Wednesday, February 10, 2010

Steps to Avoid Future Financial Crisis.

The current financial / economic crisis should be focusing the minds on economists of how to avoid a similar repeat. It will be difficult - human nature is unlikely to be changing in the near future. For example, we always have potential of more irrational behaviour and false exuberance
Also, it is not a new situation, housing boom and busts seem to be, unfortunately, quite common - Why Boom and bust in Housing markets are common.

Yet, though we cannot prevent any boom and bust, the magnitude, length and duration can be limited by a thoughtful range of policies.

Better Mortgage Products

In the boom years, banks (especially in US) were offering teaser mortgages. - A great introductory rate for first year or two. Then the interest rate shot up. These teaser rates encouraged people into a false sense of hope they could afford mortgages. When teaser rates expired - then the problems began (see: subprime crisis). Legislation against teaser rates would avoid this.
See also: Paul Krugman (NYT) on relative success of Canadian regulation to avoid financial meltdown)

Counter Cyclical Mortgage Products

When House prices rises, this encourages housing equity withdrawal and people to take on bigger mortgages. This effect is known as a financial accelerator because one rising economic indicator encourages more risky lending and spending. Similarly - When house prices fall there is a rise in negative equity. A counter cyclical mortgage product would make homeowners pay more capital back during rising house prices leaving them less to pay when the housing market turns.

Greater Use of Fixed Rate mortgages.

UK homeowners are generally reluctant to take out fixed rate mortgages, and if they do, they tend to be short term fixed rates of 2 years. Greater encouragement for longer term fixed rate mortgages would help avoid volatility of changing interest rates - not so much an issue in 2008, but definitely a factor in 1991-92

Capital Ratios.

A prominent feature of the boom years was falling capital ratios of banks. Typified by the likes of Northern Rock and Royal Bank of Scotland increasing lending and reducing their capital ratios. This made them vulnerable during credit crunch. Forcing banks to keep more capital during good years would help work against the sentiment of irrational exuberance. A fund paid to the government could then be paid back during difficult times.

Limiting Dividends and Pay.

A startling statistic - In 2008, global banks made losses totalling $60 billion, but on average still made dividend payouts of over $60 billion (1). Banks listed on the stockmarkets are under pressure to pay out dividends and keep less in reserve. The German model of banks may be preferential - less emphasis on equity and stock market listing.

The ideal mortgage product which makes people pay more mortgage payments during a boom in house prices and pay less during a fall in house prices.

According to the Bank of England Financial Stability Report (). Between 2000 and 2007, UK banks could have saved £85 billion in capital through:
  • Trimming payouts to staff by 10%
  • Reducing dividend payouts by a third
  • Stopped paying dividends in the event of an annual loss.
That kind of capital would have been an insurance against the credit crisis.

Monetary Policy

Generally, I don't blame monetary policy for the Boom and bust (see: should we blame Bank of England for recession). But, it still had an effect. Even using a standard Taylor rule, the Federal Reserve kept interest rates too low for too long. But, also by focusing excessively on inflation, Central Banks paid too little attention to an asset bubble. Certainly Central Banks need to have wider targets than just inflation.


(1) Debt Hangover B of E Andrew Haldane

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