Chart 3: Housing problems spread to banks

In a speech at the Euromoney Bond Investors Congress on Wednesday, Sir John Gieve - Deputy Governor of the Bank of England - highlighted the return of the credit cycle and how some old lessons have re-emerged in the new credit markets.

Sir John said that regulators should require lenders to set aside more capital in an economic upswing but be allowed looser standards in a downturn. Transcript of speech.

He said that:"As in previous banking cycles, a period of strong growth, low interest rates and rapid increases in asset prices lead to over confidence and bad lending at the top of the cycle; defaults, deleveraging and retrenchment follow in the downswing. But the way this old story has unfolded through the new credit markets has sprung some unpleasant surprises, including the speed with which losses in just one market in one country - the housing market in the US - have disrupted wider credit markets in all advanced economies."

“We need to consider again how far we can ... create a system which raises requirements as the boom gathers pace in order to dampen the upswing and create additional headroom for losses as the cycle turns,”he added.

He noted that"there is a role for monetary policy in smoothing the cycle but it has to address the whole economy and not just the financial sector. So we need also to consider again how far we can make our regulatory regime for capital and liquidity counter cyclical - that is create a system which raises requirements as the boom gathers pace in order to dampen the upswing and create additional headroom for losses as the cycle turns...If we cannot do so effectively an alternative may be to require larger capital and liquidity buffers across the whole cycle."

Sir John said that the issues he raised are being discussed among members of the Financial Stability Forum’s working group on market and institutional resilience, made up of international bank regulators. It plans to submit a report to the G7 in April recommending co-ordinated policy changes aimed at minimising odds of another credit crunch.

Sir John said that, while the new bank capital adequacy rules – known as Basel II – went some way towards getting banks to improve risk management systems, they did not go far enough.

Among issues that should be addressed, were the value-at-risk models that banks use to judge how much capital they need to hold.

These are based on mathematical formulae that imply risks drop – and the need for capital drops – as banks head into the boom phase of a credit cycle.

He said the alternative to the counter-cyclical measures now being suggested might be much more expensive, and harmful, to banks and borrowers because it would require holding more capital and liquidity through all cycles of the economy.

Sir John said that although the credit crunch differed in detail from previous crises, it shared some fundamental features.

“In my view, the key lies in the measurement of risk and the repeated inclination to underprice risks at the top of the cycle and thus take comfort from exaggerated estimates of risk-adjusted returns, and the corollary, a tendency to overprice risk as the cycle swings down,” Sir John said.

He concluded that:"The structured credit markets and the growth of "originate and distribute" banking have amplified the turmoil in credit markets in recent months. But under the new clothes, the old credit cycle is still recognisable. It is important we learn the lessons about the new credit instruments and markets. But we also need to address again the roots of the credit cycle."

Former Federal Reserve Chairman Alan Greenspan famously referred to the rise in stock prices in 1996 as reflecting "irrational exuberance" but the markets soon got even frothier.

Edmund L. Andrews wrote in the New York Times in January 2006: