Financial Policy Committee Must Tread Delicate Path on New Bank Capital Rules

Mervyn King

The Bank of England makes a telling point in its lengthy document to discuss the new powers it will soon have to force banks to hold more capital if it sees potentially dangerous bubbles being created in the economy.

Had the Spanish and Irish authorities forced banks to hold more capital against property lending in the runup to the 2008 crisis – when around 20% of each country's GDP was reliant on the construction industry – the slowdown in economic growth that would have occurred would have been small compared to the "very severe effects" that were caused by the credit crunch. In the event, Ireland needed a sovereign bailout, Spain a bailout of its banks.

It is an argument that the Financial Policy Committee inside the Bank of England is going to need to deploy and adapt as and when it begins to use the two new tools it will be handed. Set up by the coalition to try to spot potential blow-ups in the financial system before they become as damaging as the 2007 credit crunch, the FPC is to have a countercyclical capital buffer (CCB) to force banks to build up capital during the good times which can be burnt through in the bad times. This CCB is being introduced through new international Basel rules. The second sectoral capital requirement (SCR) will allow policymakers to increase bank capital cushions against certain sectors, such as commercial property. Legislation currently going through parliament means this power may be handed to the FPC by the time of its next meeting in June. It gives an example for the mortgage sector where it could increase the capital requirements against high loan-to-value deals or loan-to-income measures to "lean against exuberance in specific subsectors".

The use of such powers could be potentially explosive, preventing would-be homeowners securing a mortgage which could force politicians to incur the wrath of the electorate.

It could also have an impact on growth. The science is not precise but a rule of thumb is that one percentage point increase in capital requirements forces up the cost of borrowing by as much as 25 basis points – a quarter of a percentage point – but lead to a decline in bad loans. GDP could be reduced as much as 35 basis points.

The FPC – which will be chaired by Bank of England governor Sir Mervyn King for the last time in June before Mark Carney arrives – will be treading a delicate path and clear explanations of why decisions have been taken will be needed. With that in mind, for the first time the FPC has published a grid of the 17 indicators it will consider – ranging from a bank's core tier one capital ratio to spreads on UK lending – before requiring banks to add or release capital in their countercyclical buffer.

The Bank notes that "the probability of a future systemic financial crisis cannot be readily observed" so the use of the 17 indicators will be a skill which needs to be honed over time. A watchful eye will also need to kept on the firms which fall outside the new rules – which only cover banks, building societies and the largest investment firms.

It marks a dramatic change and one that may well be the cause of much controversy. An illustration of the changes afoot can already be found in the market for interest-only mortgages. Demands by the regulators that the ability of customers to pay back loans before approving the mortgages has sounded the death knell for such home loans. Unpopular with some. But it could be just the beginning of the potential impact of new regulatory regime.

Powered by Guardian.co.ukThis article was written by Jill Treanor, for guardian.co.uk on Monday 14th January 2013 15.34 Europe/London

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image: © Bank of England

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