Indeed, this is a very very important issue. I used to be more concerned about it than I am now, but it is something that really needs to be discussed by economists. I’ve also seen Gareth Morgan and his team discussing it more recently.

I discussed briefly here:

http://www.tvhe.co.nz/2013/06/19/gareth-morgan-housing-and-blaming-the-rbnz/

One of the key things is that the most “binding” rules are quite recent, and are less binding than they have been overseas. As a result, this is more an issue for thinking about a future – than necessarily an explanation of misinvestment in the past (which some have tried to make it about).

It is an issue I am under the impression the RBNZ is thinking about – and one that makes me nervous about to much central bank micromanaging through setting relative risk too directly. One of the reasons I have a preference for straight equity based regulation, or clear rule based policy:

http://www.tvhe.co.nz/2013/08/28/cochranes-macroprudential-rules/

me too. i wonder how influential the RBNZ’s prudential rules are here. they affect the cost of funds for a bank and they differ by risk class. that structure could easily mis-direct loan finance.

Market failures are definitely possible – like to see the argument made directly rather than what we often see 😉

fully agree re consistency. also agree that its not obvious that banks are not pricing risk in a socially optimal way. but that is entirely possible.

My key thought with this is that we need to make sure our views and policies are consistent – simultaneously saying that credit is too tight and financial institutions are too conservative, then saying that credit is too loose and financial institutions too risk (ergo macro prudential regulation) is inconsistent.

People will say, but its too tight for small firms and too loose for households – banks are pricing risk in the wrong way. This is an argument I’ve heard and something I do not find self-evident, I have to be honest!

Yes, to justify this policy it would need to be the case that financial institutions are “too conservative” in some sense. That certainly has happened before in the history of the world – as the successful rise of microfinance shows. Mind you, that also shows that markets can fix some of these problems.

Not sure what the story is in Israel regarding implicit government guarantees, but its a patchy landscape in NZ isn’t it? Plenty of finance companies have gone to the wall, though SCF got a bail-out.

So if we have a situation where the firm owners have unlimited liability and sufficient equity this isn’t a worry. Indeed, but this isn’t the situation – and in fact, if this was the situation why are banks not willing to lend?

Is our premise then that financial institutions are too conservative? If so, if that consistent with our view of financial institutions lending behaviour due to the existence of an implicit government guarantee?