MACROPRUDENTIAL POLICY, LEVERAGE, AND BAILOUTS.

• Author: Malz, Allan M.

Macroprudential policy is a major initiative developed after the 2008 global financial crisis. It aims to reshape regulatory policy, emphasizing financial stability as well as the viability of individual intermediaries. It refers to a wide range of policy measures intended to avoid crises, partly drawn from established regulatory and supervisory tools. Proponents hope it will emerge alongside monetary policy and the regulation and supervision of intermediaries as a primary approach to securing stable growth.

The promise of macroprudential tools, however, is overstated. Macroprudential tools cannot compensate for an existing regulatory system that increases risks to financial stability. Banks are inadequately capitalized, and the larger banks are too complex and opaque for their risks to be grasped by regulators, investors, and securities analysts, or even their own management. Explicit or implicit public-sector subsidies and guarantees of support for some intermediaries and types of debt, collectively known as "too big to fail" (TBTF), the safety net, and bailouts, generate moral hazard and shift risk to the public. Confidence in the ability of narrowly targeted rules or on-site supervision to correct for the resulting high leverage is misplaced.

The problems of leverage and moral hazard can be addressed directly, and not through additional layers of rules. The rationale for macroprudential tools in addressing these issues assumes an unrealistic extent of detailed knowledge of the financial system and ability to control it, and the ability to correct specific weaknesses in the financial system with policy measures that have predictable effects.

Relying on macroprudential tools may also lead to deemphasizing monetary policy at critical junctures. A focus on financial stability has always been an inherent part of monetary policy. But macroprudential tools are advocated not only as useful occasional supplements to changes in interest rates and monetary aggregates, but as alternatives to monetary policy and the primary means of responding to concerns about financial stability.

It may be the case that monetary tools are not sufficient in some circumstances to ensure financial stability as well as the goals of stable prices and growth. However, using macroprudential tools as a first resort, absent a lasting solution to the problems of undercapitalized banks and overt and tacit guarantees, can only muddle policy. TBTF is largely a creation of policy. It would be better to first stabilize banking and end TBTF, and then see what tools are still needed to complement monetary policy.

Historical Background of Macroprudential Policy

Although the term "macroprudential policy" is relatively new, (1) central banks' focus on financial stability is not. Bagehot's rule for a central bank as crisis lender of last resort contains a macroprudential provision: emergency liquidity is to be provided only against good collateral, encouraging banks to maintain a stock of unencumbered, reliably eligible assets. In its first decade, the Federal Reserve considered imposing "direct pressure" on banks to restrain short-term call money financing of stock purchases (Friedman and Schwartz 1963: 283). (2)

Not long before the global financial crisis, today's macroprudential debate was foreshadowed by one over "lean or clean." By the late 1990s, the prevailing monetary policy framework--setting the policy interest rate close to the unobservable natural rate to attain low positive inflation and growth at capacity--had been clearly formulated. (3) It seemed overwhelmingly successful in the disinflation of the 1980s and in contributing to stable growth during the Great Moderation years that followed and ended with the crisis. Inflation rates were surprisingly low, while real growth was steady, if somewhat disappointing, and with a surprisingly low variance.

Tension between financial stability and monetary policy goals nonetheless increased. Signs of excessive financial ease appeared, such as buoyant stock markets and rising leverage. Large financial shocks were more frequent compared to the immediate postwar era. It was unclear whether low real interest rates were due to easy monetary policy or fundamental economic factors.

One strand to the discussion questioned whether low and stable inflation was a sufficient condition for financial stability. Proponents of "leaning against the wind" argued that low inflation didn't justify monetary ease in the face of alarmingly loose financial conditions. Failing to take account of financial conditions in setting monetary policy could defer, but not avoid, the resulting fragility and misallocation of resources. (4) Those taking the "clean up afterwards" view argued that, if what turned out in hindsight to be a monetary error eventually obliged the central bank to tighten abruptly and induce a credit crunch, it could address those consequences (Bernanke and Gertler 2001).

Another strand debated whether financial variables not part of the standard framework, particularly asset prices, should be taken into account in setting monetary policy. Proponents of leaning called attention to the pattern of rapidly rising asset prices and unusually low volatility followed by financial shocks. Opponents argued that it was difficult to measure risk premiums or identify deviations from fundamental values ex ante. Rising asset prices would in any case induce the appropriate monetary tightening through their stimulative effects.

This was part of a debate on whether the financial system is naturally stable or has an endogenous, inherent tendency to excessive swings. While the lean-versus-clean debate focused on asset prices, the volume and riskiness of credit aggregates were also identified as behaving procyclically. Easy financial conditions perpetuate and reinforce themselves and vice versa, leading to alternating booms and busts. Financial cycles extend over a much longer period than business cycles, the macroeconomic fluctuations that are usually the focus of monetary policy (Borio 2014). One could have an extended period of macroeconomic and apparent financial stability, but under the surface excessive debt levels were ultimately leading to a crisis. (5)

The debate turned in part on costs and benefits. The "lean" view focused on the tail risks of accommodative monetary policy, that is, the risk of a financial crisis and a large, protracted, and extremely costly decline in real growth. The costs of leaning may at best be deferred rather than avoided if an expansion is unsustainable. The "clean" view emphasized the cost in forgone growth of raising interest rates in response to false positives in asset prices and credit aggregates. The costs of growth limping perpetually behind potential would be greater than the highly uncertain benefits of successfully avoiding crises. (6)

Rationale of Macropnidential Policy

The crisis placed systemic risk--the risk of severe financial crisis--in the foreground of the debate.' Macroprudential policy has found remarkably wide support, uniting central-bank and academic analysts with otherwise divergent views on financial regulation. The background remains the compatibility of financial stability with the desired stance of macroeconomic policy, but skepticism of the stability of the financial system has grown, and efforts to identify non-monetary tools to address stability risks have intensified.

Financial markets are viewed as more prone to market failure than other sectors of the economy, a view buttressed by two propositions about the sources of systemic risk. The first is the presence of externalities unique to financial markets. The leverage of one intermediary has a negative and uncompensated impact on the asset risk of others, by increasing their risk as lenders and their market and credit risk as investors. The second is that variations in risk appetite can lead to large responses of risk premiums to a shock or change in economic conditions. For some economists skeptical of market efficiency, these variations are "bubbles," resulting from irrational bouts of ill-founded optimism in booms and pessimism in busts. Others view them as adaptations to economic realities such as the role of collateral and limited ability to diversify and hedge important risks. (8)

Macroprudential tools can shore up the overall resiliency of the financial system, internalize the systemic costs of leverage, and mute variability in the response of risk premiums to changes in risk appetite (Adrian, Covitz, and Liang 2015). Even among observers with more confidence in financial markets' rationality and efficiency, macroprudential policy is appealing as a second-best response to defects in the regulatory system that are unlikely to be remedied anytime soon, such as the incentives to take risk generated by public-sector guarantees.

The rationale of macroprudential policy relates it to monetary policy. Procyclicality implies that easy credit tends to self-reinforce, increasing the odds that any shock is severe enough to trigger a systemic risk event. If tighter regulation enables the financial system to withstand larger shocks without crisis, it can relieve monetary tightening of some of the burden of avoiding it. Monetary policy on its own, or the use of just one instrument, interest rates, is inadequate to achieve the two goals of macroeconomic and financial stability, so an additional instrument, macroprudential policy, is needed.

The rationale is sometimes framed in terms of additional channels through which monetary policy affects the economy. The credit channel refers to its impact on financing by external lenders, which has higher monitoring costs than internal financing. Lower interest rates support asset values and strengthen firms' balance sheets, enabling firms to secure financing on more favorable terms and making them less dependent on retained earnings (Bernanke and Gertler 1995). The...