outcome

As the paper points out (and as Hyman Minsky famously noticed) there is a tendency for banks to get overexposed to risk in the upswing of a credit cycle. After all, it is the banks that are driving the cycle. As they become more confident about lending against assets, more funds are available to investors/speculators and asset prices rise, increasing the confidence of all involved. As a proportion of GDP, commercial lending to real estate doubled between 2002 and 2008. In the UK banking system, leverage (as measured by total assets to shareholders’ claims) increased from 20:1 to 50:1 within a decade. Both measures ought to have caused alarm but nothing was done.

There is little new in this, as the paper recognizes. Credit cycles have nearly always been marked by lending against property. But property is an illiquid market and prices fall very sharply when the balance of supply and demand shifts, often wiping out of all of a bank’s collateral. Meanwhile, the duration of bank funding was steadily falling, from an average maturity of 10 years in the early 1980s to four years by 2008 (the US followed a similar trajectory). This left the banks very vulnerable to a run on liquidity.

The FPC says the authorities have, in principle, three types of measure to deal with these risks.

those that affect the balance sheets of financial institutions

those that affect the terms and conditions of loans and other financial transactions

those that influence market structures

For example, balance sheet measures include maximum leverage ratios and liquidity buffers; the second group includes caps on loan-to-value ratios and minimum margins; the third includes requirements for disclosure to reduce uncertainty about the market exposure of individual banks, but also the use of central counterparties to clear trades.

The paper then conducts an excellent and clear-eyed assessment of the pros and cons of these measures, without coming to any definite conclusion (the paper is part of a consultation process). What is clear is that the authorities cannot rely on just one or two measures, esepcially given the proved willingness of banks to game the system. Of course, the authorities cannot prevent all future financial crises, but they can still be a lot more alert than they were in the early 2000s. The paper shows the FPC is making a good start.

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Iran nuclear crisis: Sanctions ‘beginning to bite’

Iran nuclear crisis: Sanctions ‘beginning to bite’

The US has said threats by Iran to restrict Gulf shipping in the event of further sanctions shows international pressure is having an effect.

The State Department said sanctions on Tehran over its nuclear programme were starting to bite and that Iran was trying to create a distraction.

Iran has conducted 10 days of exercises near the strategically vital Strait of Hormuz, test-firing several missiles.

Its currency is at a record low, but it has denied sanctions are to blame.

The UN Security Council has already passed four rounds of sanctions against Iran for refusing to halt uranium enrichment.

Highly enriched uranium can be processed into nuclear weapons, but Iran denies Western charges that it is trying to develop them.

Tehran says its programme is peaceful – it needs nuclear technology to generate electricity to meet growing domestic demand.The US has also sanctioned dozens of Iranian government agencies, officials and businesses over the nuclear programme.

The government in Tehran has dismissed the latest measures announced in the wake of a critical IAEA report in November.

US President Barack Obama signed into law the US bill targeting Iran’s central bank on Saturday. It enters into force in six months’ time.

Since then, however, the Iranian national currency, the rial, has lost about 12% of its value – trading at about 17,200-18,000 rials to $1.

Earlier on Tuesday, French Foreign Minister Alain Juppe called for “stricter sanctions” and urged EU countries to follow the US in freezing Iranian central bank assets and imposing an embargo on oil exports.
‘Mock’ exercises

Speaking to journalists, the State Department’s Victoria Nuland said Tehran was feeling increasingly isolated because of the sanctions.

“Frankly we see these threats from Tehran as just increasing evidence that the international pressure is beginning to bite there and that they are feeling increasingly isolated and they are trying to divert the attention of their own public from the difficulties inside Iran, including the economic difficulties as a result of the sanctions,” she said.

Meanwhile Pentagon spokesman George Little responded to Iranian warnings to keep an aircraft carrier out of the Gulf, saying the Navy was operating within international law and had no plans to pull warships out of the region.Iran has been holding a series of naval exercises in the Gulf, and on Monday

said it had successfully test-fired a surface-to-sea Qader cruise missile, a shorter range Nasr and later, a surface-to-surface Nour missile.

A medium-range surface-to-air missile was successfully launched on Sunday, Iranian media reported.

Iran has conducted 10 days of exercises near the Strait of Hormuz, through which 20% of the world’s traded oil passes.

Tehran said on Monday that “mock” exercises on shutting the strait had been carried out, although there was no intention of closing it.

The BBC’s Iran correspondent James Reynolds says Iran is using the exercises to try to show that it owns the Gulf and has the military capability to defend against any threat to its dominance.

But, says our correspondent, few believe Iran would carry out its threat to shut the Strait of Hormuz as to do so would be considered too economically, politically and possibly militarily damaging for Tehran.

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