2nd June 2014

A beginner’s guide to the FPC and macro-pru

Written by Adam Cull, the BBA’s Senior Director (Financial Policy and Operations)

Later this month the Bank of England’s new Financial Policy Committee (FPC) will meet to discuss risks to financial stability and whether anything can be done about them – “macro-prudential policy” in the jargon. Top of their agenda will be the housing market. Given the headline grabbing nature of its focus, now seems as good a time as any to reflect on the FPC’s purpose and powers.

The financial crisis exposed a glaring gap in the regulatory structure. For years, the focus had been on monitoring the health of individual financial institutions and on maintaining price stability. The Bank, Financial Services Authority and HM Treasury shared responsibility for financial stability but no one had a clear focus on the aggregate risks to the financial system or the measures needed to address them.

The FPC is the UK solution to that problem and has two statutory objectives: maintaining and enhancing UK financial stability in a manner which is consistent with the Government’s economic objectives, particularly those for growth and employment. This second part is essential because it prevents the Committee from taking measures that, as the Chancellor put it, would achieve “the stability of the graveyard”.

The FPC has two types of powers at its disposal. The first is a broad ranging ability to make recommendations which, when addressed to the Financial Conduct Authority (FCA) or Prudential Regulation Authority (PRA), can be on a “comply or explain” basis. The second is the more technical sounding power of direction that allows the Committee to influence the cost and quantity of bank lending.

This is achieved by changing the amount of capital banks are required to hold either in total or against specific types of lending via one of two tools:

  • Sectoral capital requirements (SCR) allow the FPC to require banks to hold more capital against mortgages (or certain types of mortgages), commercial property or exposures to other parts of the financial system.
  • Counter-cyclical capital buffers (CCB) enable the FPC to increase the total amount of capital banks hold if the FPC believes the economy is overheating, strengthening the resilience of individual banks and reducing lending to the economy in the process. Once the threat to financial stability has passed, as the name suggests, the CCB can be released to support economic recovery.

Experience with tools of this type in advanced, open economies is limited but some early examples suggest that SCR powers can change lending behaviour of banks. A 2010 decision by the Brazilian central bank to require banks to hold more capital against new long term car loans led to a 40 per cent drop in such lending over the next 18 months. Countries such as Sweden and Switzerland are also using similar powers to alter requirements for residential mortgages, but it is too early to assess the impact.

Given the difficulty of predicting the impact of a FPC decision with any certainty, what might all this mean for the UK’s housing market? A guide to the FPC’s potential next steps was set out in the November Financial Stability Review:

  • Make recommendations to the FCA or PRA on the underwriting standards for new mortgages, including the appropriate interest rate stress testy to be applied when assessing affordability
  • Make recommendations to the Treasury on the Help to Buy scheme
  • Issue recommendations or directions to the PRA on bank capital requirements on residential mortgage lending (the SCR power)
  • Take a decision to turn on the CCB
  • Recommend maximum terms, loan to value ratios, loan to income ratios or debt to income ratios for mortgages.

The FPC will debate these steps at its meeting on 17 June with the record of that meeting to be published on 1 July. This will be followed by the mid-year Financial Stability Review, which will be published the following day and give the Bank’s latest assessment of the current risks to UK financial stability. We might even see the UK’s first official foray into macro-prudential policy.

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