The future of financial regulation

Jean-Charles Rochet, Pierre-François Weber, 2 April 2009

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Editor-in-Chief’s Note: The Banque de France and the Toulouse School of Economics hosted a conference in January on “The Future of Financial Regulation”. This column is an opinionated offspring of that event.

The current crisis started as a solvency crisis that degenerated into a broad-based liquidity crisis. The root causes of such solvency problems are diverse. The key is that they were largely hidden.

What went wrong?

Cheap credit artificially inflated some asset values and resulted in excessive leverage, providing the illusion of abundant liquidity in the system. Additionally, several factors induced banks to:

  • Reduce their equity over the years, not least to increase their return to shareholders and
  • Compress their capital buffers to levels that clearly proved insufficient to withstand large confidence or liquidity shocks.

Some regulatory factors played a role in these trends, notably the prudential treatment of off-balance sheet positions that created an incentive to accelerate the velocity of capital by removing some assets from the balance sheet. As the crisis deepened, it also appeared that fair-value accounting, through the write-downs on traded assets it imposed, directly weakened banks’ capital positions. At the same time, all stakeholders, public and private, were insufficiently concerned with, and proved unable to detect and mitigate, endogenous systemic risks. Importantly, systemic liquidity risk was under-priced in the run up to the crisis.

Financial regulation and cycles: Flaws in Basel II

It is now a shared concern that bank capital regulation may amplify business cycles. While Basel II’s risk measurement framework and mitigation of regulatory arbitrage (a major driver of risk taking prior to the crisis) make it an improvement over previous approaches, it is still likely to be pro-cyclical. Smoothing input parameters using cycle averages would make risk measures less cyclical. Further, Basel II’s transparent framework could be complemented with countercyclical overlays that would help build up capital cushions in good times and allow them to be drawn down in bad times. However, such adjustments only go part of the way towards addressing the risks to financial stability that the crisis has revealed, including the dangerous parallel rise of leverage and maturity transformation.

More far-reaching reforms may be warranted. Neither non-linearities in correlations nor the systemic risk component of maturity transformation are well captured by the models underpinning Basel II. Risks surrounding asset valuation are far bigger than was expected. Recognising this would imply the need for creating specific buffers to mitigate against those risks.

The rationale for macro-prudential policies

The crisis has shown that policymakers, when balancing systemic risk and moral hazard concerns, will lean towards reducing the former at the expense of the latter. Large amounts of public money have been committed to stabilise financial institutions through various forms of intervention.

This, more than any other consideration, is the rationale for setting up a fully-fledged macro-prudential policy framework. Public interventions to prevent systemic failures need to have counterparts in the form of either enhanced/expanded scrutiny of firms or a wider set of regulatory constraints. The inherent limitations of relying exclusively on micro-oriented prudential policies provide another reason to support a fully-fledged macro-prudential approach.

Macro-prudential surveillance and policies

Macro-prudential surveillance provides the overarching framework to monitor and address risks to both financial stability and the real economy. It rationalises monitoring financial systemic risks in terms of mitigating the spillover effect these may have on the business cycle. In practice, it should serve two purposes. One would be to alert public authorities and the financial industry to the build-up of large imbalances across institutions. Another would be to try to assess the likely consequences on financial stability of the failure of individual institutions. Rather than a definition of systemic entities based on predefined criteria, policymakers must have an informed view on the implications of bailing out (or not) individual institutions. Much work will be needed to develop adequate tools and data to pass such a judgment. In practice, the macro-prudential supervisor needs both access to micro-prudential data and the legal authority to request additional data. Indeed, the crisis suggests that a close relationship between the banking supervisor and the macro-prudential authority (typically the central bank) provides for better policymaking processes in stress times.

A clear advantage of macro-prudential policies and tools, compared to monetary policy, is that they can be more targeted. In theory, this should help overcome potential adverse incentives and time-consistency problems in the use of blunt monetary instruments to prevent asset price bubbles. For instance, some regulation aimed at fostering adequate private pricing of liquidity risk may enhance the effectiveness of emergency liquidity support. Indeed, it may be rational for private entities to under-price liquidity risk; they may anticipate that in a crisis the central bank will inject liquidity to prevent markets and firms from failing because of liquidity runs or “black holes”. Regulations aimed at raising the price of liquidity ex ante can be seen as a response to a time-consistency problem of central banks.

Macro-prudential policies do face some incentive problems, including “disaster myopia” and well-known political economy problems. To solve these problems, the authority in charge of macro-prudential surveillance and triggering commensurate policy actions needs to be independent, credible and transparent. Of the existing institutions in developed economies, the central bank best matches this description.

Automation, rules, discretion

In light of the current policy discussion, it is likely that a macro-prudential policy framework will have two layers. One will be built on existing micro-level regulation and aimed at limiting the cyclicality of financial activities. Some aspects of this pillar will be automatic, such as a form of dynamic provisioning à l’espagnole for banking book activities (and possibly also traded assets, if feasible). If achievable, one would also want to have built-in liquidity risk cushions. Counter-cyclical add-ons to solvency regulation are another option. Broadly speaking, these tools are needed to build a cushion to absorb risks when they materialise, to reduce the scope for leverage, and to give institutions some breathing space when the financial environment deteriorates sharply.

The second layer will likely rest on measures that may not, and maybe should not, be automatic or compulsory for financial entities. Capturing systemic risks through indicators, let alone through regulation, is very challenging. Using pre-identified indicators for policy actions faces the “Goodhart’s Law” problem. As a result, the macro-prudential authority will need to guide its assessment using a range of approaches and indicators. The same would apply for its policy recommendations.

All in all, two analogies are useful to think about macro-prudential policies. The first relates to the experience with prompt corrective actions. An interesting feature of such actions is that they constrain authorities using some predetermined, transparent rules, alleviating the incentive problems mentioned above. The second relates to the conduct of monetary policy and provides nuance to the lessons of the first. Both monetary and macro-prudential policies must deal with uncertainty and mix art and science. For both, credibility requires that a clear target be assigned to the authority in charge and, in theory, that the analytical framework used to steer policy towards its target be pre-specified to some extent (e.g. the two-pillar framework of the ECB). In both cases, however, there would be significant costs in setting excessively strict or binding rules on the conduct of the policy on a day-to-day basis.

Speakers at the Banque de France/TSE conference

Claudio Borio, Bank of International Settlements
Rama Cont, Columbia University
Mathias Dewatripont, Université Libre de Bruxelles,
Christian Gollier, Toulouse School of Economics
Martin Hellwig, Max Plank Institute
Jean-Pierre Landau, Banque de France
Peter Praet, National Bank of Belgium
Rafael Repullo, Centro de Estudios Monetarios y Financieros
Jean-Charles Rochet, Toulouse School of Economics
José Scheinkman, Princeton University
Jean Tirole, Toulouse School of Economics

Topics: Financial markets, Macroeconomic policy
Tags: financial regulation, macro-prudential policy

Professor of Economics at the Toulouse School of Economics and Research Director at Institut D’Économie Industrielle

Head of Macro-Finance Division, Financial Stability Directorate at Banque de France