Let’s Move to Rule-Based Regulation of Leverage and Money
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A research paper featured in the Bank for International Settlements’ (BIS) most recent Quarterly Review looks at the rising prominence of the word “macroprudential.” According to the paper, the word has surged from relative obscurity to more than 120,000 online references since January 2008. “Macroprudential” roughly describes concern for the soundness of the overall financial system rather than its constituent parts. Chairman Bernanke has used the word when suggesting that Congress “broaden the mandate of regulators and supervisors to encompass consideration of potential systemic risks.” Secretary Geithner has emphasized “macroprudential oversight” and coordination within the G20. A major objective of the “Financial Services Oversight Council” that’s included in the House-passed financial regulatory reform bill is to provide macroprudential oversight and closer scrutiny of “systemically significant” firms.
Implicit in the campaign for new laws to enhance macroprudential oversight is the notion that existing institutions lack this authority. Chairman Bernanke pursued this line of thought in his Atlanta speech before the American Economic Association: Fed policy during the bubble years was appropriate, he argued; what was lacking was a regulatory apparatus “attentive to the stability of the financial system as a whole” instead of the stability of individual institutions. In that speech (and elsewhere) Bernanke advocated “financial regulatory reforms, such as the creation of a systemic risk council, which will reorient the country's overall regulatory structure toward a more systemic approach.”
Suggestions that the Federal Reserve lacks the authority to provide macroprudential oversight are seriously misleading. Macroprudential oversight amounts to nothing more than evaluating supervisory and monetary policy decisions in light of the pro-cyclical tendencies of financial markets. In 2001 – i.e. just after the collapse of the most recent (previous) asset price bubble – the BIS published a paper documenting how borrowing costs, asset prices, risk assessments, ratings from agencies, and banks’ loan loss provisions all move in concert. As banks extend loans to finance certain investments, asset prices related to those investments rise. This asset price increase leads to more investment (per Tobin’s Q) and provides support to overall economic expansion. In short, the good times create their own momentum, which then reduces perceptions of risk and increases the willingness of banks to assume more risk and extend even more credit.
Since early 2000, analysts have urged policymakers to take this pro-cyclicality into consideration when setting interest rates and reserve requirements. A lengthy article in Der Spiegel chronicled the longstanding debate between BIS Chief Economist Bill White and Alan Greenspan on the proper focus of Fed policymaking. White’s message to the G20 in 2009 was the same message he carried to the Fed’s Jackson Hole symposium in 2003: “raise interest rates when credit expands too fast and force banks to build up cash cushions in fat times to use in lean years.” It was roughly the same argument that Kansas City Fed Bank President Thomas Hoenig made in a 2004 speech entitled “exploring the macro-prudential aspects of financial sector supervision” and Bill White made again in a 2006 working paper. In short, the failure of the regulatory apparatus was not a lack of authority, but a lack of focus. As the regulator of bank holding companies and the independent monetary authority, the Fed already possessed the policy tools necessary to reduce the potential for a systemic event.
It is always easier for policymakers to claim they lacked authority rather than admit to a possible error. But in this case, the excuse could lead to the creation of a regulatory superstructure to layer on top of the Fed, FDIC, the Treasury and its subordinate regulatory offices. This new regulatory power center would have sweeping new authorities, including “resolution authority” – a euphemism to describe the government’s ability to seize private businesses – and consumer product regulatory authority to set the parameters of what kinds of financial relationships with households are lawful.
Rather than debating new regulatory bodies with broad powers, the Fed and other federal regulators should get back to basics by focusing on simple, rule-based approaches. For example, researchers at the New York Fed have found that one of the greatest sources of pro-cyclicality in the financial markets is the “haircut” on repurchase agreements ("repos").
A repo is a collateralized loan where a borrower finances a position in a security by pledging that security as collateral to a lender. Because it is structured as a “sale” of a security to a lender with a commitment to repurchase it at a later date, the transaction can be abused, as it was by Lehman Brothers in its now infamous “Repo 105” transactions, and treated as an actual sale. But the much bigger problem from a systemic perspective is not outright fraud – which is already illegal and is the province of regulators supervising individual institutions – but the inverse relationship between haircuts and overall economic conditions.
The “haircut” is essentially the amount that the purchaser of an asset through a repo transaction must finance itself; if the haircut is 5%, the purchaser needs to put up $5 for every $95 financed and can leverage its money 20-to-1. As seen in the table below, from April 2007 to August 2008, the haircuts on various securities changed dramatically. The permissible leverage on asset-backed securities (ABS) plunged from over 33-to-1 (3% haircut) to 1.67-to-1 (60% haircut). An investment bank that could use $3 million to acquire $100 million of ABS in April 2007 could only finance $5 million of ABS with that same $3 million 16 months later. Such dramatic shifts in allowable margins lead to equally dramatic shifts in asset prices. The magnitude of these shifts also shows how investment banks could go from being the most profitable sector of the economy in 2006, to requiring bailouts in 2008, to being ultra-profitable again in 2009.
The regulators not only missed the bubble in real time, but believed the development of the bubble was positive, on net. Rather than vesting fallible humans with greater discretion, regulators – with the consent of Congress, if necessary – should set static margin requirements for security purchases to dampen the inherent cyclicality of the financial system. Fed policymakers should also use their authority over bank holding companies to require greater cash holdings during good times. And, perhaps most importantly, the Fed should look beyond “price stability” to recognize the imbalances caused by keeping the fed funds rate below its natural level. Just as with regulating leverage, monetary policy works best when it strictly adheres to well-defined policy rules.
Christopher Papagianis is the Managing Director of e21 and was Special Assistant for Domestic Policy to President George W. Bush.