If the cap fits

Pricking bubbles: The closest thing to a post-crisis consensus is that regulators should be charged with deflating future financial bubbles. There is also agreement that interest rates alone will not do the job. Some policymakers want to restrict the supply of credit by changing banks’ capital ratios. But in order to be really effective, they may also need to be able to limit how much people are able to borrow.

At its core, the recent credit boom was a worldwide property bubble. As Adair Turner, chairman of Britain’s Financial Services Authority, pointed out in a speech on March 17, the vast majority of net lending to the UK corporate sector in the past decade has been to commercial real estate. If regulators had been able to target that lending directly, they could have limited the damage.

One way of dealing with the excess is to require banks to build up their reserves during a boom. This acts as an automatic brake on credit growth.

But it does not allow regulators to tackle overheating in specific areas. Hence the suggestion, by the Bank of England among others, that a bubble-pricking body have the power to vary banks' capital ratios for particular types of lending. The snag is that borrowers could still seek out non-bank entities or borrow from the capital markets. Much of the recent property boom, for example, was financed by securitisation.

That is why regulators need to be able to restrict demand for credit by capping the proportion of a property's value that buyers are allowed to borrow, as some places such as Hong Kong already do. Such loan-to-value caps - which should be applied to residential as well as commercial mortgages - are easy to understand. They could also be varied through the cycle, with regulators cutting the maximum mortgage people could get when they thought the property market was overheating.

Capping lending alone will not prevent the next boom. Regulators must also co-ordinate their approach so that borrowers who are turned down in one country cannot simply get a loan elsewhere. What is clear, however, is that pricking the next bubble will require a new set of tools. Regulators should have a lending cap in their toolbox.