The dangers of false certainty in financial regulation

Critically there has been renewed concentration on making the financial system safer, in a global context, particularly as extremely generous monetary policies by major central banks have made finance cheaper and led many to worry about the emergence of new asset bubbles.

Easy monetary policy creates a conundrum: loose policies are designed to support economies which are yet to recover from the financial crisis but those policies, if they do indeed lead to asset bubbles, may inadvertently create the next crisis.

The FSI mood appears to be shifting towards higher capital buffers, “bail-in” structures so holders of bank debt rather than taxpayers carry the cost of a crisis, stricter controls on bank leverage and perhaps even formal separations of higher risk parts of the business from retail deposit taking divisions.

Murray’s argument for more capital is not illogical. As he has argued, because Australia is a capital importer it must be attractive for international providers of capital, hence the need to be not only safe but safe as measured by international regulation.

That’s true, obviously. The major Australian banks are among the few AA-rated banks left and hence attractive to investors. There’s a prima facie case then to add braces to the belts.

But’s that’s only prima facie. The banks in Australia have argued one side effect of adding more capital is it will make finance in the real economy more expensive or indeed lead to tighter availability. Which is counter-productive in view of the what’s happening in real economies.

But another issue for the FSI is the sheer complexity of financial systems and the unpredictability of new measures. Indeed, emerging asset bubbles are themselves an unintended consequence of a targeted cure.

For example, the ratings outlook for Canadian banks was cut by agencies when their regulator canvassed the option of so-called bail in provisions which would mean bond holders rather than taxpayers funding the cost of bank failure. (Or at least more of the cost.)

Naturally, given the ratings agencies exist to forewarn investors in bonds (even if their track record has not been great) such a move increases the risk to bondholders. But if agencies do take the next step, one of the implications for individual Canadian banks of a safer system will be a ratings downgrade – and hence a higher cost of debt.

The FSI then faces the challenge of deciding whether measures designed to improve system stability and shelter taxpayers would a) work and b) be worth the cost.

Take two key areas of anxiety in the current climate, house price bubbles and unsustainable asset price inflation.

The former is typically blamed on cheap credit and a lowering of lending standards. The latter on the global liquidity glut due to central bank money printing.

To tackle the former, one response has been to use what are known as “macro-prudential” tools which including limits on lending and loan-to-valuation ratios. New Zealand has adopted some of these measures.

Now the International Monetary Fund has published a research paper on such policies more broadly, analysing nearly 3000 banks in 48 countries over two years. In its working paper, “Macro-Prudential Policies to Mitigate Financial System Vulnerabilities”, by Stijn Claessens, Swati R. Ghosh, and Roxana Mihet the IMF found “measures aimed at borrowers – caps on debt-to-income and loan-to-value ratios – and at financial institutions – limits on credit growth and foreign currency lending – are effective in reducing asset growth”.

But “countercyclical buffers are little effective through the cycle, and some measures are even counterproductive during downswings, serving to aggravate declines, consistent with the ex-ante nature of macro-prudential tools”.

So these tools do work to limit asset price rises but they do rely on identifying where potential bubbles are located. Moreover, while the research found macro-prudential policies reduced vulnerabilities as cycles rose, they were less effective in reducing the impact on the downside – they didn’t work to build buffers to offset crunches.

Moreover, the authors were careful to note not only the variation between markets but that their research didn’t incorporate the non-bank sector.

“It could, however, be that these policies are also more easily avoided by channelling financing through less regulated parts of the financial system (note that this applies less to those macro-prudential policies aimed directly at borrowers as those are less likely to be avoided),” the authors say. “As such, using macro-prudential policies need not be associated with less overall systemic risks or reduced financial cycles.”

Meanwhile, in the latest Chicago Fed Letter, financial economist Ben Chabot asks “Is there a trade-off between low bond risk premiums and financial stability?” 

It’s a vital question because considerable concern is being generated by the impact of quantitative easing on risk premiums with the fear easy money is once again – just as before the financial crisis – leading to premiums being driven by demand (excess money in search of returns) rather than a genuine measure of risk.