Following the banking crisis of 2007/8 a new set of international banking regulations was agreed in 2010 by the Basel Committee on Banking Supervision. The purpose was to strengthen banks’ capital base. Under ‘Basel III’, banks would be required, in stages, to meet specific minimum capital adequacy ratios: i.e. minimum ratios of capital to (risk-weighted) assets. The full regulations would come into force by 2019. These are shown in the chart below.
The new Financial Policy Committee of the Bank of England has judged that some UK banks have insufficient ‘common equity tier 1 capital’. This is defined as ordinary shares in the bank plus the bank’s reserves. According to the Bank of England:
… the immediate objective should be to achieve a common equity tier 1 capital ratio, based on Basel III definitions and, after the required adjustments, of at least 7% of risk-weighted assets by end 2013. Some banks, even after the adjustments described above, have capital ratios in excess of 7%; for those that do not, the aggregate capital shortfall at end 2012 was around £25 billion.
Thus the banking system in the UK is being required, by the end of 2013, to meet the 7% ratio. This could be done, either by increasing the amount of capital or by reducing the amount of assets. The Bank of England is keen for banks not to reduce assets, which would imply a reduction in lending. Similarly, it does not want banks to increase reserves at the expense of lending. Either action could push the economy back into recession. Rather the Bank of England wants banks to raise more capital. But that requires sufficient confidence by investors.
And the end of this year is not the end of the process. After that, further increases in capital will be required, so that by 2019 banks are fully compliant with Basel III. All this will make it difficult for certain banks to raise enough capital from investors. As far as RBS and the Lloyds Banking Group are concerned, this will make the prospect of privatising them more difficult. But that is what the government eventually wants. It does not want the taxpayer to have to find the extra capital. Re-capitalising the banks, or at least some of them, may prove difficult.
The following articles look at the implications of the FPC judgement and whether strengthening the banks will strengthen or weaken the rest of the economy.
Articles
Financial policy committee identifies £25bn capital shortfall in UK banks The Guardian, Jill Treanor (27/3/13)
Banks Told To Raise Capital By Financial Policy Committee To Cushion Against A Crisis Huffington Post (27/3/13)
UK banks’ £25bn shortfall: positive for banks, negative for BoE credibility, Sid Verma (27/3/13)
Doubts over Bank of England’s £25bn confidence game The Telegraph, Harry Wilson (27/3/13)
Bank of England tells banks to raise £25bn BBC News (27/3/13)
Q&A: Basel rules on bank capital – who cares? Laurence Knight (13/9/10)
U.K. Banks Seen Avoiding Share Sales After BOE Capital Review Bloomberg Businessweek, Gavin Finch and Howard Mustoe (27/3/13)
Banks Cut Basel III Shortfall by $215 Billion in Mid-2012 Bloomberg (19/3/13)
Will strengthening banks weaken the economy? BBC News, Robert Peston (27/3/13)
Bank of England News Release
Financial Policy Committee statement from its policy meeting, 19 March 2013 Bank of England (27/3/13)
Questions
- Explain the individual parts of the chart.
- What do you understand by risk-weighted assets?
- Distinguish between capital adequacy ratios and liquidity ratios.
- What could the banks do to increase their capital adequacy ratios? Compare the desirability of each method.
- If all banks around the world were Basel III compliant, would this make another global banking crisis impossible?
With many countries struggling to recover from the depression of the past few years, central banks are considering more and more doveish moves to kick-start lending. But with short-term interest rates in the USA, the UK and Japan close to zero, the scope for further cuts are limited. So what can central banks do?
The first thing that can be done is to adopt a higher inflation target or to accept inflation above target – at least for the time being. This could be accompanied by explicitly targeting GDP growth (real or nominal) or unemployment (see the blog from last December, Rethinking central bank targets).
The second option is to increase quantitative easing. Although in a minority at the last MPC meeting, Mervyn King, the current Bank of England Governor, argued for a further £25 billion of asset purchases (bringing the total to £400bn) (see MPC minutes paragraph 39). It is highly likely that the MPC will agree to further QE at its next meeting in March. In Japan, the new governor of the Bank of Japan is expected to include asset purchases as part of the policy of monetary easing.
The third option is for the central bank to provide finance at below-market rates of interest directly to the banking sector specifically for lending: e.g. to small businesses or for house purchase. The Bank of England’s Funding for Lending Scheme is an example and the Bank is considering extending it to other financial institutions.
One other approach, mooted by the Bank of England’s Deputy Governor before the House of Commons Treasury Select Committee, is for negative interest rates paid on Banks’ reserves in the Bank of England. This would, in effect, be a fee levied on banks for keeping money on deposit. The idea would be to encourage banks to lend the money and not to keep excessive liquidity. As you can see from the chart, three rounds of quantitative easing have led to a huge increase in bank’s reserves at the Bank of England. (Click here for a PowerPoint of the chart.)
The following articles consider these various proposals and whether they will work to stimulate lending and thereby aggregate demand and economic recovery.
Central banks: Brave new words The Economist (23/2/13)
Phoney currency wars The Economist (16/2/13)
Analysis: Global central banks will keep taking it easy Reuters, Alan Wheatley (22/2/13)
Quantitative easing: the markets are struggling with a serious drug habi The Guardian, Larry Elliott (24/2/13)
Negative interest rates idea floated by Bank’s Paul Tucker BBC News (26/2/13)
Bank of England mulls negative interest rates Independent, Ben Chu (26/2/13)
BoE floats extending Funding for Lending to non-banks Mortgage Solutions, Adam Williams (26/2/13)
Funding for Lending Scheme failing to get banks lending Left Foot Forward, James Bloodworth (26/2/13)
Mortgage market boosted by lending schemes, says Redrow BBC News (26/2/13)
Widespread quantitative easing risks ‘QE wars’ and stagnation The Guardian, Nouriel Roubini (28/2/13)
Questions
- Consider each of the methods outlined above and their chances of success in stimulating aggregate demand.
- Go through each of the methods and consider the problems they are likely to create/have created.
- How important is it that monetary policy measures affect people’s expectations?
- What effects do the measures have on the distribution of income between borrowers and savers?
- What are annuities? How are these affected by policies of monetary easing?
- How has actual and anticipated Japanese monetary policy affected the exchange rate of the Japanese yen? How is this likely to affect the Japanese economy?
- Explain the sub-heading of the final article above, “When several major central banks pursue QE at the same time, it becomes a zero-sum game”. Do you agree?
At present, the Bank of England has an inflation target of 2% CPI at a 24-month time horizon. Most, other central banks also have simple Inflation targets. But central bankers’ opinions seem to be changing.
Consider four facts.
1. Many central banks around the world have had record low interest rates for nearly four years, backed up in some cases by programmes of quantitative easing, officially in pursuit of an inflation target.
2. The world is mired in recession or sluggish growth, on which monetary policy seems to have had only a modest effect.
3. Inflation seems to be poorly related to aggregate demand, at least within an economy. Instead, inflation in recent years seems to be particularly affected by commodity prices.
4. Success in meeting an inflation target could mean failure in terms of an economy achieving an actual growth rate equal to its potential rate.
It’s not surprising that there have been calls for rethinking monetary policy targets.
There have recently been two interesting developments: one is a speech by Mark Carney, Governor designate of the Bank of England; the other is a decision on targets by the Fed, reported at a press conference by Ben Bernanke, Chairman of the Federal Reserve.
Mark Carney proposes the possible replacement of an inflation target with a target for nominal GDP (NGDP). This could be, say, 5%. What is more, it should be an annual average over a number of years. Thus if the target is missed in one year, it can be made up in subsequent years. For example, if this year the actual rate of nominal GDP growth is 4%, then by achieving 6% next year, the economy would keep to the average 5% target. As Stephanie Flanders points out:
Moving to nominal GDP targets would send a signal that the Bank was determined to get back the nominal growth in the economy that has been lost, even if it is at the cost of pushing inflation above 2% for a sustained period of time.
In the USA, Ben Bernanke announced that the Fed would target unemployment by keeping interest rates at their current record lows until unemployment falls below a threshold of 6.5%.
Until recently, the Fed has been more flexible than most other central banks by considering not only inflation but also real GDP when setting interest rates. This has been close to following a Taylor rule, which involves targeting a weighted averaged of inflation and real GDP. However, in January 2012, the Fed announced that it would adopt a 2% long-run inflation target. So the move to targeting unemployment represents a rapid change in policy
So have simple inflation targets run their course? Should they be replaced by other targets or should targeting itself be abandoned? The following articles examine the issues.
Articles
UK
Mark Carney hints at need for radical action to boost ailing economies The Telegraph, Philip Aldrick (11/12/12)
George Osborne welcomes inflation target review The Telegraph, Philip Aldrick and James Kirkup (13/12/12)
Monetary policy: Straight talk The Economist, R.A. (12/12/12)
New Bank of England governor Mark Carney mulls end of inflation targets The Guardian, Larry Elliott (12/12/12/)
Carney’s trail of carnage Independent, Ben Chu (12/12/12)
Mark Carney suggests targeting economic output BBC News (12/12/12)
A new target for the Bank of England? BBC News, Stephanie Flanders (14/12/12)
Should the UK really ditch inflation target? Investment Week, Katie Holliday (14/12/12)
BoE economist Spencer Dale warns on Mark Carney’s ideas The Telegraph, Philip Aldrick (12/12/12)
USA
Ben Bernanke Outlines Fed Policy for 2013 IVN, Alex Gauthier (14/12/12)
Fed gives itself a new target BBC News, Stephanie Flanders (13/12/12)
Fed to Keep Easing, Sets Target for Rates CNBC, Jeff Cox (12/12/12)
Bernanke calls high unemployment rate ‘an enormous waste’ Los Angeles Times, Jim Puzzanghera (12/12/12)
Think the Fed has been too timid? Check out Britain and Japan. Washington Post, Brad Plumer (13/12/12)
Inflation Targeting is Dead, Long Live Inflation! The Market Oracle, Adrian Ash (14/12/12)
Speech and press conference
Guidance Bank of Canada, Mark Carney (11/12/12)
Transcript of Chairman Bernanke’s Press Conference Federal Reserve Bank, Ben Bernanke (12/12/12)
Questions
- Which of the following would meet an NGDP target of 5%: (a) 5% real growth and 0% inflation; (b) 5% real growth and 5% inflation; (c) 5% inflation and 0% growth?
- What are the main arguments in favour of an NGDP target?
- What factors would need to be taken into account in deciding the target rate of NGDP?
- What are the main arguments against an NGDP target?
- Is it possible to target two indicators with one policy instrument (interest rates)? Explain.
- Explain what is meant by Taylor rule?
- Is having an unemployment target a type of Taylor rule?
- Why may the rate of inflation (whether current or forecast) be a poor indicator of the state of the real economy?
The story of the UK economy over the past few years has been one of bad news and worse news. With a double-dip recession having kept confidence low in the UK, positive news for the economy was seemingly a distant hope of government ministers. However, official statistics show that that in the 3 months from July to September, the UK economy emerged from recession, with growth of 1.0%.
This positive GDP figure (click here for a PowerPoint of the chart below) was undoubtedly helped by the London Olympics over the summer, which may have added as much as 0.2 percentage points to GDP, according to the ONS. Millions arriving in London and other venues, spending money on countless things. Yet, other factors have also contributed to this welcome growth. Stephanie Flanders said:
The positive ‘surprise’ in these figures is largely to be found in the service sector, which is estimated to have growth by 1.3% in the third quarter, after shrinking by 0.1% in the three months before.
Further to this, in Stephanie Flanders’ ‘Stephanomics’, she says that ‘it confirms that the last three months of this latest recession were brought to you by the Queen. Or at least, the extra Bank Holiday to celebrate her Jubilee.’ The Bank of England suggests that the Jubilee took 0.5 percentage points from official GDP statistics. So, the news so far is positive, but the economy is far from being back to its pre-recession size.
The 2008-2009 recession knocked 6.4% off the UK economy. Since then, the total growth (over the past 4 years) has reached only half of that – 3.2% and that includes the 1% figure just published. Thus, while we may be on ‘the right track’, there is still a long way to go. Economists differ in their interpretations of what this means for the overall recovery: some say that this is a sign of what’s to come; others argue that this recovery has been driven by one-off factors.
What is certain is that government policy over the next few months will be crucial in keeping the economy on the right growth path. The following articles consider the implications of this new economic data.
A special recovery BBC News, Stephanomics, Stephanie Flanders (25/10/12)
UK GDP rises 1pc: economist reaction The Telegraph (25/10/12)
Nick Clegg warns economic recovery will be ‘fitful’ The Guardian, Daniel Boffey (28/10/12)
GDP figures set to show UK economy has exited double-dip recession The Telegraph, Philip Aldrick, Emma Rowley and Jessica Winch (25/10/12)
UK economy returns to growth with help from Olympics BBC News (25/10/12)
U.K. posts quarterly gain in GDP, lifted by Olympics Wall Street Journal, Cassel-Bryan Low (25/10/12)
GDP figures show UK emerging from recession: full reaction The Guardian (25/10/12)
UK growth signals move out of recession Financial Times, Sarah O’Connor and George Parker (25/10/12)
Questions
- How do we define a recession?
- How is GDP calculated and what does it measure?
- Which factors have contributed towards lower GDP data towards the beginning of this year?
- Which factors have helped boost GDP in the 3 months from July to September?
- Why is there disagreement about the likelihood of positive GDP figures continuing throughout the rest of the year?
- Prior to the official release of the GDP figures, David Cameron hinted at positive news. Given that the market is so sensitive, what effect might this suggestion have had?
- Given this positive figure, what implications does this have for the government’s quantitative easing programme?
- If we translate this latest growth data onto an AD/AS diagram, how would you show what has recently happened?
The housing market is crucial in any economy, as it provides so many jobs in related industries. It is frequently a good signal of how buoyant the economy is. With recession in the UK, mortgage rationing continuing and many homeowners having to find 20% deposits to buy a house, many would expect the housing market to be showing signs of trouble.
And to some extent this is the case. Studies on house prices have clearly shown how unpredictable this market is and prices remain 0.7% below what they were a year ago. However, in August house prices increased, recording their biggest rise in two and a half years, at 1.3%. For many, this rise was a surprise, but came as a welcome relief following the declines in previous months. Despite this rise, analysts have suggested that this trend is unlikely to continue throughout the rest of the year, as the demand for houses remains weak. Robert Gardner, the Chief Economist at Nationwide said:
“Given the difficult economic backdrop, the extent of the rebound in August is a little surprising. However, we should never read too much into one month’s data, especially since monthly price changes have been impacted by a number of one-off factors this year, such as the ending of the stamp duty holiday for first time buyers’.
So, what is behind this upward trend? Nationwide’s Chief Economist says that it could be explained by a resilient labour market, where employment has risen in recent months, despite the recession. The labour market undoubtedly has a big effect on the housing market, as mortgages do take up so a large percentage of take-home pay.
However, another key factor that affects house prices is the availability of mortgages. The Bank of England and Treasury launched the Funding for Lending Scheme at the beginning of August in a bid to make mortgages cheaper and more easily available. However, analysts suggest that the scheme is yet to have an effect. Furthermore, until deposit requirements are eased, that first step on the property ladder will remain elusive for many people. Mortgage approvals did increase slightly in July, but still remain a major barrier for the housing market to really boom.
The following articles consider this ‘surprising’ rise in house prices and the factors behind it.
Articles
House prices in ‘surprising’ jump, Nationwide says BBC News (31/8/12)
UK house prices record surprise increase Financial Times, Tanya Powley (31/8/12)
Surprise house price rise in August not indicative of market, says Nationwide The Telegraph, Emma Wall (31/8/12)
House prices in surprise rebound Independent, Vicky Shaw (31/8/12)
House prices continue to hold The Economic Voice, Jeff Taylor (31/8/12)
Mortgage approvals still subdued, Bank of England says BBC News (30/8/12)
Banks are pulling back from property – expect prices to fall Money Week, Matthew Partridge (31/8/12)
UK house prices up, as London continues surge Share Cast, Michael Miller (29/8/12)
Data
Lending to Individuals Bank of England 2012
House Price Index Land Registry 2012
UK house prices (links) Economics Network
Questions
- Use a supply and demand diagram to analyse recent trends in the housing market.
- Why is the Bank of England’s lending scheme not having the expected impact on the housing market?
- To what extent do you think the state of the housing market depends on mortgage rationing? Which other factors are likely to affect the housing market?
- In the article from the Economic Voice, the author says that house prices holding as they are is a surprise, because of relatively high inflation and the fact that wages are not keeping pace. Explain the economic thinking behind this view.
- The Chief Economist at Nationwide has said that the future of the housing market depends heavily on what happens to the labour market. Why is this the case?
- Why have mortgages been rationed and minimum deposit requirements been increased?
- Why is the housing market so important for the economy?
Following the banking crisis of 2007/8 a new set of international banking regulations was agreed in 2010 by the Basel Committee on Banking Supervision. The purpose was to strengthen banks’ capital base. Under ‘Basel III’, banks would be required, in stages, to meet specific minimum capital adequacy ratios: i.e. minimum ratios of capital to (risk-weighted) assets. The full regulations would come into force by 2019. These are shown in the chart below.
