The move toward a tougher capital and liquidity regime undoubtedly receives the greatest attention in terms of the measures being implemented to make large banks safer. However, there also are a number of other important changes being made to supervisory practices in the United States and elsewhere. One noteworthy example is the more widespread use of horizontal stress tests to ensure that banks have adequate capital. This is a very important development, because it makes the evaluation of capital more forward-looking. The issue is not just how much regulatory capital a bank has currently but how that bank’s capital level is likely to evolve over time in adverse economic circumstances. In the United States, another important change is that we are refocusing our supervisory practices to identify structural weaknesses and to push firm managements to remedy their shortcomings relative to “best practice” standards. Horizontal reviews across the large banks are being undertaken to identify firm-specific deficiencies. At the Federal Reserve, we are placing greater emphasis on understanding banking organizations’ business models and strategies – in other words, better understanding the specific markets and activities from which the banking organizations make money over time and the nature of the risks they take in this process. Strong risk management practices within organizations are particularly important, as risk managers must be empowered to stand up to those in the front office and prevent activities and practices that create risks or incentives that are incompatible with bank safety and soundness.
But there is good reason to believe that a mutually reinforcing combination of strong demand, weak supply and expectations of a rising market could lead to a period of sustained and very powerful pressure on house prices in the UK. The extent to which that will jeopardise financial stability depends on whether that pressure actually results in more transactions at higher prices, whether that in turn leads to an increase in household indebtedness and where that debt is concentrated. These are, of course, all linked. The laws of supply and demand must, in the end, apply also to housing even in the UK. House prices cannot grow faster than earnings indefinitely. While households may be prepared to spend an increasing amount of their income on housing, there is a level at which house prices are simply not affordable. Ultimately – given purchases are in the main financed by long term mortgage lending – it is the price and availability of mortgage credit, including maximum loan-to-value and loan-toincome ratios, offered by lenders that determines the point at which affordability constraints bite on house purchasers and so how far they can stretch to match rising prices. At present, affordability constraints do not seem to be having a braking effect on the rise in prices. But prices are still below their 2007 levels in most regions and the house-price-toearnings ratios a multiple below its pre-crisis peak. If prices continue to grow faster than earnings, affordability will increasingly be an issue for purchasers and for lenders.