The traditional micro-prudential regulations of bank-by-bank audit and supervision proved inadequate during the recent global financial crisis. There is now a new thinking on (i) how to reform the global financial system and how to reduce the vulnerability of the system to adverse changes in macroeconomic and market conditions; and (ii) which macroprudential approaches to be introduced to complement micro-prudential policies to deal with systemic and aggregate risks, such as excessive leveraging by all types of firms and households coupled with liquidity mismatches during a boom followed by excessive risk-averseness and de-leveraging during busts. There is also the issue of how best to deal with too big to fail institutions and inter-connectedness.
The objective of macroprudential policies is to ensure financial stability which means maintaining a steady stream of financial services to the whole economy, such as payment services, credit availability and insurance against risk. Other goals such as dampening unnecessary exuberance and over-leveraging, and avoiding asset price bubbles can also be added to the objectives of macroprudential policies. So there is a need for consensus on what exactly should be the goal(s) of macroprudential policies and supervision.
The current thinking is that over and above the existing capital ratios, central banks should be entrusted to put in a place a surcharge to dampen over-lending during boom times. Could this be at sectoral level (say on housing sector loans) or targeted at 'pockets' of emerging exuberance (say particular area where housing prices are sharply rising or at particular types of over-lending as in commercial real estate), or could it be at particular firms (say too big to fail financial firms). Increasing capital ratios or surcharges during boom will lower lending and act as self-restraint and self-insurance on the banks, while lowering capital ratios or surcharges during economic slowdown will give banks incentives to increase lending and therefore could avoid credit crunch as the one observed during Aug 2007 to much of 2008. In this way, systemic risks arising from hot sector, industry, or firm-level can be dampened.
All this means that central banks will have to do a lot more analysis at sector, industry, geographical and firm levels, and subjective judgments has to be made as to when, what and where should the capital surcharges need to be raised or lowered. Central Bank cannot be guided by fixed rules but by operational judgment.
As Haldane (2009) details, over the past century, in the UK, capital-asset ratios have fallen steadily from 25% of total assets in 1880 to about 6% in 2000 and for US the capital ratio fell from 17% in 1880 to 4% in 2008. Liquidity ratios have also decreased from 30% of total assets in 1968 to close to zero now. Therefore, the banking systems in US and UK are becoming more risky for the states while returns received by banks were close to 30% and volatility of returns has also increased since 1970. Haldane (2009) points out that the largest bank has over three trillion dollars in assets while the largest hedge fund operates with $40 billion in assets, and hedge funds are small, specialized, with high entry and exit compared to the banking system. All this means that macro-prudential policies alone are not enough to avoid another financial crisis.
Policy responses should also focus on (i) how to reduce the probability and suspect of failure of a systemically important financial firm; (ii) making the financial system better able to deal with such a failure. This would need (i) higher capital and liquidity requirements for systemically important firms; (ii) contingent capital in case of failure; (iii) legal structure and business model link to capital requirement in case of complex or not; (iv) self-will transparency in information about its own "demise" plan; (v) moving all over the counter derivatives markets onto an electronic exchange trading platform; (vi) separate out traditional banking business which supports the real economy from the investment banking. There are some practical issues in doing this, so a transitional hybrid approach may have to be followed; and (vii) stopping unregulated firms that developed special investment vehicles which collaterized assets which were illiquid and risky.
Original article can be found on the World Bank Institute's Growth and Crisis Blog.