Reviving a Policy Marriage

WASHINGTON, DC – Not long ago, the separation of financial supervision and monetary policy was in vogue in many countries. Some countries – like the United Kingdom and Australia – went so far as to unbundle these functions by assigning responsibility for financial stability to specialized agencies and extricating their central banks from financial supervisory issues altogether. In the aftermath of the global financial crisis, however, financial supervision and macroeconomic management have been forced to reunite.

This rapprochement is a consequence of the growing recognition that asset-price cycles must be taken into account for both macroeconomic management and financial supervision. Prior to the crisis, asset-price cycles were seen by many as basically harmless or, at least, as a relatively insignificant monetary-policy channel. Even when the frequent appearance of asset-price bubbles was acknowledged, most believed that efforts to detect and prick them at an early stage would be impossible – and potentially harmful. Interest-rate cuts after bubbles burst would be a safer way to safeguard the economy.

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The dominant policy blueprint looked roughly as follows: the monetary authorities’ focus on inflation-targeting in setting interest rates should suffice to maintain price stability and economic growth near its potential rate. As for financial supervision, stability would be guaranteed by ensuring that individual financial institutions adopt sound prudential rules that preserve capital cushions commensurate with their risk exposure. While central banks should be in charge of maintaining adequate levels of liquidity in the system, so-called “microprudential” financial regulation should independently oversee financial institutions’ soundness and the protection of depositors.

The crisis has shattered the belief that well designed microprudential rules alone are sufficient. It is now increasingly recognized that significant asset-price increases (for example, in real estate or existing equities) may well be reinforced by the pro-cyclical nature of risk assessment embodied in those rules.

What this means is simpler than it sounds: the rising value of collateral tends to be seen as offering higher repayment probabilities. Moreover, if financial institutions follow their own risk assessments when estimating appropriate capital cushions, the costs associated with such provisions decline. Better repayment prospects and lower regulatory capital costs then fuel the asset-based financing of further acquisition of assets.

If asset-price bubbles develop, balance sheets may look sound individually, but the entire network of interlinked asset-liability structures will become increasingly dependent on overvalued collateral, and thus vulnerable to financial contagion. The unraveling of such a network – through panic and runs against financial institutions, asset fire sales, credit crunches, and the like – then becomes a nightmare for financial supervisors and monetary authorities alike.

Moreover, systemic risks potentially created during periods of booming asset prices escape the purview of macroprudential rules. In the advanced economies at the core of the recent financial crisis, the rules, implicit or explicit, of strict inflation-targeting regimes led monetary authorities to stay put while a massive pyramid of debt was built on a base of overvalued collateral. Now financial risks are deemed to be sufficiently important for macroeconomic management to warrant regulatory arrangements going beyond that of the microprudential supervisor.

With respect to financial supervision, there has been increasing support since the crisis for countercyclical capital requirements, at least for banks. Capital buffers to absorb losses during the downturn of the cycle can be more easily built during the upswing. Furthermore, by raising regulatory capital costs in boom times, some counterweight to the pro-cyclical bias intrinsic to financial systems would be introduced.

Such countercyclical capital requirements are likely to be added to the toolkit of macroprudential rules and policies, the use of which has risen as enthusiasm for light-touch financial supervision has faded. Those tools include caps, linked to borrowers’ characteristics, on loan-to-value ratios; direct limits on currency and maturity mismatches in financial institutions’ balance sheets; limits on their balance sheets’ interconnectedness; and minimum reserve requirements for specific financial instruments.

Beyond capital rules, however, monetary policy and financial supervision must cooperate very closely on liquidity management, particularly through credit mechanisms. Given modern financial systems’ demonstrated ability to create (and destroy) liquidity endogenously – via financial innovation and global mobility – financial and macroeconomic stability may become more difficult to achieve if monetary instruments and macroprudential tools are not used in a consistent manner. Policy harmonization, rather than separation, seems to be the key to happy cyclical endings.