In a recent Herald article, Geoff Simmons discusses the core funding ratio. I work near the GMI team, and I have a lot of time for their outside the box thinking on issues – however, this is one case where I will have to respectfully disagree with the conclusions.
What was the conclusion? It was that the RBNZ should look at varying the Core Funding Ratio (CFR) at its next meeting in order to reduce inflationary pressures, instead of increasing interest rates.
Now it has been suggested that adjusted the CFR during the “extremes” of the cycle may carry weight – but here I want to get into the trade-offs involved, and why I don’t think it is appropriate now.
We can think of the logic behind a CFR sort of like a reserve ratio (RR) from back in the day. [Note they are quite different, I just find this an easier way to describe their structural role]
These were greatly discredited due to the belief that “private agents (banks) will account for risk” – however, nowadays people realise that there are two issues that make a RR necessary:
- Moral hazard: Retail banks know that the central bank will bail them out – and so will take on more risk then we would like.
- Information asymmetries and incentive schemes inside banks can lead to excessive procyclical risk taking.
By setting a structural RR, we ensure that the “doomsday” scenario is ruled out – and improve the stability of the financial system and general economy.
Very good. However, in the article changing the CFR is suggested as a way of controlling monetary policy. How does this work?
Impossible Trinity and capital controls
A CFR ensures that a certain proportion of any asset class held by a bank (a loan) there is a certain match in terms of the quality and length of the liabilities they have (the money they bring in to fund the loans). By doing this, the central bank is partially dictating the type of risk banks can take on, and also ensuring that banks don’t always face the lowest “cost” when they try to lend out.
By increasing said “cost” of lending out, a CFR in turn increases interest rates in the economy and lowers lending – relative to the case where there is no ratio.
Now I get the feeling that the Herald article believes we can get a “free lunch” out of this. By increasing the CFR we increase interest rates and lower lending, but since new “funds” from overseas can’t “flow” in we don’t get the increase in the exchange rate. Huzzah, we have increased interest rates without pushing up the exchange rate!!!
This is only a partial story though. Essentially the CFR increase is acting as a capital control in this context … this is an application of our good friend, Mr Impossible Trinity.
Since the exchange rate is not rising, in order to control inflation we either need a larger increase in domestic interest rates then we otherwise would have face (real underlying interest rates that businesses and households face, not the OCR) and a sharper drop in economic activity. We stabilise our exchange rate by explicitly lowering our incomes by more than we needed to, in order to control inflation.
Let us not forget that by doing this, we are effectively blocking a whole lot of lending on investment that makes sense given economic conditions – if we are worried that a high exchange rate will “lower long-term growth” (debatable, as we need to discuss what is going on and why – and even then, a one-off boost due to tightening monetary conditions will likely be independent of these), we are trying to “solve” the problem by lowering investment … which will UNDENIABLY lower long term growth.
Conclusion and opinion
In the current context, where we are crawling out of a recession and where inflationary pressures are starting to manifest themselves we can all agree we are nearing the time when monetary policy must “tighten”. However, I would disagree that changing the CFR makes sense as the way to tighten. Using the CFR will lead to a larger increase in domestic interest rates and/or sharper drop in output, just to keep the exchange rate stable.
There are two important additional points I must raise here:
- IMO, the only reason why we would use the CFR instead of the OCR for monetary policy targets is if we believe there is some “structural” break going on – such as an asset bubble in the exchange rate. In this case we may wish that the CFR is at a higher level – but it should be justified on financial stability grounds – not monetary policy grounds.
- The idea that there are “hot flows” of money driving up the dollar vexes me a little. It is true that there is some “infinite supply” of funds out there, but we need domestic demand for it as well! If the CFR is binding, it link between the dollar and the exchange rate is not necessarily clear (as any increase in borrowing from overseas will need to be matched by some amount of domestic saving as well). And if its not binding, then there isn’t an issue …
I’ve been told that this is the way the RBNZ see’s CFR’s – and that it is consistent with my conclusion that rolling it out now would be a touch inappropriate:
Core Funding Ratio
The Core Funding Ratio is a tool that can help promote greater financial system resilience by requiring banks to fund credit using more stable sources than they might choose in the absence of the requirement. This discipline is particularly desirable during periods of rapid credit growth, when recourse to relatively cheap short-term wholesale funding rather than more stable longer term funding is more likely.
As a tool to actively lean against excessive credit growth, our simulations suggest that the Core Funding Ratio could, in some circumstances, play a useful supplementary stabilising role by requiring banks to always maintain a proportion of core funding which is typically more expensive than shorter-term wholesale funding. Alternatively, the Core Funding Ratio could be used as a counter-cyclical policy tool. Although the Core Funding Ratio could be a less effective anchor on credit growth during a global boom (when funding spreads become compressed), it would still be effective in its primary role of ensuring that banks resort to more stable funding sources.
From Allan Bollard speech in Mar 2011