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Symposium 2011

Proposal - Macroprudential policy must curb excessive use of debt in the economy and in the financial system, taking account of various manifestations of excessive debt

The Challenge

The global financial crisis has revealed how systemic risk in the banking system can lead to huge economic downturns. Many of the problems leading to the crisis have been discussed and many suspects h ...

The global financial crisis has revealed how systemic risk in the banking system can lead to huge economic downturns. Many of the problems leading to the crisis have been discussed and many suspects have been identified (including investment banks, central banks, rating agencies, regulators and the economics profession).

The key reasons for most financial crises are excessive growth in assets and excessive debt, which, in essence, are the different sides of the same coin.

In the recent crisis, in addition to the mortgage boom in many countries, especially in the US, the excessive use of short-term debt within the financial sector itself turned out to be the most dangerous form of debt. At the same time, effectively very thin equity buffers were allowed in the banking sector. The true fragile state of the financial system was then largely missed by the authorities and investors.

The crisis experience hence suggests that particular attention must be paid to banks’ non-core liabilities (that is, liabilities of intermediaries held by other intermediaries, such as short term market-based debt instruments). As a related matter, the network of short-term inter-bank debt exposures must be better monitored and analysed. This is because for a given level of inter-bank debt, its distribution among banks may have implications for the degree systemic risk in the network.

However, most of the recent and forthcoming regulatory changes focus almost exclusively on improving the loss absorbency of financial institutions. This, although necessary, is inadequate in achieving a stable financial system. We must also have effective regulatory tools to contain excessive asset growth and excessive use of debt in its different forms.

We need policy tools that explicitly aim to slow down excessive lending and leverage during a boom. Well-known examples of such tools are the loan-to-value (LTV) and debt-to-income (DTI) caps on household borrowing. These measures addressing excessive household borrowing should be included in macroprudential authorities´ toolkits.

The research community should also examine the costs and benefits of such macroprudential tools that directly address banks´ excessive short non-core funding. One potential tool is a levy or tax on banks´ non-core liabilities. This tool, as argued by Shin (2010) , has many desirable features. In particular, it acts as an automatic stabiliser as the levy bites hardest during a boom, when non-core liabilities are large. Second, it is also likely to curb excessive bank lending, as a fast increase in lending is often funded by a sharp increase in non-core funding.

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