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A Marriage of Convenience

Otaviano Canuto's picture

Photo: Wikipedia Commons User, Ssolbergj The world of presumed stable monetary and financial conditions was severely shaken by the recent global financial crisis. And with that, the separation in some quarters of financial supervision and monetary policy that reigned supreme over the past decades might also be coming to the end.

Before the crisis, the policy paradigm used to look like this: central banks around the world would focus on inflation-targeting and on setting interest rates, while financial regulation would be left to specialized, ad hoc agencies. Central banks’ primary role would be enough to maintain price stability and economic growth. On their side, financial regulators, through so-called “microprudential” rules, would ensure the soundness of financial institutions and protect depositors.

We all know what happened to this picture. The crisis tested the limits of both financial regulation and monetary policy acting individually. The existing regulations were insufficient to contain the spillover effects of the collapse of financial institutions to the rest of the economy. Now, in the wake of the Great Recession, there’s an increasing recognition of the need for macroprudential regulation to ensure the stability of the financial system as a whole and to mitigate risks to the real economy.

In fact, prudential regulation and monetary policy are complementary. Neither one can replace the other on its own. The combined use of both tends to be more effective than a standalone implementation of either. After all, financial risks are now seen as important enough for macroeconomic management to deserve a stronger regulation going beyond that of specialized agencies.

As I argue in a recent note, a pragmatic approach that combines elements of both monetary policy and prudential regulation is ideal. In particular, both policies can work in tandem to:

• Monitor the local market characteristics of financial stability and the various indicators that can be associated with it, such as rapid credit growth beyond past historical trends.
• Identify precisely the dynamics and determinants of permanent structural changes in credit markets.
• Look for ad hoc special shocks that might be contributing further to the observed credit and asset price booms.
• Identify other forms of balance sheet mismatches arising from booms.
• Assess the maturity structure of credit extension and its usage, discerning whether it is of a more long-term nature (and thus supposedly favoring investment) or of a more short-term nature.

As in other aspects of life, being alone is better than having bad company. But in this case, two together are better than each alone.

Sometimes, a marriage of convenience does work.

For more details on the topic, take a look at “How Complementary Are Prudential Regulation and Monetary Policy,” the most recent note in the World Bank’s Economic Premise series.
 

Comments

In 2003 and 2004 while an ED (same time as Otaviano Canuto), and while Basel II was being discussed, and as recollected in my book Voice and Noise of 2006, I suggested “flexible capital requirements, like moving up to 8.2 % or down to 7.8% by region, in response to countercyclical needs.”, which makes me one early proponent of macro-prudential regulations. But, of course, my proposal was strictly related to the basic capital requirement, because, when it comes to the setting of the risk-weights that translates the basic capital requirement into the effective ones, I have always opposed them wholeheartedly, now more than never. It is not prudent to interfere when there is no reason whatsoever to believe that you are in possession of superior knowledge. The role of regulators is not to concern themselves with the risk that the market already sees but with the risk the market might not be seeing. I ask, why should they regulate, as they do, basing it on the credit ratings being right, when what they really should be concerned with is when the credit rating are wrong? But since avoiding excessive risk taking can so easily tilt over into creating a dangerous excessive risk-adverseness, I also loudly voiced that “An excess of Basel’s banking regulations could be very harmful to your country’s development.” But you do not have to take my word for it. If anyone wants to understand the real implications of the dangerously prudish Basel regulations, I suggest reading the few pages on “Coping with Weak Private Debt Flows—Basel II” which appeared in the World Bank report “Global Development Finance 2003.” Just as an example it states “The regulatory capital requirements would be significantly higher in the case of non-investment-grades…borrowers borrowers with a higher credit rating would benefit from a lower cost of capital… A quantitative assessment of such effects is not straightforward, as the results are sensitive to a number of factors, including banks’ loan pricing policies and, in particular, the extent to which banks’ economic capital, which derives loan pricing, may exceed the minimum capital charges under the IRB approach. A recent study by the OECD (Weder and Wedow 2002) estimates the cost in spreads for lower-rated emerging borrowers to be possibly 200 basis points.” That chapter refers of course primarily to the problems of emerging nations… but it serves equally well to understand why there are now so many submerging nations… as small businesses and entrepreneurs have to pay according to my estimates 270 basis point more than a AAA rated client, just in order to compensate the banks for the regulatory discrimination based on perceived risk, the perception for which the banks have already naturally discriminated for by means of higher interest rates. What a shame that chapter got to be so ignored! I totally agree with Otaviano’s recommendations of “Monitor”, “Identify”, “Look for” and “Assess”, and the more of that the regulator will make available of that to the public the better, but also, the less of that the regulator will act on the better… because the regulators are quite often themselves the greatest source of systemic risk… as the current crisis has conclusively proved.

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