Regulation key for central bank bubble fight

Central banks are searching for tools to carry out new responsibilities for tackling asset bubbles at an early stage and are looking at regulatory measures to prevent future financial crises.

Dynamic provisioning of loan losses could become the next buzz phrase while money supply and lending data look set to get more scrutiny. But one weapon missing from the armoury is interest-rate policy, which central bankers think is best reserved for combating any threat of inflation.

Central banks want to use their new regulatory powers to safeguard financial stability and will be especially mindful of the risks posed to this by spiralling asset prices, above all when financed with debt.

"The instrument best suited to maintain financial stability is macroprudential regulation," Vittorio Corbo, a former Governor of the Central Bank of Chile, said in a research paper.

"(It) should have a dual purpose: Reduce the incentives for financial institutions to increase leverage during a boom, and make the financial system more robust during a bust."

The central banks are looking to use new tools separately from monetary policy.

"We need a new, independent policy area, which will be entrusted with this task of the macroprudential oversight and regulation," ECB Governing Council member Axel Weber has said.

Across the Atlantic, New York Fed President William Dudley has similarly said central banks should rely more heavily on regulation in curbing asset prices and Fed Vice President Donald Kohn has warned that "leaning against the wind" -- raising rates to contain asset prices -- would increase inflation and output volatility.

Expanding Tool Chest

Central banks are likely to start looking more at money supply and especially lending data to contain asset prices.

"Certainly central banks will be exercising more caution and exercising more surveillance with asset prices," said Lloyds TSB economist Kenneth Broux.

"Obviously, something went amiss in the way that central banks monitored the level of money supply and credit supply."

And central bankers are making noise signalling a move in that direction.

ECB President Jean-Claude Trichet said last week rapid credit growth like the one that sparked the financial crisis should always set off alarm bells at central banks.

"Too rapid overall credit growth should always be a warning signal for central banks in all advanced and emerging economies," he said.

The planned regulatory powers for central banks prove handy here. Requiring higher capital and lending-to-asset-value ratios would enable central banks to squeeze on credit availability when they see signs of a bubble to stabilise the system.

"It is not just about asset prices, it is about the amount of risk taken in the financial sector," said Nomura economist Laurent Bilke. "This is probably something central bankers can agree on."

The U.S. Federal Reserve and the European Central Bank are set to take a central stake in regulation under reforms currently before legislators, while Britain's government has similar plans for the Bank of England.

Of the four main central banks, only the Bank of Japan -- preoccupied with beating deflation -- has stressed the need to watch asset prices in conducting monetary policy and has no new instruments under consideration for fighting asset bubbles.

Dynamic Provisioning

Central banks could also require "dynamic provisioning" of loan losses, meaning banks would have to book losses against outstanding loans in line with an estimate of long-run expected loss. This aims at impinging on bank profits and balance sheets more evenly across the business cycle than at present -- reducing loan availability in booms and boosting it in busts.

"Dynamic provisioning is the one (rule) that has been most often mentioned," Bilke said.

"It is really a macro tool, it applies to all banks."

Requiring higher down-payments in mortgages could be used to cool demand when housing prices are seen topping fundamentals. This would make it impossible for some prospective buyers to buy a house, capping demand and easing price pressures.

Such a move is in the works in Sweden, where the top financial regulator proposed last month capping mortgages at 85 percent of a property's value in an attempt to curb a booming property market.

Some policymakers want to go further. Bank of England Governor Mervyn King has said higher capital and liquidity buffers might not be enough, and splitting up investment and retail banking could be a better way forward. However, there is no consensus on the issue and splitting up banks remains a controversial issue.

But while adding regulations could be the best option available to curb asset prices, it will not be a silver bullet.

"We cannot know what the next bubble will look like," said Bilke. "But there is going to be another one at some point."

[Source: By Sakari Suoninen, Reuters, Frankfurt, 23Jun10]

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