As Paul Krugman wrote recently, deposit insurance (by preventing bank runs) and bank capital requirements (by reducing the incentive for banks to take advantage of guarantees to gamble with other peoples’ money) had been the twin pillars of banking regulation for many decades now. However, the rapid emergence of non-depository banking and non-exchange traded (or over the counter) financial instruments (like derivatives), and their pervasive ("too inter-connected to fail") and dominating ("too-big-to-fail") role in the financial markets have rendered the conventional regulatory tools blunt.
It is also now well-acknowledged that under-pricing of risk and the application of uniform and time invariant risk ratios/weights played an important role in sustaining resource mis-allocation and amplifying the contributory factors to the asset bubbles. The major pro-cyclical risks arise from the inflating asset values that incentivizes and enables financial institutions (and households) to expand their both lending and borrowing. The systemic impact of such collective bouts of "irrational exuberance" is much more than the sum of their individual impacts.
Financial market regulation proposals in the aftermath of the sub-prime crisis continue to remain focused on micro-prudential (firm specific) regulation, albeit with increased attention to the counter-cyclical dimension. Primarily this means tightening the monitoring and enforcement, and increasing the conventional capital requirements (capital adequacy ratio) and liquidity and reserve ratios. There have also been proposals to use more innovative debt instruments like contingent convertible bonds (CoCos) that automatically convert into equity when risks mount; and attempts to re-define the meaning of capital (whether it includes only common stock or covers others like preferred stock and deferred tax assets). But the macro-prudential dimension of regulation is yet to evolve into concrete proposals.
As Claudio Borio explains, macro-prudential (or systemic) regulatory frameworks have two dimensions - managing the cross-sectional risk distribution across the financial system at any given time and addressing the evolution of the aggregate risk over time. The challenge in the first dimension is to deal with common (co-related) exposures (to similar asset classes or linkages among them) across financial institutions that causes institutions to fail together.
The key issue with the second dimension is to deal with pro-cyclicality or "how system-wide risk can be amplified by interactions within the financial system as well as between the financial system and the real economy". As Borio writes, "During expansions, declining risk perceptions, rising risk tolerance, weakening financing constraints, rising leverage, higher market liquidity, booming asset prices, and growing expenditures mutually reinforce each other, potentially leading to the overextension of balance sheets. The reverse process operates more rapidly, as financial strains emerge, amplifying financial distress."
As Avinash Persaud writes, the need for macro-prudential regulation arises from the fact that "financial firms acting in an individually prudent manner may collectively create systemic problems". Further, in the busts following booms, "all financial firms responding to common, prudential, market-based risk controls would lead them all to want to sell the same assets at the same time, creating a liquidity black hole". In other words, effective micro-prudential regulation (of individual institutions) does not obviate the need to monitor and regulate emergent system-wide risk factors.
Persaud and a few others have advocated the automatic (or indexed) raising of capital adequacy requirements (for individual firms) when aggregate borrowing (or some other index of systemic riskiness) in an economy or a sector is above average so as to "put sand in the systemically dangerous spiral of rising asset prices" and thereby reduce the amplitude of the bubbles. This can be extended to include a counter-cyclical dimension to all capital and other reserve ratios, by indexing them to certain systemic risk parameters that more or less accurately reflect the emergent risk scenarios. Such automatic stabilizing instruments have been called asset based reserve requirements (ABRR).
Apart from the counter-cyclically indexed ratios, Claudio Borio also advocates having capital ratios, insurance premia etc which are determined depending on the estimates of the individual institutions’ contribution to system-wide risks. This would imply having tighter standards for institutions whose contribution is larger, contrasting sharply with the microprudential approach, which would have common standards for all regulated institutions.
Another macro-prudential tool would be to have systemic rules that incentivize firms that can absorb short-term liquidity risks (because they have long-term funding/debts or larger capital cushions) to not join the selling frenzy in a downward spiral, instead of some common prudential rules for all that only amplifies the spiral.
In a Vox article, Enrico Perroti draws the distinction between aggregate risk creation (which affects financial stability), which is highly co-related with the business cycle, and systemic risk creation (which affects the larger macroeconomic stability) in credit booms. He writes that while asset risk is the natural remit of micro-financial regulators (including central banks by way of liquidity support during a deleveraging spiral), the task of managing the systemic risk arising from panic withdrawals of short-term funding (and the resultant system-wide propogation of risks) should be assigned to "macro-prudential councils" (which also contains central bank representation). This is similar in concept to the super regulators, like that proposed in the last Union Budget in India, who would be tasked with monitoring systemic risks.
He argues that aggregate asset risk factors, such as co-related holdings of long-term assets, can be targeted with countercyclical capital requirements and regulation (such as prudential limits, rules on disclosure, and clearing arrangements). Similarly, systemic levies, imposed through the aforementioned macro-prudential councils, offer a policy that can tighten financial discipline without the need for a large increase in interest rates across the whole economy.
He therefore proposes a liquidity-risk levy on intermediaries relying on fragile uninsured short-term funding (to the extent of such funding) for the negative externalities they create for others (when they make fire sales to repay rapid withdrawals of funding) by such borrowings. This would also act as a "charge (on) intermediaries ex ante for the de facto insurance of uninsured liabilities, though without creating an explicit insurance promise".
Such levies would be aimed at future incentives, discouraging rapid asset growth funded by investors bearing no risk (like carry trade strategies to invest in securities), and also increase maturity transformation from the current absurd over reliance on overnight repo markets, thus increasing financial resilience to shocks. Further, he also feels that such "liquidity-risk charges should be scaled by bank size – to tackle the too-big-to-fail problem – and by interconnectedness – to control intermediaries which cannot be easily disentangled from others".
Update 1 (18/7/2010
The Basel III Committee has this draft working paper on counter-cyclical capital buffer. When credit is expanding faster than GDP, bank regulators slowly increase their capital requirements, signaling those requirements clearly one year in advance. The higher capital requirements serve three main purposes: they help to slow down credit bubbles, they make an economy’s banks stronger, and they offer a way out of the paradox of capital. See also this and this.