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Why International Financial Regulation Still Falls Short

  • William White
  • Sep, 2020
  • 95
  • Banking & Finance

Despite post-2008 regulations, the boom-bust credit cycle continues to run wild

The last three major economic downturns in the global economy (1990, 2001 and 2008) did not have their roots in rising inflation and a determined central bank response. Rather, they had their origins in rising debt levels and associated disturbances in financial markets. Taming the “boom-bust” credit cycle should by now have displaced inflation and the business cycle as the chief concern of central bankers. Unfortunately, this crucial lesson has not been learned. Rather, excessive reliance has been placed since 2008 on tightened regulation of the financial sector, in large part following internationally agreed guidelines. These regulations, mostly affecting banks, have already “fallen short” of preventing a further, dangerous increase in global debt ratios and other threats to economic and financial stability. Indeed, it can be argued that they must “fall short” for a variety of reasons explained in my new INET Working Paper.

First, the primary objective sought by the regulations has been to ensure that a weak financial system does not aggravate economic downturns, by restricting the supply of credit. Arguably more important, and having received some but much less attention, is the need to ensure that an overly exuberant financial system does not weaken other parts of the economy, by encouraging a rapid buildup of debt during upturns. This aggravates the subsequent downturn by limiting the demand for credit.

The only policy that would suffice to avoid both problems is to “lean against the wind” of debt accumulation in the upswing of the credit cycle. We need a macrofinancial stability framework to do this effectively. Both monetary policy and time-varying macroprudential regulatory policy must be used in a way that reflects their relative strengths and weaknesses. Without monetary support, regulatory restrictions will be circumvented. Without the support of cyclically- sensitive macroprudential policies, monetary tightening alone might prove destructive for the whole economy. This “belt and braces” approach is consistent with the insights provided by treating the economy as a complex adaptive system.

Second, the time-varying macroprudential policies introduced in recent years do not have the objective of leaning against the credit cycle. That objective has now been focussed much more narrowly on preserving the stability of the financial system, defined as a system capable of providing essential services even in the aftermath of a financial crisis. As with monetary policy, macroprudential policies have now become more focussed on resilience (clean up after) than sustainability (lean against the wind). This narrowed objective is unfortunate since dangerous “imbalances” can build up outside the banking system (threatening market functioning) and even outside the financial sector (in the form of excessive household and corporate debt).

Third, when time-varying macroprudential policies are directed to the stability of the financial system, they run into a whole host of implementation problems. National governance arrangements (commonly interagency committees) are generally a blueprint for inaction. The fact that most macroprudential instruments are microprudential instruments already assigned to other official bodies (but for a different purpose) is a further institutional complication. Moreover, absent agreed models on how financial crises unfold, deciding when to change regulatory instruments (and which ones) becomes highly uncertain. The need to evaluate and to trade off the joint effects on near term growth, financial stability and distributional issues makes such judgements even less reliable.

Fourth, while there have been significant improvements to financial sector regulations that do not vary with time, individual changes still have shortcomings and their coherence as a package has also been questioned.

One evident improvement in recent years has been the growing emphasis on systemic vulnerabilities, allied with the recognition that threats to the system can be growing even if all the financial agents look individually healthy. This insight has led to the introduction of non time-varying macroprudential policies. Regulatory attention has focussed on identifying Global Systematically Important Banks (GSIBs) and how they might be wound down without unacceptable side effects and with minimal costs to taxpayers. Significant attention has also been put on reducing interdependencies in the financial system that could lead to systemic distress. While important progress has been made, significant shortcomings still need to be addressed as do the problems of unintended consequences arising from the policies adopted. Significant doubts still remain as to whether a GSIB or a large central counterparty ...

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