David Prosser: Will the Bank's new financial toolkit be filled with blunt instruments?

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The Independent Online

Outlook Mervyn King is no doubt looking forward to taking delivery of the new tools he was promised last night by the Chancellor in his Mansion House speech. George Osborne hasn't yet detailed exactly what the Governor of the Bank of England will have at his disposal in order to "take effective action in response" to "the macro issues that may threaten economic and financial stability" but Mr King has made it clear he believes his lack of firepower up until now has represented a serious flaw in the regulatory system.

The Governor is right, of course. With hindsight, it seems obvious that a regulatory system which does not even have a mechanism for taking into account phenomena such as credit bubbles, let alone the powers or mandate to target them, is too narrowly focused.

And yet, the way we have been talking about the financial crisis in recent days, with a focus on how the Bank might seek to impose maximum loan-to-value ratios on mortgage lenders, or even to cap lending to earnings multiples, suggests there is a misconception about what happened during those tumultuous months of 2008.

It is worth a quick history lesson. Britain's banking system was not brought to its knees because the nation's mortgage lenders were suddenly caught out after years of making overly risky loans. On the contrary, in 2007 and ever since, bad mortgage debt has actually risen very modestly. Arrears and repossessions remain well below the levels seen in the early 1990s, for example.

No, this was a crisis of mortgage funding. As the residential mortgage-backed security market gummed up, almost overnight, lenders found themselves unable to fund new advances. Northern Rock's Together mortgage, its 125 per cent loan-to-value product, has come to be seen as the height of irresponsible lending, but it wasn't defaults on the deal that killed the bank but a funding catastrophe.

Should the Bank of England keep a close watch on the lending policies of Britain's biggest mortgage providers – and the impact their behaviour might have on financial stability? Of course. But to say this means the Bank should be preventing banks from lending more than 75 per cent of the purchase price of a property, for instance, or restricting borrowers to loans worth only three times their earnings, is to miss the point.

In truth, the supply of lending to would-be mortgage borrowers already looks likely to be very constrained for many years to come. From next year, lenders have to begin repaying the Bank of England the £300bn of emergency funding support they received during the crisis. There is not going to be much room for another explosion of easy credit, even assuming that this is what we had prior to the crisis.

Who, in any case, would be most disadvantaged by a cap on loans to value of, say, 75 per cent? Certainly not those who are already on the housing ladder, many of whom are already able to identify equity of 25 per cent or more in their homes thanks to the house price appreciation – notwithstanding the recent correction – of the past decade. In fact, first-time buyers would be hardest hit by such a crackdown, reduced to scrabbling around for deposits that most would have no hope of saving.

The worst-case scenario is that home buyers locked out of the market by these caps might resort to unsecured borrowing – at three or four times the cost of mortgage finance – in order to make good the shortfall. That would present a far greater risk of a significant rise in bad debt levels and repossessions.

None of this is to say that Mr Osborne is wrong to present the Governor with a shiny new toolkit – just that it is very difficult to work out which specific micro measures one should use in order to manage macro-prudential risk. This is unchartered territory which no regulatory authority in the world has yet got to grips with satisfactorily.

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