Sunday, December 5, 2010

Economics 5/12/10: Reserves requirement ratio

In response to the following tweet:

"A question. You wrote here that the decision of the Chinese government to raise reserve requirement ratio for the commercial Chinese banks in order to cut down on their lending as "monetary tightening".

According to this article by Phillippe Legrain

The Republic of Ireland could have taken similar measures during the past decade to cool down the property bubble but didn't.

I thought after European monetary union, a monetary option wasn't open any more to the Republic of Ireland.

Yet what you described as "monetary tightening" in China was possible in the Republic of Ireland according to Phillippe Legrain."

My view on the topic: Legrain is correct.

As a member of the Euro zone, Ireland retained full control over one of the tools of monetary policy, known as 'reserve requirement ratio' - or capital requirement ratio. Irish regulators (CBFSAI) has a full right to increase requirement on the banks operating in Ireland to hold the proportion of their deposits and/or proportion of their loans in reserves as capital to cover any expected losses.

Such an increase in the ratio would have reduced amount of credit available in the system and would have offset the dramatic increase in lending spurred on by the introduction of higher risk products such as 100% mortgages.

At a dinner event in 2006 I told, at the time, Governor of the Central Bank of Ireland that this is exactly what he needed to do to cool down the market for mortgages lending in the Republic. His reply was along the lines that this was politically impossible to do.

That this lever of policy is still available to Ireland is best illustrated by the two recent decisions by the new Financial Regulator to hike capital requirement ratios for Irish banks to 8% Tier 1 and most recently to 12%. Unfortunately, this decision came too late.

Were Irish banks required by the CBFSAI to hold, say 12% of their risk-weighted assets in form of capital, the taxpayers would have seen their total exposure to the banking crisis significantly reduced. Instead of ca €16.2 billion in capital available to cover writedowns against the total lending of €360 billion across our banking institutions, our banking system would have had ca €34-35 billion in capital cushion against lending of €280-290 billion. (Note: these are back of the envelope calculations, but they still show the impact of raising reserve requirement ratios).

PS: for those of you who missed an excellent PIMCO note on Irish situation and EU's 'solution', here's a link. (Hat tip to Georg)
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