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Symposium 2013

Proposal - Macroprudential Policy: Getting the Architecture Right

The Challenge

The global financial crisis has revealed regulatory failure in financial markets and demonstrated the urgent need for reform. In particular, it is now widely accepted that in addition to established m ...

The global financial crisis has revealed regulatory failure in financial markets and demonstrated the urgent need for reform. In particular, it is now widely accepted that in addition to established microprudential policies, macroprudential policies aimed at increasing the stability of the financial sector as a whole are imperative. But an active debate has emerged over what role the central bank should play with this augmented set of policies.

Summary: While there is widespread agreement in the aftermath of the global financial crisis on the need for macroprudential policies, there is little agreement on how to structure or organize it, in general and in Europe in particular.

In the wake of the global financial crisis, there is widespread agreement on the importance of macroprudential policies. The traditional approach of supervising individual banks and nonbank financial firms (microprudential supervision) needs to be urgently supplemented, according to this new consensus, by macroprudential supervision in which the correlations among individual risks and systemic consequences are properly taken into account. Failure to do so before 2008, it is now agreed, was an important factor – perhaps the important factor – in the global financial crisis. This will not be news to many, of course; one can say the same thing about the role of systemic risks in the Asian financial crisis of 1997-8 or, for that matter, many earlier crises in economic and financial history.

Further, there is widespread agreement that monetary policy is too blunt an instrument for dealing with systemic financial risks and that central bankers who attempt to burst bubbles may jeopardize the attainment of standard monetary-policy goals. Fiscal policy, for its part, is too slowly moving: it can be difficult for political reasons to make sharp adjustments in the stance of fiscal policy in response to developing risks. All this points to the need for additional instruments –for countercyclical capital and liquidity ratios, adjustable loan-to-value ratios, dynamic provisioning and the like – capable of addressing these concerns.

Beyond these generalities, however, there is little agreement. Where, for example, should the macroprudential supervisor reside? On the one hand, cohabitation with the microprudential supervisor allows information on individual and systemic risks to be pooled. But, on the other, combining the two functions creates a danger of administrative overload.

Similarly, situating this function inside the central bank allows for efficient information sharing between the macroprudential supervisor and the lender of last resort. But placing the macroprudential supervisor outside the central bank avoids conflicts of interest between monetary policy and supervision.

Either way, making the macroprudential supervisor independent is important insofar as taking the credit punchbowl away while the party is going, by requiring higher lending standards for example, is bound to be unpopular. But such independence may be problematic politically, especially if the macroprudential supervisor is housed in the central bank. If central banks are given macroprudential objectives in addition to their traditional mandate to pursue low inflation, then the wide range of functions they are carrying out may create reservations in the minds of politicians and the public about delegating such weighty responsibilities to an anonymous committee of technocrats. Central banks have engaged in a variety of unprecedented interventions in recent years – controversial interventions that have already raised problems for accountability and independence. Also making central banks responsible for macoprudential supervision would only heighten these problems.

The straightforward solution is for central banks to become even more transparent about their decision making, so that their boards can be held accountable for those decisions in the court of public opinion. But transparency, while it enhances accountability and is therefore helpful for political reasons, can also create noise and excite financial markets. Having the macroprudential supervisor provide too much information on the fragility of the financial system before the problems in question have been addressed may not be an entirely good thing, for obvious reasons. It might only excite the volatility that the regulators are seeking to avert.

So can we conclude anything other than “it depends?” We can if we are willing to mine the rich trove of historical experience we possess on the organization, structure and operations of supervisors and monetary authorities around the world. In a series of papers, my colleague Nergiz Dincer and I have sought to do just that.

We find that capital ratios are higher and bank credit booms are less prevalent where the central bank is the lead supervisor. An interpretation is that monetary policy makers are more sensitive to the development of financial fragilities and credit market excesses and more inclined to adjust monetary policy to head them off when they have supervisory responsibilities. Another is that supervisors are more likely to clamp down on such excesses when they have first-hand knowledge of what monetary policy is doing to encourage them. Either way, our evidence thus provides at least some support for the recent trend of giving central banks macroprudential responsibility.

We also find that outcomes are better where central banks are both more independent and more transparent. Independence insulates decision making from politics. And it does not appear that central bank transparency has yet reached the point where providing still more information on decisions would be destabilizing.

The Eurozone has recently decided to place its single supervisor inside the European Central Bank, but members of the board continue to resist calls to publish the central bank’s minutes and to otherwise become more transparent. Our research suggests that the first decision is right but the second one is wrong. It also suggests that the two decisions sit uneasily with one another.

Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley.

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