A one standard deviation increase in ‘excess credit’ results in real GDP per capita being 1.5% lower five years after a normal recession.23 Bunn and Rostom (2015) find that more highly indebted groups of households made larger cuts in spending following the financial crisis. And Bailey et al (forthcoming) exploit Facebook data to identify how social interactions can drive contagious risk-taking in the US housing market. In summary, the market failures associated with fire-sale externalities and behavioural tendencies which can drive short-termism provide a strong case for a macroprudential regulator with an objective of preserving the dynamic resilience of the financial system, both among banks and, prospectively, among non-banks. No less compelling, however, is the evidence, both micro and macro, linking credit booms to aggregate demand externalities. That, in turn, provides a rationale for pre-emptive macroprudential interventions to avoid excessive inflation of credit and asset prices in the first place. Instruments of Macroprudential Policy The Bank of England’s second public foray into the macroprudential policy debate was a 2011 discussion paper on elements of the macroprudential toolkit (Bank of England (2011)). That paper described 12 distinct macroprudential tools (see also CGFS (2010, 2012), Hanson et al (2011) and ESRB (2015) for discussions of macroprudential instruments). The majority of these targeted different aspects of banks’ balance sheets including: the countercyclical capital buffer (CCyB); sectoral capital requirements (SCRs); leverage ratio buffers; dynamic provisions; and liquidity buffers.
As well as lending to households and businesses, banks lent to other banks which bought ever more exotic instruments created by the financial system itself. The effect was to replicate the original risky loans many times over. Over the past five years, the balance sheets of many of the world’s largest banks more than doubled. From the early 1990s to the start of the financial turmoil in 2007, total debt in the UK relative to GDP almost doubled. Around two-thirds of the increase in total debt was accounted for by lending to the financial sector. A marked expansion in debt of the financial sector also occurred in the United States and the euro area. The Bank did not stand idly by during this period. The Monetary Policy Committee set Bank Rate to achieve the inflation target. Monetary policy – here and in our major partners – was successful in controlling inflation and maintaining economic stability. From the early 1990s until the onset of financial turmoil in 2007, output growth, both here and in the industrialised world in general, was close to its long-run average. Moreover, through our regular publications and speeches on financial stability the Bank highlighted the dangers posed by the growth in the size and complexity of the financial sector. Nevertheless, it is clear that policy did not succeed in preventing the development of an unsustainable position.