Smoothing out the boom bust cycles
Below is a very informative video from the Reserve Bank of New Zealand about smoothing out the boom bust cycles in the New Zealand economy. There are some notes that follow which have been edited from the transcript.
Objectives macro prudential policy.
- To build resilience of the financial system so that it can cope with the business cycle if it turns from boom to bust.
- To be proactive in dampening the risk to begin with. This could include dampen the growth of credit, house prices or other asset prices. An example of this was in New Zealand in the late 1980’s – share market crash and the plunge in commercial property prices.
Macro Prudential Tool Kit – 4 Tools
1. Counter-cyclical capital buffer
This is where the banks are required to hold an extra margin of capital during the boom part of the cycle so that if the boom turns to bust the banks have an extra margin of capital that they can then call on to meet loan losses.
2. Sectorial capital overlay
This is very similar to a counter-cyclical capital buffer but it is about holding extra capital against a particular sector that the banks might be leaning to, for example the household sector, the farming sector, or potentially the commercial property sector.
3. Loan to value ratio for residential housing lending
This is a limit on the amount of high loan to value ratio lending or low deposit lending that the banks are able to do for the household sector. High LVR lending potentially fuels rapid house price growth and so that might be another reason why you would use that particular instrument.
4. Core funding ratio
This is a tool that has been a permanent fixture for the banks. There are a number of reasons why the core funding ratio might change. Potentially if the banks are facing an increase in risk, the Reserve Bank could require them to hold more core funding, funding that would be more likely to remain in the system during a downturn. By holding more of that stable funding, they’d be less likely to stop lending in a downturn because the funding would remain in the system.
Boom bust cycles are cycles in the economy and in the financial system are of course a fact of life. Macro-prudential policy certainly won’t prevent those cycles from occurring. What it will do is provide some cushioning to the cycle. It will hopefully clip the highs and the lows to some extent so that the flow of credit and the flow of financial services in the economy continue through time. It’s not about preventing the cycle or dampening it completely. It’s about taking some of the extremes out of the cycle.