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The Warwick Commission

The Counter-Revolution Begins: The Rise and Premature Fall of Macro-Prudential Regulation by

By Avinash Persaud (Chair of the Warwick Commission)

An early consensus to emerge from the wreckage of the global financial system was that in addition to the old, we needed a new type of regulation: macro-prudential regulation. This became so readily accepted, at a time when policy makers were ready to accept almost anything that appeared to be affirmative action, that the term, “macro-prudential regulation”, quickly became a cliché: over-used and poorly understood. So poorly understood, it now appears, that despite much talk of the need for macro-prudential regulation and its cousin, “systemic risk regulation”, it is actually hard to find any detailed macro-prudential regulation in the US Administration’s White Paper. Bank of England Governor, King, has also pointed out that despite being given broader responsibility for systemic risk by the UK Government, he has not yet been given any macro-prudential tools to achieve it.

The term macro-prudential regulation was probably first used in the late 1980s by Andrew Crockett, former General Manager of the Bank of International Settlements. In more recent years his colleagues at the Basle-based BIS, in particular, Bill White and Claudio Borio, championed the idea along with some policy officials –it may be unhelpful to them to identify them by name - and macro-economists like Charles Goodhart, Jose-Antonio Ocampo, myself and others. The point of macro-prudential regulation is that financial firms acting in an individually prudent manner may collectively create systemic problems. Macro-prudential regulation is a response to a failure of composition problem: we cannot make the financial system safe, merely by making every financial institution and product safe.

Proposals to improve the regulation of firms, products and markets - contained in the US Administration’s White paper - are generally a good thing, but they are not macro-prudential. Moreover, these proposals neglect the critical observation that we have spent the last 20 years tightening up micro-prudential regulation and yet financial crashes are just as deep if not more so and they do not occur randomly, which a failure of a rogue firm might imply, but always follow booms. This boom-bust cycle implies there is something “macro” going on we need to address urgently.

A common source of macro-prudential risk is common behaviour by financial firms - often as a result of closer adherence to tougher micro-prudential rules. During booms, asset prices rise and measured risks fall. Acting prudently, financial firms will feel it is safe to expand lending. All financial firms expanding together will lead to a scramble for assets that will create, post-hoc, excesses in valuations and lending. During the resulting crashes asset prices collapse temporarily and measured risks soar. In “Sending the herd off the cliff edge” (IIF, 2000) I showed how all financial firms responding to common prudential, market-based risk controls, would lead them to want to sell the same assets at the same time, creating a liquidity black hole.

Macro-prudential regulation is about encouraging different behaviour than a prudent firm would follow, wherever this prudential behaviour could undermine the financial system if followed by everyone. It is rather like the paradox of saving. Individually saving is good; collectively we can have too much of it. A classic macro-prudential tool that has been adopted by the Warwick Commission is to raise capital adequacy requirements, not for all times, but specifically when aggregate borrowing in an economy or a sector is above average in an attempt to put sand in the systemically dangerous spiral of rising asset prices leading to rising borrowing to buy assets, leading to rising asset prices. This will not end boom-bust cycles, but it will help to reduce their amplitude. India could be said to have carried out macro-prudential regulation when the RBI tightened up credit conditions for lending in the housing market.

Another macro-prudential tool supported by the Warwick Commission is to take a holistic approach to the financial sector and encourage certain risks to flow to places with a capacity for that risk. When the crash comes, firms that can absorb short-term liquidity risks, perhaps because they have long-term funding, are not forced to join the selling frenzy in the name of common prudential rules for all, but are more able to buy and diversify liquidity risks across time. This would forestall the implosion of the financial system that would occur if there are no buyers, only sellers.

Buried beneath the US Administration’s proposals are hints at counter-cyclical provisioning, extra capital for liquidity risks at banks and differentiated accounting, but the Paper essentially gives to much to those carrying the pitch forks in Congress who argue that what was wrong was that we didn’t have enough regulation. The brave observation is that we had too little of the right, and too much of the wrong, regulation. Doubling up existing regulation will satisfy the justifiable moral outrage against bankers that many voters feel; but it will lead to more of the same in financial boom and bust because it is insufficiently macro-prudential.

Keywords: Finance, Regulation

11:51, Thu 16 Jul 2009

Great Expectations and International Finance Reform by

By Leonard Seabrooke

What are the limits of the possible for international financial reform? In recent months we have seen behaviour from governments and financial institutions that 18 months ago would have been considered unthinkable or heresy. Bail-outs, nationalisations and quasi-nationalisations in key OECD economies have demonstrated how flexible governments can be in uncertain times. All is in flux. The idea of self-regulation within financial markets has been discredited by the depth and scope of the crisis. Scandals over bonuses to bankers have captured headlines, and prominent politicians have sought to avoid national introspection by blaming weaker economies, such as tax havens. Hints and nods toward international supervisory coordination have been prominent with little detail on what will happen. Discussions of fiscal stimulus targets among the G-20, as well as the reform of the International Monetary Fund, are underway, yet uncertainty is pervasive. Regulators are watching the markets for signs of confidence, while the markets are hanging back wondering who they can trust with their money. Both are uncertain about what assets are really worth, be they ‘toxic’ or otherwise. Governments and markets are waiting for ideas on how to reform while also engaging in institutional experiments with the hope of restarting the extension of credit and, from that, economic demand and growth.

We may consider how best to reform the financial system based on what an ideal system would look like. Such vision is important and necessary as we transform financial regulation and explore options for international coordination and cooperation. And a vision is especially important if we wish to avoid half-baked solutions that make matters worse. A number of commissions have been formed to foster ideas on how to change financial regulation for a more stable international system. Be they in the international public sector, such as through the UN, or from the financial community, most of these commissions have focused on technical matters. This is very important work, contributing to the marketplace for ideas about financial reform. We should also consider that this marketplace, like all markets, is mediated by political interests. This politics is formal, from political parties and governments, as well as informal in what citizens expect from their governments and what they expect from their financial system. Because the current crisis arose within strong democracies, politicians have a clear incentive to consider these expectations from the public when thinking through ideas and options for national and international financial reform.

There are clear reasons why we need to think through what we could call the political economy of international financial reform. We often discuss the link between the financial sector and the real economy during periods of high financial stress. The current crisis has often been interpreted as demonstrating both the madness of financial instruments and schemes bearing no relationship to the real economy, as well as how the most mundane of instruments, a mortgage, can bring down the international system. Beyond the idea of the real economy are real political and economic interests in how national financial markets relate to national welfare concerns. Financial policy is intimately tied to social and welfare policies in all countries.

The most obvious link between financial policies and social policies can be seen in how housing is financed. There is great variety in how governments regulate the relationship between financial markets and housing, which is a reflection of how different societies see the need for housing. Political economy scholars call this a welfare trade-off. In some countries citizens opt for high taxes and high welfare that provides social housing. Other societies favour low taxes and low welfare and then have to build assets over their life through housing and pension fund contributions. Governments and financial markets have a clear interest in innovating to meet the political and economic need for housing. How citizens in different countries save and borrow also reflects their particular welfare trade-off.

Let us consider the political economy of two highly advanced systems where housing finance and financial markets are closely linked, the US and Denmark. In the US the low welfare regime means that citizens have a strong need for housing finance. It is no surprise that mortgage securitisation emerged within this society, and that access to credit was politicised as groups were excluded from credit access due to income or, especially in the past, race. In the US access to credit for housing was, and is, a political good. Politicians have a clear incentive to increase credit for housing since those who miss out know that they are dependent on a weak welfare state. It is also not surprising that governments create institutional innovations to meet political and economic needs. The creation of the sibling institutions Fannie Mae, Freddie Mac, and Ginnie Mae (which is linked to the civil rights movement) was to mediate the interests of private capital and public values. As we now know, the most recent US property boom made it harder for many Americans to be ‘prime’ borrowers through the siblings and led to the boom in sub-prime mortgage securitisation. Sub-prime mortgages attracted a lot of investment, from home and abroad, because they were lucrative and risky, or because they were hidden within seemingly safer mortgage pools. Poor judgment from credit ratings agency compounded problems. At base, the now ‘toxic’ sub-prime mortgage-backed securities are tied to Americans’ welfare trade-offs. It is a priority for the US government to restart securitisation as soon as possible because it performs a critical political and economic function within the American system. Formal and informal politics are intertwined and provide hard constraints. President Obama will have an interest in saving securitisation since without it he may have an administration in which the community groups from which he claimed some of his political legitimacy have fewer chances to build assets through access to housing. Expectations for these political and economic goods are very high.

The Danish system for housing finance, which has been hailed George Soros and others as world class, provides a contrast. Small little Denmark has the biggest housing bond system in Europe and it is based on a ‘balance principle’ covered bond market that does not recycle capital in the same manner as US-style mortgage securitisation. Danes carry more personal debt than other Europeans, and to an extent that would make the most bloated of Americans blush. Danes can do so because of their high taxes and high welfare state, and because only half the population own property despite their impressive wealth. The high welfare state and low income inequality, along with a consensus-style political party system, makes it easier to slow down he extension of credit. Expectations are lower, as long as the high tax and high welfare state remains. This also means that exporting the Danish model to other countries may be difficult where the public expect more housing credit than this system can provide, or where citizens do not have the capacity to bear debt because of a weaker welfare state. We need only think of other countries with different political economy dynamics to consider the broader logic. For example, Germany’s high savings and low home ownership system means that its politicians and public want different things from the German financial system. Welfare trade-offs matter for what politicians and citizens want and these desires will have a deep impact on what is possible for national and international financial reform.

In considering what kind of financial systems we want at the national and international levels, there is a range of important questions. Among them are questions of what the appropriate size for the financial sector would be, how regulators might avoid capture from special interests, how to address the complexity of financial instruments, and how risk can be used to generate innovation and growth rather than uncertainty and inertia. We also need to consider to what extent regulation should be local rather than global, as well as how to improve the representation of developing countries in international institutions that set financial standards. As ideas for reform are put forward they have to be placed in a political economy context that would help assess the chances of actual policy change. Financial policy is tied to social policy and social policy is political. What societies expect from their financial systems will constrain international financial reform. We should expect to see a lot of variety in how OECD economies respond to the crisis. Such divergence rather than convergence may well be legitimate because it reflects different welfare trade-offs and social purposes. An international financial crisis that arose from within strong democracies cannot be solved behind closed doors and removed from the public. We need to be aware that great expectations will shape international financial reform for good or bad.

Leonard Seabrooke is Director of Studies for the Warwick Commission on International Financial Reform and Professor in International Political Economy at the University of Warwick.

Keywords: Finance, Regulation, Social

15:52, Thu 2 Jul 2009