Friday, December 18, 2009

Changing role of Central Banks?

The focus of modern central banking has been to provide price stability by controlling inflationary pressures on the prices of goods and services commonly traded in the real economy. It was also argued that they should desist from trying to prick asset bubbles in financial markets and smoothing the booms and busts of business cycles.

This orthodoxy was best exemplified by a famous paper co-authored by the present Fed Chairman Ben Bernanke with Mark Gertler, and presented at the annual Jackson Hole enclave in 1999. Central Bankers led by Alan Greenspan have dutifully followed this strategy, even as the world economy developed serious macroeconomic imbalances and financial asset bubbles during the last two decades.

They have believed that it was not possible to accurately assess whether and when asset price increases assume the character of a bubble. Further, even if a bubble was developing, assessment of the time, extent and scope of the intervention required was thought to be beyond the abilities of policymakers. And compounding the problem is the difficulty in choosing the right mix of instruments to deploy in such situations. The dilemma facing central bankers is - when to intervene, by what extent and using what instruments? The risk was of intervening either too early and/or too aggressively, and thereby adversely affecting economic growth.

However, in light of the dramatic events of the past fifteen months and the havoc wreaked by the systemic risks that got built up due to the passivity of Central Banks, it appears that the momentum may have shifted in the direction of more aggressive Central Bank intervention to deflate asset price bubbles and stabilize the business cycle.

I have blogged earlier about using Markov regime-switching analysis for a variety of major global market events to detect advance signs of emerging market turbulence and manifestation of systemic risk building up. Further, as the figure below indicates, it is amply clear that asset prices have exhibited "irrational exuberance" on multiple occasions due to varying factors since late nineties.



WSJ points to the work (see this presentation) of Princeton Professor Hyun Song Shin and New York Fed researcher Tobias Adrian, draws attention to the impact of monetary policy on the funding conditions of financial institutions and development of financial asset bubbles. They show that the credit bust was preceded by an explosion of short-term borrowing by US securities dealers such as Lehman Brothers and Bear Stearns. They point to the borrowing in the so-called repo market (where Wall Street firms put up securities as collateral for short-term loans), which more than tripled to $1.6 trillion in 2008 from $500 billion in 2002. Further, as the value of the securities rose, so did the value of the collateral and the firms' own net worth, in turn spurring firms to borrow even more in a self-feeding loop. And when the value of the securities started to fall, the loop went into reverse and the economy tanked.

In other words, "the most dangerous part of a bubble may not be the rise in asset prices, but the level of debt that builds up at financial institutions in the process, fueling even higher prices". The commonest policy intervention to prevent the build up of such levels of debt, and thereby pre-empt these busts, is to raise interest rates. Accordingly, Adrian and Shin highlight the need to factor in the trends and directions in credit flows ("balance sheet quantities") into Fed interest-rate calculations. They feel that small additional increases in rates in 2005 might have tamed the last bubble, and claim that interest rate is the "most effective instrument" for regulating risk-taking by firms.

However, this too runs into the same aforementioned uncertainties, risks, and inefficiencies. Interest rate decisions not only affect these financial institutions, they also impinge on all types of consumer spending and business investment decisions. Further, its universal sweep means that even the more prudent and responsible financial institutions are penalized for the excesses of their greedy and irresponsible compatriots. Or are there broader systemic parameters, which reflect the build-up of more universal distortions, that can be used to time such interventions?

A more effective and systemic intervention to prevent such debt spirals would be higher and uniform (across all types of financial institutions) capital adequacy ratios or tighter collateral requirements on borrowings. And these ratios should also take into account the varying extents of systemic risks posed by different financial institutions - remember the too-big-to-fail (TBTF) institutions! A sliding scale of increasing capital requirements as debt levels increase may help offset the amplified risks posed during such borrowing binges. Restricting leverage would have to become the primary control mechanism. Differential provisioning requirements, based on the investment risk profiles, are another excellent means to limit excessive build up of credit in high-risk sectors.

Update 1
Mark Thoma draws attention to Paul Volcker and Ben Bernanke who both advocate an important role for the Fed in regulation and supervision of banking sector, especially in light of recent events which conclusively demonstrates that monetary policy and the structure and condition of the banking and financial system are irretrievably intertwined.

Bernanke's arguement rests on two issues - such powers significantly enhances the Fed's ability to carry out its central banking functions (the Federal Reserve’s ability to effectively address actual and potential financial crises depends critically on the information, expertise, and powers that it gains by virtue of being both a bank supervisor and a central bank); the twin functions of consolidated supervision of individual banks and assessing macroprudential rystemic risks require expertise that only the Fed possesses.

Update 2
Rajiv Sethi feels that it "might be possible to obtain information about the prevalence of beliefs about an asset bubble by looking at the prices of options... In the case of a bubble involving a large class of securities (such as technology stocks) a widespread belief that prices exceed fundamental values should be reflected in higher prices for index straddles: a combination of put and call options with the same expiration date and strike price, written on a market index."

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