IMF Uses Denmark to Show Anti-Bubble Bank Rule a Blunt Tool

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As Denmark becomes the latest country to present its proposal on bank capital rules designed to fight asset bubbles, the International Monetary Fund is taking the opportunity to list its concerns.

Countercyclical buffers, which banks are supposed to build during boom cycles so that they have enough reserves to absorb losses when markets turn, are “a blunt instrument,” according to James Morsink, IMF mission chief for Denmark’s financial system stability assessment.

The fund’s main worry is that such a buffer “applies to all exposures, so there’s no focus on areas where lending is growing particularly fast,” Morsink said by phone. While his agency said it welcomes the buffer’s introduction, it’s also urging Denmark to consider other measures.

The comments come as Denmark unveils its proposal on how big its counter-cyclical buffer should be and under what circumstances it needs to be triggered. The IMF’s criticism suggests the extra layer of capital risks distorting credit markets. The IMF says that additional measures are needed when banking systems dwarf the economies they operate in.

“If you have shocks, it’s going to have a bigger effect if the balance sheets are bigger, and if they’re connected, it’s not going to have an effect just on a part of the financial system,” he said. “It’s going to be transferred rapidly to the other parts of the financial system.”

‘Move Carefully’

The Danish Systemic Risk Council recommended today that the countercyclical buffer be set at 0 percent when it goes into effect Jan. 1. The council said that while there are no signs of risks building, it’s continuously monitoring for possible effects from the low interest rates.

Including the insurance industry, Denmark’s financial system is 650 percent of gross domestic product, the IMF estimates. Banks alone have assets that are four times the size of the $310 billion economy.

Countercyclical buffers are among the macroprudential tools that Cleveland Fed President Loretta Mester said Dec. 5 should be the “first line of defense.

According to a working paper by the IMF’s research department this month, there’s not yet enough information available on how the buffers and other macroprudential tools will work to predict their effectiveness. It recommended that regulators “move carefully” in adopting the measures.

Track Record

“Much remains to be studied,” according to the paper. This includes “tools’ costs by adversely affecting resource allocations” and how to tailor them to individual countries’ circumstances, it said.

In addition to the countercyclical buffer, Denmark ought to consider a number of other measures, Morsink said. These include higher risk weights on lending to specific parts of the economy, a limit on loans against property that floats according to the economic cycle, and a debt-service-to-income ratio.

The IMF prefers the latter two because they’ve been implemented more widely so their effects are better known, Morsink said. “Track record is important,” he said.

Denmark has taken steps this year to tighten mortgage lending, including new rules for banks and a 95 percent limit on loans as a percentage of property values.

Mortgage Lending

The lending limit “is an important step in the right direction, as it would discourage the riskiest loans,” Morsink said. “If it is to be used as a macroprudential tool, the authorities will need to reduce the LTV ceiling during a credit boom when house prices are rising rapidly, making any given LTV limit less binding.”

Macroprudential tools risk misallocating resources, according to the IMF working paper. That means potentially choking industries that still need credit as growth is constrained in others. That’s because banks’ lending portfolios can swell in one area of the economy without experiencing growth in others, according to the IMF.

“Mortgage lending is an obvious candidate, but it can be unsecured lending or corporate lending,” Morsink said. “In the U.K., they are looking at commercial real estate lending.”

The Danish central bank this month warned lenders against easing credit standards too fast as competition for customers intensifies. A burst housing bubble in 2008 plunged Denmark into a financial crisis that has wiped out more than 60 community lenders since.

“Even though the system is very resilient, given its size and interconnectedness, it needs to be even more resilient,” Morsink said.