Author: Sir Paul Tucker
Published: 13 September 2021
Macroprudential policy is (supposedly) the dynamic component of financial stability policy. Leading researchers recently described its purpose as being to “moderate the procyclicality of the financial system and thereby secure the resilience and stability of the financial system as a whole.”[1]
There is a good deal to be said about that, including whether any country with an international finance centre is operating a policy anything like it (no), and whether they should if they could. But jumping straight to such questions is hazardous because the nature of any dynamic policy depends on whether the background regime of resilience requirements for financial intermediaries is broadly optimal or materially deficient. In the latter case, which is the one that matters now, a vital role for dynamic macropru policy is to mitigate the costs of gaps and inadequacies. In practice, it has not done so.
Questions about the adequacy of the regime for financial stability: gaps highlight an important missed opportunity for dynamic macro-prudential policy
The purpose of a financial stability regime is to ensure that worries about the stability of the financial system do not materially affect the functioning of the wider economy. That is a few paces back from pinpointing procyclicality as the root of the problem: when the banking system has next to no equity, as before 2007, severe procyclicality is caused by lack of resilience, not vice versa.
Important questions, therefore, coming before normative assessments and prescriptions, are whether the static regime is complete, clear, and incentive compatible.
Away from banks, the big issue is holes in the regime, mostly concerning leverage and liquidity mismatches outside banking. That this matters is underlined by the March 2020 rescues — mainly in the US but probably not only there — that dare not speak their name.[2]
This is where dynamic macropru might have made a difference. With monetary policy constrained by passive (or contractionary) fiscal policy to bear pretty much the whole burden of reviving economic activity after the Great Financial Crisis, it was widely expected to have some undesirable side effects, including fueling a sometimes reckless, and in any case herd-like search for yield in financial markets. When taken with the incentives for some risk-taking to move out of re-regulated banks to less regulated or unregulated vehicles, the expectation was for a build-up of fragility outside the perimeter of the de jure safety net.
One obvious mitigant was for macroprudential bodies dynamically to increase minimum margin requirements in derivative markets and minimum collateral-haircut requirements in secured-financing markets since that would have contained leverage, and hence exuberance. Policy actions would have made sense for central banks cornered into being the only game in town.
If such measures were considered but rejected, it is not clear where those big choices — decisions not to act — were publicly scrutinized. We might provisionally conclude from this that dynamic policy faces incentive problems — for both policymakers and their political overseers. Systemic stability should not rely on a financial stability avatar of the late Paul Volcker keeping things safe and sound whatever the costs in popular or political support.
Starting again from the beginning: begin with a policy for “safe assets”
Those challenges are notoriously related to the wider problem of shadow banking. Ferocious lobbying aside, the absence of a general policy in this area plausibly reflects a failure to distinguish between two issues: the precarious safety of assets widely treated by traders and investors as safe and excessive leverage among intermediaries and vehicles that do not issue “safe assets.”
Money is the canonical safe asset: neither regular people nor financiers spend time thinking about whether it is safe. In economists’ jargon, money is informationally insensitive.[3] But it is not the only instrument treated by traders, asset managers and investors as safe. Uninsured bank deposits are and money fund units and repos in many risky instruments, and the upper tranches of many securitizations, and so on. Unsatisfied demand for safe assets generates myriad private sector mechanisms for synthesizing safety from bundles of risky assets.
An important feature of such instruments is the tendency of holders to run for the exits whenever, sometimes quite suddenly, it seems they might not be safe after all. Where the issuers of any such unsafe “safe asset” are large, individually or in aggregate, and where they play an important role in providing financial services to the economy (supply of credit, risk-transfer, or payments and settlement-services), the social costs of the switch in perceptions can be large. Faced with such disasters, the state tends to step in — typically in the form of the central bank — to render the assets safe after all, even when they said they wouldn’t do that.
This is no way to run a railroad. A quite different starting point for a credible stability regime would be to require the issuers of assets treated as safe, regardless of their legal form, to have access to the central bank’s discount window and for 100% of their “safe” liabilities to have to be covered by the value of their assets when so discounted. To give only one example, clearinghouses would be embraced because if their members’ claims on them are not treated as safe, they are nothing.
For banks and other vehicles that issue equity-like instruments, the central banks’ collateral haircuts would determine how much equity they needed. For vehicles like money funds, the haircuts would determine the proportion of a holder’s investment that could be presented as safe in their statutory accounts, published reports, and marketing.[4]
In that set-up, one arm of macroprudential policy would comprise keeping haircuts up to date as conditions change. Haircut decisions — taken by committee on a published schedule, but with provision for emergency meetings — would be the financial stability equivalent of setting interest rates for monetary policy. Remarkably, at present, reductions in official sector haircuts pass without notice, let alone scrutiny.[5]
Such a regime would share some features with today’s but differ in others. Unlike now, liquid assets would be usable because a minimum holding of liquid assets would not be a regulatory constraint. But for entities, such as banks, issuing debt instruments, insolvency would still be an issue, and therefore the need for credible resolution regimes and bail-in-able securities would continue.
Leverage without offering “safety”
Such a policy would ripple through financial markets. It is striking that the dominant forms of short-term financing for large corporates seem to be endogenous to the policy regime. Thus, for over a century, when London was the centre of international finance, it was bills of exchange, with their multiple acceptors and guarantors all subject to oversight by the old Bank of England: a pretty good system. Today, it has been commercial paper, which, by contrast, is one-name paper, and largely issued to money funds lying outside Federal Reserve’s oversight and liquidity insurance. In other words, today’s supposed policy regime and consequent financial structure is not incentive-compatible, implying deep design flaws.
Where should this leave financial intermediaries and vehicles that do not issue purportedly safe liabilities but are highly leveraged and so are liable to embark on socially harmful fire-sales of positions in bad states of the world? Two suggestions, falling short of a fully-fledged regime. First, any participant in markets, of whatever kind, above a certain size threshold should be required to publish their leverage a few times per year. This would apply to large family offices (so yes, outfits like Archegos), university endowments, and others. Publishing leverage would not reveal positions, but it would help to incentivize providers of leverage to ask more questions. Second, where the leverage of such large entities exceeds some threshold, they should be required to have a robust resolution plan for their orderly wind down without taxpayer support.
Dynamic macroprudential policy redux
All this might seem distant from macroprudential policy as framed (by others) in the opening paragraph. That is not an oversight. We should be somewhat worried by the avalanche of research papers on macroeconomic/financial spillovers, on early-warning systems, on welfare wedges, and more when we do not even have a core regime that can avoid the repeated implosions in shadow banking, or incentivize some of the largest and complex financial firms in the world to heed common sense risk-management principles. One final substantive comment is in order in that context.
Much of the literature currently revolves around what is known as GDP-at-Risk, which entails projecting the severity of the tails of the probability distribution for economic activity, as an input to taking action to head off such tail events.[6] The idea is useful. The data on which most such work is based are not. First, when, as is not unknown, the state steps in on time to head off economic collapse, the averted disaster is not in the GDP-data time series, but the rescue might still destabilize a country’s social and political harmony.
Second, and more profoundly, the time series do not capture other financial instability near misses. It is worth recalling that, when the telco debt bubble burst in late 2002, two of the largest firms in the world were said to be precariously positioned. Following up such near misses is as vital as it gets in this field. During Covid-19 there might have been less dramatic near misses.
Concluding thoughts in this opening blog
The theme in the background of this piece is the need to frame macro- and micro-prudential policy by working backwards from distress and failure. It is open to question whether that revolution, the great lesson of 2007-09, has occurred. But having been invited to contribute the opening blog to this site, I would like to finish with some suggestions for other issues that might usefully be debated.
Do we, for example, know how the myriad discretionary tweaks to policy regimes and supervisory practices over any year affect the equity levels required from individual banks?[7] How can outsiders be assured that there is not any (zero) reverse-engineering in stress testing? Does it matter that, outside the US, prudential policy committees have not had minority votes, so that, in stark contrast to monetary policy, parliamentary overseers, commentators and the public cannot see where there have been disagreements of view or strategy? This is especially important given the stability field, unlike monetary policy, is one with asymmetric lobbying: a mighty industry, but scattered users of its services. Rather differently, would any determined dynamic macroprudential policy require international coordination given potential spillovers? How would that fit with capital controls, and can we tell the difference? And, finally, are stability policymakers being asked to do too much, or not enough?
But, subject to learning from the debate I hope this website will help promote, I start from the view that the biggest issue is an incomplete regime that incentivizes stability-threatening activity to migrate beyond the perimeter of policy, only to be bailed out — again and again — when the music stutters.
Endnotes
[1] Shin, Hyun Song and Kwanho Shin, “Lessons for Macro-Financial Policy in Korea,” forthcoming.
[2] This is apparent in the barely disguised alarm in subsequent speeches, on both sides of the Atlantic.
[3] Holmstrom, Bengt. “Understanding the Role of Debt in the Financial System.” BIS Working Paper No. 479, 2015.
[4] For earlier versions, focussing on banks: King, Mervyn. The End of Alchemy: Money, Banking and the Future of the Global Economy, 2016; and Tucker, Paul (2019), ‘Is the Financial System Sufficiently Resilient? A Research Programme and Policy Agenda’, BIS Working Paper No 792. Thoughts on application to relevant mutual funds reflect discussions with Steve Cecchetti. There is much more to be said; for example, there would need to be credible punishments (eg, a lifetime ban from commerce) for the officers of any vehicle that ended up receiving liquidity assistance but had not signed up ex ante.
[5] Among other considerations, haircuts need to be set on the basis of the assets’ liquidation or run-off values in the event of a counterparty’s default. Given the distress of a Systemically Important Financial Institution would disrupt the economy and markets, they would (and should already) face haircut add-ons, just as today they do for directly imposed minimum requirements for tangible common equity.
[6] For a review: Aikman, David et al (2021), “Credit, Capital and Crises: A GDP-at-Risk Approach”, CEPR Discussion Paper 15864.
[7] A few years ago, it was suggested that equity requirements for UK banking groups had been subtly reduced. See Vickers, John (2016), “The Systemic Risk Buffer for UK Banks: A Response to the Bank of England’s Consultation Paper”, Journal of Financial Regulation, Vol 2, Issue 2, August, pages 264-282.
