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)


jck said...

It seems you are confusing "reserve requirement ratios" on the asset side of a bank balance sheet and "capital requirement ratios" on the liability side.
The central bank of Ireland has no authority to raise reserve requirements, these are set by the Governing Council of the ECB (see Article 19.1 of the Statute of the ECB/ESCB ). On the capital requirement side, the financial regulator has the authority to raise capital requirements. It turns out that in Ireland the CB and the regulator are the same, unlike most countries in Europe (or China), where they are distinct like in Germany with Bundesbank/BAFIN. As for China, the central bank has increased reserve requirements ratio, 22 times since early 2007 (not easy to stop a bubble with reserve requirements ratios...) and the bank regulator (China Banking Regulatory Commission) has threatened several times to increase capital requirements, but not done so yet.

TrueEconomics said...

Thanks for the comment.

Article 19 Minimum reserves

Article 19.1. Subject to Article 2, the ECB may require credit institutions established in Member States to hold minimum reserve on accounts with the ECB and national central banks in pursuance of monetary policy objectives.

Regulations concerning the calculation and determination of the required minimum reserves may be established by the Governing Council. In cases of noncompliance
the ECB shall be entitled to levy penalty interest and to impose other sanctions with comparable effect.

19.2. For the application of this Article, the Council shall, in accordance with the procedure laid down in Article 42, define the
basis for minimum reserves and the maximum permissible ratios between those reserves and their basis, as well as the appropriate sanctions in cases of non-compliance.

Hence, per my reading, ECB sets minimum requirements, so nothing prevents national regulators to raise the bar. This is similar, again IMHO, with the case of MiFID requirements being minimal requirements and allowing countries to expand these above, but not below, MiFID-set conditions.

You are right that I do not explicitly distinguish between reserves held against assets and those held against liabilities. To me, as economist, not accountant, these are second-order distinctions, as balancesheets are always in accounting balance, while financial risks are not.

Again, the above is my interpretation of the Euro zone rules. I doubt if the CBFSAI were to raise minimum reserve requirements on Irish banks, having explained to the ECB the reason for such action, would have encountered resistance from the ECB in doing so.

jck said...

I understand your logic, but I believe this rules it out: [regarding setting reserve requirements by the ECB] "...whereas this implies, inter alia, the principle of not inducing significant undesirable delocation or disintermediation; whereas the imposition of such minimum reserves may constitute an element of the definition and implementation of the monetary policy of the Community, being one of the basic tasks of the ESCB as specified in the first..." (Council Regulation (EC) No 2531/98 concerning the application of minimum reserves by the ECB). Even if the ECB had allowed it and I doubt it (there is scope for gaming this and getting "undesirable delocation or disintermediation" ), reserve requirements don't work well at stopping bubbles as seen in the China case.
The financial regulator had room to increase capital requirements (but again scope for gaming i.e more securitisations for ex.).
Perhaps the Irish authorities could have regulated the mortgages market better by imposing some minimum deposits for borrowers, you would be very hard pressed to find 100% mortgages in Germany, France or Italy and many other countries, so there is a failure of regulation here, and that can be solved without involvement from the ECB.
The reason I pointed the difference between reserve requirements and capital requirements is that usually these are controlled by different entities i.e central banks and bank regulators,and while the central bank can provide liquidity and add/adjust reserves, this impacts the asset side of commercial banks balance sheet, but the central bank can do nothing regarding the liability side (capital), so the accounting distinction matters.

TrueEconomics said...

I agree.

The issue is - they never tried to do anything about the credit pump. The problem wasn't the introduction of specific product, although the solution should have also involved some regulation of product suitability etc. The issue was that the Irish banks hoovered liquidity in loose credit markets of Euro zone and hosed it blindly onto Irish economy in hope that somehow, some of it will yield a return.

The first point of call on this road for a regulatory body would have been to test rules to restrict credit inflows. After that, deal with product regulation. None were even attempted. And after that we have:

Just as my reference to a conversation with John Hurley was to point that our CBFSAI was concerned about political fallout from, allegedly and statutorily (de jure) politically-independent monetary authority.

Let's remember:

"The Minister for Finance, Mr Brian Lenihan, TD, announced today that the Government will request President McAleese to re-appoint the current Governor of the Central Bank, Mr. John Hurley, on the completion of his term of office in March of this year.

The Minister for Finance stated that he was anxious that the Governor would continue in office over the coming months to ensure continuity and leadership during the current disruption in financial markets.


8 January 2009"

Unknown said...

What????....Do you mean to imply that the Governor of the Central Bank was nothing more than a political hack!! Say it ain't so.....say it ain't so......

Cormac Lucey said...

The authorities could also have changed the rules of the game by making future mortgage debt non-recourse in nature.

By shifting a large portion risk from borrowers to banks this might have drawn the banks' attention and that of their funders to the growing risks they were then taking by lending to an already overextended residential property market.