The Counter–Revolution Begins: The Rise and Premature Fall of Macro–Prudential Regulation
By Avinash Persaud (Chair of the Warwick Commission)
An early consensus to emerge from the wreckage of the global financial system was that in addition to the old, we needed a new type of regulation: macro-prudential regulation. This became so readily accepted, at a time when policy makers were ready to accept almost anything that appeared to be affirmative action, that the term, “macro-prudential regulation”, quickly became a cliché: over-used and poorly understood. So poorly understood, it now appears, that despite much talk of the need for macro-prudential regulation and its cousin, “systemic risk regulation”, it is actually hard to find any detailed macro-prudential regulation in the US Administration’s White Paper. Bank of England Governor, King, has also pointed out that despite being given broader responsibility for systemic risk by the UK Government, he has not yet been given any macro-prudential tools to achieve it.
The term macro-prudential regulation was probably first used in the late 1980s by Andrew Crockett, former General Manager of the Bank of International Settlements. In more recent years his colleagues at the Basle-based
Proposals to improve the regulation of firms, products and markets - contained in the US Administration’s White paper - are generally a good thing, but they are not macro-prudential. Moreover, these proposals neglect the critical observation that we have spent the last 20 years tightening up micro-prudential regulation and yet financial crashes are just as deep if not more so and they do not occur randomly, which a failure of a rogue firm might imply, but always follow booms. This boom-bust cycle implies there is something “macro” going on we need to address urgently.
A common source of macro-prudential risk is common behaviour by financial firms - often as a result of closer adherence to tougher micro-prudential rules. During booms, asset prices rise and measured risks fall. Acting prudently, financial firms will feel it is safe to expand lending. All financial firms expanding together will lead to a scramble for assets that will create, post-hoc, excesses in valuations and lending. During the resulting crashes asset prices collapse temporarily and measured risks soar. In “Sending the herd off the cliff edge” (IIF, 2000) I showed how all financial firms responding to common prudential, market-based risk controls, would lead them to want to sell the same assets at the same time, creating a liquidity black hole.
Macro-prudential regulation is about encouraging different behaviour than a prudent firm would follow, wherever this prudential behaviour could undermine the financial system if followed by everyone. It is rather like the paradox of saving. Individually saving is good; collectively we can have too much of it. A classic macro-prudential tool that has been adopted by the Warwick Commission is to raise capital adequacy requirements, not for all times, but specifically when aggregate borrowing in an economy or a sector is above average in an attempt to put sand in the systemically dangerous spiral of rising asset prices leading to rising borrowing to buy assets, leading to rising asset prices. This will not end boom-bust cycles, but it will help to reduce their amplitude. India could be said to have carried out macro-prudential regulation when the RBI tightened up credit conditions for lending in the housing market.
Another macro-prudential tool supported by the Warwick Commission is to take a holistic approach to the financial sector and encourage certain risks to flow to places with a capacity for that risk. When the crash comes, firms that can absorb short-term liquidity risks, perhaps because they have long-term funding, are not forced to join the selling frenzy in the name of common prudential rules for all, but are more able to buy and diversify liquidity risks across time. This would forestall the implosion of the financial system that would occur if there are no buyers, only sellers.
Buried beneath the US Administration’s proposals are hints at counter-cyclical provisioning, extra capital for liquidity risks at banks and differentiated accounting, but the Paper essentially gives to much to those carrying the pitch forks in Congress who argue that what was wrong was that we didn’t have enough regulation. The brave observation is that we had too little of the right, and too much of the wrong, regulation. Doubling up existing regulation will satisfy the justifiable moral outrage against bankers that many voters feel; but it will lead to more of the same in financial boom and bust because it is insufficiently macro-prudential.