Speech

Remarks by Agustín Carstens

November 22, 2004

Welcome. I think we would all agree that this morning's general discussions on financial sector procyclicality were very productive, and I look forward to interesting discussions this afternoon on procyclicality as it applies to Asia. I believe this is a particularly apt time to consider this issue. Most countries in the Asian region are in an expansionary phase of the business cycle, and concerns about excessive credit growth are rising. Now is the perfect juncture to consider how policymakers in Asia can best respond to the risks associated with procyclicality—before those risks have had a chance to build up.

There are at least three major issues to think about. First, there is the overarching, strategic objective of ensuring that the financial system framework strikes the right balance between prudential and development considerations. Second, a policymaker must continually be on the lookout for developments that pose undue risks to the stability of the financial system. And third, the policymaker must devise an appropriate policy response to such hazardous developments.

Regarding the first issue: there is some inherent tension between prudential and developmental aspects of financial systems. On the one hand, there is ample evidence that deepening the financial system can encourage stronger economic growth and improve welfare. Thus, it behooves policymakers to invite development. But that development must be sustainable. Innovation should be undertaken at a pace and in a sequence that will support faster growth, but not so fast as to encourage instability—in particular, excessive procyclicality.

In practice, it is very difficult to achieve the right balance. Should policymakers allow financial market participants to introduce any innovation, and then regulate as they see appropriate? Or should policymakers try to regulate first and constrain the incentives for innovation of financial market participants? Typically, the former model is the one chosen, since the latter risks stifling innovation and unduly limiting financial market development, which would clearly result in lower social welfare. Yet, in the innovate-then-regulate model, policymakers risk being "behind the curve" on the regulation front. It is critical that policymakers be equipped to recognize risks to financial development that arise from weaknesses in the financial system, and to respond to potential problems early on, including by slowing development until weaknesses have been addressed.

But that leads to the second issue. In practice, it is very difficult to recognize when procyclicality has become a problem. For example, when is an economy is experiencing a credit boom—and not just rapid, but sustainable, credit growth? It is typically the case that credit grows faster than GDP as an economy develops, because of financial deepening. And, as we discussed this morning, some degree of procyclicality is a normal consequence of a market economy. So how can a policymaker distinguish between a normal expansion, and an excessive expansion that is unsustainable?

There is no magic formula, but in general we find that there is greatest cause for concern when rapid credit growth is accompanied by indications of growing macroeconomic, financial, and corporate imbalances. These often include investment booms, rapidly rising asset prices, current account deficits, and increases in the price of nontradables—although increases in inflation are typically not observed. Private credit tends to rise rapidly as a share of total bank assets and nondeposit liabilities typically increase. In the corporate sector, particularly among firms that produce nontradables, leverage and short-term debt often increase.

Yet, even if excessive procyclicality (or a credit boom) is identified, its underlying cause must be determined before an appropriate policy response can be crafted. There are many potential causes — let me just touch on a few.

In some cases, financial liberalization (or financial market innovation) may itself initiate a boom. For example, improvements in housing finance can fuel a property market boom and wider use of credit cards can initiate a consumption boom—either of which could spur broader credit growth. This brings us back to the prudential/developmental trade-off. Appropriate sequencing of liberalization measures is critical to minimize the chances that financial liberalization will increase financial fragility. This usually means that liberalization should go hand-in-hand with improvements in the financial infrastructure, including greater transparency and a strengthening of the domestic legal system. But, even in the best of circumstances, we must acknowledge that financial sector innovation can be so fast that regulators will have difficulty keeping pace.

In other cases, an underlying misalignment may be the culprit. We have seen many times how an anticipated step revaluation of the exchange rate precipitates capital inflows and thus a credit boom. Alternatively, if monetary control is insufficient, an anticipated step devaluation can lead to excessive borrowing in the local currency as borrowers try to short the domestic currency. These are difficult situations. Dealing with them effectively often requires a joint effort—measures to strengthen the financial system while, at the same time, introducing more exchange rate flexibility—in order to make the system less vulnerable to exchange rate changes and help limit rapid credit growth.

In still other cases, imprudent lending by financial intermediaries may spawn a credit boom. This may result from poor investment decisions—indeed, the mispricing of credit risk is a key cause of excessive procyclicality. Sometimes, this can result from capital inflows, which lead to excessive liquidity and compressed lending margins. But other factors also tend to be at work, such as poor credit assessment capacity, an excessive reliance on collateral, and a tradition of connected or directed lending. If regulation and supervision are adequate, such problems can be spotted promptly and policymakers can take the music away from the party early on.

In the face of a credit crunch, some voices have advocated the use of forbearance to counteract the procyclical bias of regulation. But forbearance will only work if it is used to buy time to make fundamental reforms to improve the functioning of the financial system. But once imbalances exist, it is less than clear how to avoid exacerbating them in the process of reform. More often than not, forbearance allows for a build-up of increasingly risky positions.

What is the alternative to forbearance, then? Clearly, it's a good idea to impose discipline before imbalances are created, for example by strengthening general prudential standards, supervisory and legal systems, and credit assessment capacity. But more dynamic, pro-active prudential reforms may also be helpful. As was discussed in this morning's session, Basel II requirements cause risk weightings to vary over the cycle in a way that can exacerbate procyclicality. To offset this tendency, capital-asset requirements can be adjusted counter-cyclically. This would help to limit the underpricing of risk in a way that is incentive-compatible for banks.

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The policymaker in charge of financial issues has a difficult job. He or she must balance prudential and developmental considerations, recognize nascent problems—like excessive procyclicality—at an early stage, and then craft the appropriate policy response. Forbearance can be tempting—but it is also very risky. Given the high stakes involved, it is clearly worthwhile to consider the alternatives. Today's conference is a welcome opportunity to advance our thinking on this issue, and I and my colleagues look forward to bringing back with us your views and experiences here in Asia, which will be of great benefit our other members. I look forward to our continuing discussions this afternoon. Thank you.