Localized capital rules could prevent housing boom and bust cycles

by Diana Aqra05 Jul 2013
Boom and bust cycles that caused the housing crisis may have been prevented if policymakers considered enforcing higher capital restrictions on residential lenders during the initial stages of the cycle, according to economic researchers.
In a report titled, “Preventing House Price Bubbles, Lessons from the 2006-2012 Bust,” authors James Folain and Seth H. Giertz argue that localized “capital buffers” that raised capital requirements for financial institutions when the housing market was booming would have prevented a bust. 
Specifically, authors argued that raising the capital requirements on lending institutions that were doing business in booming areas would have minimized irresponsible lending, and therefore prevented an unsustainable rise housing prices. 
For example, as housing prices soared in Florida, a financial institution’s capital requirements would proportionately increase, thereby limiting lending where a boom/bust was predicted.  The concept stems from the idea that as an asset’s “perceived” value increases, so should its liability, or capital requirement. 
Further, authors argued that Fed policy to control interest rates is not doing enough to prevent future housing bubbles. 
“Indeed, monetary policy appears to be especially ineffective in combatting house price bubbles. While interest rates do affect housing demand, they do not dominate or dampen the effects of all other drivers of house prices such as local employment and household income. Policies to prevent house price bubbles must therefore recognize these key indicators of local market conditions," the authors said.
“Furthermore, using monetary policy to combat housing bubbles would likely compromise the Fed’s dual mandate of promoting employment growth while maintaining stable prices.
“In contrast, countercyclical capital policies are a more promising direction because they could be tailored to specific housing markets, putting the brakes where price bubbles appear to be developing without stalling healthy price growth in other areas.”
The report was published by the Lincoln Institute of Land Policy in Cambridge, Massachusetts. 



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