More than even monetary policy management, increasingly it is evident that the greatest challenge facing central banks is in maintaining financial market stability. On the one side, the central bank has to encourage financial market innovations that promote economic growth, while on the other hand prevent these innovations from inflating asset bubbles and other market distortions. As the events of the last decade have shown, central banks are still unsure about how to achieve this twin objective. They face the following problems during the boom times
1. Identifying what constitutes a bubble. Relevant proxy parameters, with their boundary limits, that most accurately reflects the build up of bubble is important to monitor this.
2. How much to "lean against the wind" to deflate the bubble. Acting too quickly and too aggressively risks sacrificing the beneficial effects of a boom, while the costs of being too slow and being light-touch were there to see after the sub-prime bubble burst.
3. Which instruments to deploy, so as to minimize the impact of intervention. Interest rate and other conventional macroeconomic parameters impact on the entire economy, not just those parts of the markets which have been distorted.
4. Automaticity of regulatory provisions to address the bubble. Policies that soften any bout of "irrational exuberance" will generate strong opposition from all stake holders and run the risk of being politicized. It is therefore important to have atleast some first level of self-acting regulatory requirements that kick-in as soon as the "green shoots" of a bubble appears. The more intrusive policies can then follow with the inevitable lag.
Charles Goodhart writes that "it should be possible to construct a more counter-cyclical, time-varying regulatory system in such a way as to mitigate these problems, so long as the regulations are relaxed in the downturn after having been built up in the boom". He captures this twin-dilemma nicely
"There is a tension between trying to get banks to behave cautiously and conservatively in the upswing of a financial cycle, and being prepared as a central bank to lend against whatever the banks have to offer as collateral during a crisis. Again, the more that a central bank manages to constrain bank expansion during euphoric upswings, e.g. by various forms of capital and liquidity requirements, the greater the disintermediation to less controlled channels. How far does such disintermediation matter, and what parts of the financial system should a central bank be trying to protect? In other words, which intermediaries are 'systemic'; do we have any clear, ex ante, definition of 'systemic', or do we decide, ex post, on a case-by-case basis?"
The Basel II norms had created a feeling of false comfort among banks and their regulators across the world. While it laid out quantitative risk-weighted capital adequacy requirements for banks, it left the details of what constitutes capital and risk to individual national banking regulators. Banks, often in collusion with their local regulators, gamed the system and rendered this ratio an ineffectual instrument to monitor individual bank risk. More fundamentally, this increased emphasis on risk unwittingly lent a pro-cyclical dimension to banking regulation - conventional measures of risk decline during a prolonged boom and this in turn frees up banks to ramp up leverage.
Further, it was all along presumed that firm or bank-focussed financial regulation was adequate to control systemic risks. Accordingly, macro-prudential regulation of the financial sector itself was largely ignored on the belief that regulating the institutions was sufficient. This presumption failed on two grounds
1. Individual and systemic risk do not always coincide. There are two common examples from the events of the recent past. One, while actions in the aftermath of a financial crisis to cut lending and increase liquidity is prudent and risk-lowering for individual banks, it amplifies risks for the system as a whole. Second, the now infamous "too-big-to-fail" financial institutions exert a disproportionately large adverse impact on the financial market itself.
2. The rapid emergence of the largely unergulated shadow banking sector. This meant that the conventional risk monitoring parameters, which was confined to covering the regulated banking sector, became largely superfluous as the most aggressive risk-taking was concentrated in the shadow banking sector.
Apart from the conventional credit risk arising from the quality of its assets, banks increasingly face balance sheet risks due to two factors - excessive leverage and maturity mis-match between assets and liabilities (especially significant during low interest rate cycles).
Another big challenge with financial market regulation is about getting the micro-prudential (or bank-level)and macro-prudential (or system-wide) regulation of banking and financial sector respectively right. There are those like Markus Brunnermeier and Hyun Song Shin, who advocate separate regulator for both - a Financial Services Authority tasked with the former and central banks doing the latter. They write,
"Macro-prudential regulation in particular needs reform to ensure it countervails the natural decline in measured risk during booms and its rise in subsequent collapses. "Counter-cyclical capital charges" are the way forward; regulators should adjust capital adequacy requirements over the cycle by two multiples - the first related to above-average growth of credit expansion and leverage, the second related to the mismatch in the maturity of assets and liabilities. Changes to mark-to-market procedures are also needed."
However, given the inherent difficulty of "taking the punch bowl away as the party gets going" and the empirical observation that "countries which allow a less regulated, and more innovative and dynamic, financial system grow faster than their more controlled brethren, despite being more prone to financial (boom/bust) crises", there may be an arguement in favor of having in place effective policies to quickly respond and pick up the pieces after a bust. And given the political difficulty in pushing through meaningful financial regulation plans, it may be prudent to drawn on lessons from the sub-prime mortgage bubble and its aftermath and put in place atleast an efficient crisis-management architecture.
Update 1 (20/3/2010)
Alan Greenspan blames the crisis on the dramatic decline and convergence of global real long-term interest rates in the last two decades which in turn engendered "a dramatic global home price bubble heavily leveraged by debt and a delinking of monetary policy from long-term rates". See Greg Mankiw's comments on the Greenspan paper here.
He offers three suggestion for making the financial system more crash proof. One, given the strong moral hazard of bailouts unleashed by the actions of the Fed and Treasury during the sub-prime crisis, it is important to have higher capital requirements. Otherwise, creditors to the big institutions will view them as too safe, and will lend to them too freely, and the financial institutions, in turn, will be tempted to respond to their low cost of debt by leveraging to excess.
Two, he proposes "living wills" for all financial intermediaries where they publicly disclose (thereby pre-empt counterparties from complaining after the fact that they thought they had more legal rights in the event of liquidation than they do) their own plans to wind down in the event that they fail, thereby leaving policymakers with a a game plan in hand if these instiutions fail.
Third, he also proposes contingent debt that will turn into equity when some regulator deems that a firm has insufficient capital. This debt would become a form of pre-planned recapitalization in the event of a future financial crisis, and the recapitalization would be done with private rather than public money. Since the financial firm would pay for the cost of these funds, rather than enjoying taxpayer subsidies, it would be incentivized to make itself less risky, for instance, by reducing leverage. The less risky the firm, the less likely the contingency would be triggered, and the lower the interest rate the firm would need to pay on this contingent debt.
Update 2 (29/3/2010)
Greg Mankiw favors banks and financial institutions selling contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. He feels that this would be s form of crisis insurance and a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds.
He also supports the Greenspan idea of financial firms writing their own "living wills", describing how they would wind down in the event of an adverse shock to their balance sheets.
See this excellent summary of the challenges facing financial market regulation by David Leonhardt. Mike Konczal has a superb analysis of all the financial market regulation proposals under circulation in the US.