Why macroprudential regulation?

By Matt Nolan 11/09/2012 1

With the RBNZ asking for comments on the upcoming countercyclical capital adequacy  regulation, and the RBA/APRA releasing a report on macroprudential policy now is a good time to ask – why?

I have seen many people justify these types of policies based on “debt being high” – but this doesn’t answer “why”.  I’ve heard a large number of people say it is because government savings made the private sector borrow, leading to financial instability – this not only doesn’t answer why, but it doesn’t involve any sort of sensible role for private agents and so is incoherent.

However, economists aren’t keen to let this issue slide – thank goodness!  The key concern, as previously mentioned, is trying to figure out what the market failure involved is.  What factors drive the systemic risk in the financial sector?  One interesting approach to microfound the incentives through the cycle that lead to this market failure is found here – one I found interesting at least, as there are many more :)

Now, it is useful to ask why for a couple of reasons:

  1. We can explain why these policies are actually a good idea – remember, just because something is volatile doesn’t make it bad instead we have to explain why to understand it in this sense.
  2. We can understand the impact of the policies – remember that it is likely that some financial regulation will involve a trade-off between output and stability.  When that is the case, we want to actually decide whether this trade-off is worthwhile.

If we can answer these, we can put in place good policy, policy we can explain, with impacts we can describe, and outcomes we can understand (and hopefully anticipate).

One Response to “Why macroprudential regulation?”

  • The di Iasio paper is quite good, it certainly describes the procycical effect of VAR well. I am not sure about the throwaway comment at the end about higher capital requirements on banks restricting credit supply. The banks put this about but it is just not right. I think it was Charles Calomiris who said a bank CEO told him he could easily raise more equity, he just didn’t like the price. So just make them – it’s not that hard. The end position is we just get back to making banks hold 20+% equity again, they will become low beta, ROE will fall and guess what – they will also stop trading at a massive discount to book. Banks targeting 15-25% ROEs is silly, but still normal.

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