HT PAREKH FINANCE COLUMN

JUNE 21, 2014 vol xlIX no 25 EPW Economic & Political Weekly
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Central Banks and the New
Macro-Prudential Toolkit
Avinash Persaud
Avinash Persaud (profadpersaud@gmail.com)
is Non-Resident Fellow, Peterson Institute of
International Economics and Emeritus
Professor of Gresham College, London.
The new macro-prudential toolkit
has its share of problems. It tends
to be pro-cyclical, despite being
aware that bank lending to
booming sectors also concentrates
risk, as the global nancial crisis
has shown. The emphasis of
macro-prudential policy must
take into account the nature of
risk and its location in order to
effectively guide markets by
aiming at risk-managing the
system at a macroeconomic level,
as opposed to the tendency of
using individual risk-based
micro-prudential policies.
A
fter years of being considered at
best aspirational, and at worse a
little wacky, macro-prudential
policy is now highly fashionable around
the worlds central banks. If nancial
markets were good at predicting nan-
cial crises, they would not happen as fre-
quently as they do. Financial markets
have a long and tested habit of col-
lectively underestimating risks at the
top of a boom and overestimating them
in the depths of the subsequent crash.
Monetary policy is particularly ineffec-
tive at these times. When house prices
are expected to rise 20% per annum, the
level of interest rates required to choke
off a housing boom would decimate the
rest of the economy. When the animal
spirits are low, even zero interest rates
are as ineffective as pushing on a string.
What is required is a macro-prudential
regulatory policy that acts against these
collective, self-reinforcing errors in
estimating risk.
These endeavours are complementary
to monetary policy not in conict with it.
Arguably, if regulatory policy targeted
asset-price booms and took that burden
away from monetary policy, it could be
better focused on keeping a lid on ina-
tion. We would have two policies target-
ing two specic objectives, la Tinber-
gen (1952).
To be fair, many emerging market
central banks have long pursued macro-
prudential policies. When you are prey
to externally-driven shifts in capital
ows, or follow a xed or managed
exchange rate, there is not much more to
monetary policy other than macro-
prudential policy. The Reserve Bank of
India has long used, perhaps to a fault, a
complex array of discretionary limits to
bank lending to the housing market or
other sectors. It was more in the deve-
loped world where central bankers came
to believe that there was no point trying
to second-guess nancial markets, and
at Basel, fashioned bank regulation in
the image of the markets.
Today, in the developed world, re-
born macro-prudential policies are still
in their infancy. A common formulation
is the establishment of new systemic risk
committees of the wise and connected
to judge whether capital adequacy
requirements should be raised or not.
There are more than a few challenges
with the current operation of macro-
prudential policy.
First, the inconvenient truth is that
central bankers had the supervisory dis-
cretion to tighten lending limits before
and in most cases chose not to use it.
However much those chasing evil-doers
in the rubble of a past boom would like
to think, booms are not all fakery,
hoisted upon the innocent masses by a
few crooks. There is always a good, com-
pelling, genuinely life-changing story
that grips us all, such as the advent of
the motor car, railroads, electrication,
policy reform and the internet. The col-
lective inability of humanity to escape
the preoccupations of the present is not
easily overcome by anointing a special
few to do so for us. The lesson of the cri-
sis is that we need more rules to rein in
credit growth during a boom, not more
discretion. A rule, based on bank prot-
ability or credit growth, could deter-
mine when bank capital requirements
are raised during the boom or relaxed.
Second, the problem with counter-
cyclical capital requirements is that rais-
ing them in a boom could lead banks to
concentrate their lending in the boom-
ing sector and away from others as the
booming sectors are the ones best able
to absorb higher borrowing costs. Cen-
tral bankers are alert to this tricky issue.
Capital requirements could be raised
only in the booming sectors, or banks
could be required to lower loan to value
ratios to borrowers there. This appears
inelegant and ad hoc (banks would be
incentivised to game the denitions of
the curbed sector). Arguably, macro-
prudential is more about sectors and
concentrations than aggregates. Capital
HT PAREKH FINANCE COLUMN
Economic & Political Weekly EPW JUNE 21, 2014 vol xlIX no 25
11
requirements could be raised with
increased concentrations of risk on a
banks balance sheet. However, while
this is more elegant, it is less practical.
Statistical correlations of risk are, like
almost everything else, pro-cyclical.
The same world seems to be a diversied
and liquid place in the boom and a con-
centrated, illiquid one in a crash.
A third problem is how do you reduce
bank capital requirements when the
boom is over, allowing capital to be
released and buffers used up, at the
same time as everyone is realising that
the world is a riskier place than they
thought. Just as raising capital require-
ments when the world looks to be a safer
place, the politics of this is harder than
the economics.
A Brief History
A yet bigger problem with the current
thinking on macro-prudential policy is
that it is xated with capital, dependent
on the original measurement of individ-
ual risks and not with risk-managing the
system. The global nancial crisis set-
tled the debate on the need for a macro-
prudential dimension to regulatory pol-
icy, but it may have done so ahead of
there being common ground on what
exactly systemic risk is and how best it is
managed. Macro-prudential regulation
is in danger of reverting to an enhanced
micro-prudential exercise, with macro-
prudential meaning that we have a
wider set of risks to consider, tot up and
put up capital against. As the economy
slows, perhaps under the burden of more
unproductive capital, the collective amo-
unt of risk rises, requiring more capital.
There is danger that the capital ade-
quacy regime becomes more pro-cyclical
and not contra-cyclical as intended.
Internationally, bankers complain that
despite record low levels of interest rates,
lending is constrained by regulation.
Risk can be hedged, spread and
pooled, but it is not so easily reduced.
The task of the new macro-prudential
central banker is as a risk manager for
the nancial system. A deeper under-
standing of what this means would
probably point macro-prudential regula-
tion in a different direction to where it is
pointed today. There is not one risk but
different types of risk. They are differ-
ent, not because we give them different
names, but because we would hedge
each differently. The liquidity risk of an
asset is the risk that if you were forced to
sell the asset tomorrow, you would have
to accept a deep discount in the price to
bring out an unwilling buyer, compared
to the price you would achieve if you had
a longer time to nd a more willing
buyer. The way you hedge liquidity risk
is not by owning a wide range of equally
illiquid assets, but by having the time to
sell, perhaps through long-term funding
or long-term liabilities. The credit risk of
an investment is the risk that it defaults
on its payments and principal. Credit
risk is not hedged by having more time
in which the default can take place (this
would increase credit risks) but by
spreading credit risks across diverse and
short-term credits.
A pension fund or life insurance rm
has a capacity to absorb liquidity risks,
but no particular ability to spread credit
risks. A bank funded with overnight
deposits with a raft of different borrow-
ers has a capacity to absorb individual
credit risks, but little capacity to absorb
liquidity risks. If risks in the nancial
system are in the wrong place, there is
no reasonable amount of capital that
will save it. One critical advantage of
placing risk where, if it erupts, it can be
absorbed, is that we are then less
dependent on measuring it correctly
something almost all nancial market
participants have proved poor at doing
through the economic cycle.
This could be done simply by requir-
ing all nancial institutions irrespective
of what they are called and what sector
we think they are in, to place capital
against mismatches of liquidity, credit
and market risks. This would incentivise
those with wells of liquidity to draw
liquidity risk from others and in return
sell them credit risks that they cannot
easily match and vice versa. We would
have stability strengthening transfers of
risks across the nancial sector rather
than what we had before. Within the
banking sector, international regulators
have taken one step towards this goal
by the introduction of the net stable
funding ratio with the goal of a banks
long-term assets being matched by an
equal or greater amount of long-term or
stable funding. This is one of the recom-
mendations from Basel that bankers are
most up in arms against, and one of the
most vital.
If liquidity risks were held by those
with the biggest capacity for holding
them, and the same for credit and mar-
ket risks, the system would be safest, it
would be most resilient to mistakes in
the assessment of risk, it would require
the least amount of unproductive capital
and regulatory policy would be least in
conict with the ination targeting
objectives of monetary policy. But the
banks can only effectively shed liquidity
risks if there is someone more appropri-
ate to hold them. Yet, today, right under
the noses of the new systemic risk com-
mittees, the new international regula-
tion of insurance and long-term savings
institutions looks set to achieve the
opposite. Wrongly formulated and the
proposed Solvency II regulation of
insurance companies with regards to
valuation and capital could force the
natural holders of the nancial systems
liquidity risk not to hold it. Forcing long-
term institutions to behave like short-
term ones will be the biggest contributor
to systemic risk since Basel II. What is
macro-prudential regulation if it is not a
realisation that the nancial systems
resilience is about where risks reside
across the nancial system and not just
in banks?
Reference
Tinbergen, Jan (1952): On the Theory of Economic
Policy (Amsterdam: North-Holland Publishing
Company).
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