Thursday, December 18, 2014

Macroprudentialism (An E-book)

In the old days of macroeconomics, say up to 2007, macroeconomic policy was almost entirely about fiscal and monetary policies. But in the last few years, an alternative called "macroprudential policy" has risen up. The notion is to affect the macroeconomy by using financial regulations about the permissable extent of bank capital and collateral lrequirements, consumer borrowing, margin requirements for financial trades, rules governing what derivatives are allowable, and more. Janet Yellen has argued that when it comes to financial stability, and the risks it poses to macroeconomic stability, macroprudential policy needs to play a primary role. Here's a discussion of the past use of what we would now call macroprudential tools in the U.S. economy.

For a useful starting point to the topic, Dirk Schoenmaker has edited an e-book called Macroprudentialism, a eBook from the Duisenberg School of Finance and the Center for Economic Policy Press, which includes 15 short chapters from various perspectives. Here is a scattering of some of the comments about macroprudential regulation that especially struck me.

Anil K Kashyap, Dimitrios P Tsomocos and Alexandros P. Vardoulakis: "While virtually every central banker in the world is on record supporting the concept of ‘macroprudential regulation’, there is still no agreed upon definition of what it means or how best it should be implemented.

Paul Tucker: "Legislators have typically favoured rules-based regulation. That is for good reason: it
helps to guard against the exercise of arbitrary power by unelected officials. But a static rulebook is the meat and drink of regulatory arbitrage, which is endemic in finance.  Finance is a ‘shape-shifter’.
That makes it hard to frame a regime that keeps risk-taking in the system as a whole within tolerable bounds. Instead, excessive risk-taking is likely to migrate to less regulated or unregulated parts of the system. Thus, with the re-regulation of de jure banks currently underway, some of the economic substance of banking will, again, inevitably re-emerge elsewhere. For example, anybody holding low-risk securities can, in principle, build themselves a shadow bank by lending out their securities for cash and investing the proceeds in a riskier credit portfolio. ...

"This shape-shifting dynamic can leave policymakers in a game of catch-up, responding only as each metamorphosis becomes systemically significant. Unless they are empowered to respond flexibly, it is a game they are doomed to lose. By the time the products of regulatory arbitrage are evidently systemically significant, those in the driving street will likely have the lobbying power to delay or derail reform. The powerful forces mobilised to oppose reform of the globally significant US money market fund industry illustrate that in capital letters.

"A number of implications for the design of macroprudential regimes flow from these features of the financial world. First, it will not be sufficient for bank regulation to be dynamically adjusted. It will also be necessary, for example, to vary minimum collateral (margin, haircut) requirements in derivatives and money markets when a cyclical upswing is morphing into exuberance; to tighten the regime applying to a corner of finance that is shifting from systemic irrelevance to a systemic threat; and to tighten the substantive standards, not only the disclosure standards, applying to the issuance
of securities when the pattern of aggregate issuance is driving or facilitating excessive borrowing by firms or households. That means, second, that if finance remains free to innovate, adapt and reshape itself, every kind of financial regulator must be in the business of preserving stability. That needs to be incorporated into their statutory mandates and, more generally, into the design of regulatory agencies."

Charles A. E. Goodhart: "As the Global Financial Crisis struck, central banks were saddled with two objectives at the same time: price stability and financial stability. With the policy interest rate
predicated to achieve price stability, we needed a second instrument to maintain financial stability; hence macroprudential instruments. ... As long as macroprudential instruments are able to vary the capital ratio applicable to loans, they could be effective, but only time will show how effective. ... I have argued that central banks have now been allocated responsibility for financial stability, whether keen to do so or not. If so, it would seem odd not to also give them command over the main levers (i.e. instruments) for achieving such stability. Moreover, several of these instruments involve either imposing requirements on banks – e.g. state-varying capital requirements – or changes to the central bank’s own portfolio – e.g. acting as market-maker of last resort via credit expansion (CE) – that would seem necessarily to be within the natural province of central bank decision-making."

Claudio Borio: "There is no doubt that macroprudential frameworks must be part of the solution to the perennial quest for the so far elusive goal of lasting financial stability. Adopting a more systemic orientation in prudential arrangements is essential. But intellectual pendulums have a habit of swinging too far. There is a risk of entertaining unrealistic expectations about what macroprudential schemes can do on their own. If these expectations become entrenched in policy, there is even an outside risk that, far from being part of the solution, macroprudential frameworks could paradoxically
become part of the problem. Complacency is always not too far around the corner. If the quest for financial stability has proved so elusive, it must be for a reason. Put differently, macroprudential policy must be part of the answer but it cannot be the whole answer. Other policies also need to play their part, not least monetary and fiscal policy. And making the most of macroprudential frameworks calls for a mix of ambition and humility – ambition to make systematic use of the available tools;
humility in recognising their limitations.

Wolf Wagner: The typical regulatory cycle looks as follows. An unwanted behaviour in the financial
system is observed and is attributed to a market failure. Policymakers devise a policy that specifically targets this failure. Upon implementation, it is then discovered that the policy does not work. This is because financial institutions circumvent the spirit of the policy by shifting into economically equivalent activities that are not affected by regulation. In addition, the responses of market participants often lead to undesirable outcomes in other parts of the financial system. The apparent failure of regulation in turn leads to a series of new, and increasingly complex, measures, which by themselves bring about further unintended consequences. ...

Naively designed macroprudential policies are likely to have unintended effects. Due to the inherently complex nature of systemic policies, the scope for such side effects is much larger than for traditional policies, and may easily come to outweigh the benefits. Policymakers need to step up their efforts in making sure that new macroprudential policies are incentive-compatible and do not distort the behaviour of participants in the financial system.