Why International Financial Regulation Still Falls Short

Yves here. Just so you know, this is the William White who along with Claudio Borio, when both were at the BIS, started issuing warnings in 2003 to central bankers about housing bubbles in many national markets. They later formalized it in a paper. They were pooh-poohed, particularly by Alan Greenspan, for the lack of theoretical foundations for their findings. This while he was institutionalizing the Greenspan put. And you wonder why we have trouble coming up with sensible financial regulation?

By William White, Chairman of the Economic Development and Review Committee, OECD. Originally published at the Institute for Economic Thinking website

The last three major economic downturns in the global economy (1990, 2001 and 2008) did not have their roots in rising inflation and a determined central bank response. Rather, they had their origins in rising debt levels and associated disturbances in financial markets. Taming the “boom-bust” credit cycle should by now have displaced inflation and the business cycle as the chief concern of central bankers. Unfortunately, this crucial lesson has not been learned. Rather, excessive reliance has been placed since 2008 on tightened regulation of the financial sector, in large part following internationally agreed guidelines. These regulations, mostly affecting banks, have already “fallen short” of preventing a further, dangerous increase in global debt ratios and other threats to economic and financial stability. Indeed, it can be argued that they must “fall short” for a variety of reasons explained in my new INET Working Paper.

First, the primary objective sought by the regulations has been to ensure that a weak financial system does not aggravate economic downturns, by restricting the supply of credit. Arguably more important, and having received some but much less attention, is the need to ensure that an overly exuberant financial system does not weaken other parts of the economy, by encouraging a rapid buildup of debt during upturns. This aggravates the subsequent downturn by limiting the demand for credit.

The only policy that would suffice to avoid both problems is to “lean against the wind” of debt accumulation in the upswing of the credit cycle. We need a macrofinancial stability framework to do this effectively. Both monetary policy and time-varying macroprudential regulatory policy must be used in a way that reflects their relative strengths and weaknesses. Without monetary support, regulatory restrictions will be circumvented. Without the support of cyclically- sensitive macroprudential policies, monetary tightening alone might prove destructive for the whole economy. This “belt and braces” approach is consistent with the insights provided by treating the economy as a complex adaptive system.

Second, the time-varying macroprudential policies introduced in recent years do not have the objective of leaning against the credit cycle. That objective has now been focussed much more narrowly on preserving the stability of the financial system, defined as a system capable of providing essential services even in the aftermath of a financial crisis. As with monetary policy, macroprudential policies have now become more focussed on resilience (clean up after) than sustainability (lean against the wind). This narrowed objective is unfortunate since dangerous “imbalances” can build up outside the banking system (threatening market functioning) and even outside the financial sector (in the form of excessive household and corporate debt).

Third, when time-varying macroprudential policies are directed to the stability of the financial system, they run into a whole host of implementation problems. National governance arrangements (commonly interagency committees) are generally a blueprint for inaction. The fact that most macroprudential instruments are microprudential instruments already assigned to other official bodies (but for a different purpose) is a further institutional complication. Moreover, absent agreed models on how financial crises unfold, deciding when to change regulatory instruments (and which ones) becomes highly uncertain. The need to evaluate and to trade off the joint effects on near term growth, financial stability and distributional issues makes such judgements even less reliable.

Fourth, while there have been significant improvements to financial sector regulations that do not vary with time, individual changes still have shortcomings and their coherence as a package has also been questioned.

One evident improvement in recent years has been the growing emphasis on systemic vulnerabilities, allied with the recognition that threats to the system can be growing even if all the financial agents look individually healthy. This insight has led to the introduction of non time-varying macroprudential policies. Regulatory attention has focussed on identifying Global Systematically Important Banks (GSIBs) and how they might be wound down without unacceptable side effects and with minimal costs to taxpayers. Significant attention has also been put on reducing interdependencies in the financial system that could lead to systemic distress. While important progress has been made, significant shortcomings still need to be addressed as do the problems of unintended consequences arising from the policies adopted. Significant doubts still remain as to whether a GSIB or a large central counterparty could be wound down without unacceptable collateral damage.

The reality is that most of the post crisis reform effort has gone into traditional microprudential regulatory policies. Such policies also do not vary over time and, by definition, cannot “lean against the wind”. Moreover, microprudential policies seek to strengthen the health of individual institutions, rather than the stability of the financial system as a whole. Thus, they are two steps away from the ideal of countercyclical policies directed to stabilizing the broader economic system.

Some of the post-crisis microprudential initiatives have clearly been helpful. Bank capital ratios are now much higher and the risk weighted ratios have now been complemented by an unweighted leverage ratio. Yet, a number of commentators have questioned whether the increases are adequate, especially given the many risks that have grown sharply in just the last few years; e.g., digitalisation and operational risk, losses associated with climate change, and risks arising from the increased frequency of pandemics. Moreover, certain shortcomings can also be identified. Not least, tighter regulations of institutions by sector invites migration to less regulated sectors as well as encouraging innovations specifically designed to avoid the regulations. For example, pre-crisis regulation of banks contributed to the growth of a particular form of “shadow banking”. Since the crisis, the rapid growth of asset management companies has raised questions about the risks they might now pose to the global financial system.

The seriousness of each of the concerns raised in this paper might be debated. Taken all together, however, they point to the conclusion that post crisis international financial regulation still “falls short”. The stability of the financial sector, much less the economy more generally, is still far from assured. This assessment suggests a need for a fundamental rethink of how both monetary and regulatory policies should be conducted, once the problems triggered by the covid-19 pandemic have been put behind us.

In assessing alternative proposals, a preference should be given to building on existing institutional structures in an incremental way. This suggests changing the policies of government institutions, and then adding on policies to either change the behaviour of market participants or to change the structure of financial markets themselves. Consistent with the comments above, this implies that countries should adopt a macrofinancial stabilisation framework in which both monetary and regulatory polices “lean” against the credit cycle. As a corollary, all policies (monetary, regulatory and fiscal) should be used more symmetrically over each individual cycle. That would be required to stop the buildup of stocks of debt, both private and public, over time. This regime change should be complemented with measures designed to change the behaviour of financial agents; in particular, a much greater reliance on self discipline and market discipline. Finally, structural changes to roll back financial consolidation, globalisation and securitization could be contemplated if the above, “market friendly” reforms failed to achieve their purpose.

Many critics of the current system suggest the need for much more radical reform. Those advocating “free banking” feel that financial regulation and the provision of official “safety net” support should be severely limited. Financial stability would be ensured by market discipline, with banks making imprudent loans being reined in by other banks fearing the systemic fallout. Others advocate “narrow banking”, some variant of the original proposal made by the Chicago School in the 1930s. In the original version, banks would have to hold government securities as backing for all current accounts. They would therefore lose their capacity to create money, and to drive credit “booms and busts”. Instead all risky loans would be financed by true savings, and each loan would bear a direct risk of loss. More modern versions also address the so called “boundary problem”; namely, that non-banks could create substitutes for narrow money. As with “free banking”, financial regulation and safety nets would be swept away.

Barring a decision, jurisdiction by jurisdiction, to retreat into autarky, all proposals for change at the national level will have to face international challenges. First, unilateral adoption of a macrofinancial stability framework could lead to undesirable changes in a country’s exchange rate. Second, regulatory changes at the national level will immediately raise concerns about international competitiveness and level playing fields. These arguments imply that any fundamental rethink of the conduct of monetary and regulatory policies should take place in international fora. Since we currently do not have an international monetary system, with agreed rules directed to preserving international economic stability, such a rethink would fill an existing and dangerous void.

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  1. Ignacio

    This is very good but still doesn’t addresses other side effects of credit cycles that are related with what is called here “asset management”. It is ignored that each credit bust is managed in ways that create asset concentration in lesser hands. This outcome isn’t still considered deleterious by central bank managers or analysts but this indeed reinforced credit cycles and should be addressed.

  2. Christopher Herbert

    I’m in Michael Hudson’s camp. Public banking is required and tax laws encouraging private debt need to be cashiered. A public option is free from exorbitant salaries and stock options, management fees and other financialization tactics, not to mention political lobbying and fines for the now chronic misbehaviour of the largest banks. We need to restore strong regulators. We need to go back to Glass Steagall and get retail banking out of investment banking. We need to tax rents, monopolies and limit ‘extractive’ financial activity that has no meaningful productive purpose. Also, it is easier for government to cancel debt owed to itself.

  3. Sound of the Suburbs

    The Americans wrapped a new ideology, neoliberalism, around 1920s economics and we returned to 1920’s ways of thinking.

    At the end of the 1920s, the US was a ponzi scheme of over-inflated asset prices.
    The use of neoclassical economics and the belief in free markets, made them think that over-inflated asset prices represented real wealth accumulation.
    1929 – Wakey, wakey time

    Why did it cause the US financial system to collapse in 1929?
    Bankers get to create money out of nothing, through bank loans, and get to charge interest on it.
    What could possibly go wrong?
    Bankers do need to ensure the vast majority of that money gets paid back, and this is where they get into serious trouble.
    Banking requires prudent lending.

    If someone can’t repay a loan, they need to repossess that asset and sell it to recoup that money. If they use bank loans to inflate asset prices they get into a world of trouble when those asset prices collapse.
    As the real estate and stock market collapsed the banks became insolvent as their assets didn’t cover their liabilities.
    They could no longer repossess and sell those assets to cover the outstanding loans and they do need to get most of the money they lend out back again to balance their books.
    The banks become insolvent and collapsed, along with the US economy.

    Why does neoclassical economics crash the capitalist system?
    It was this economics that brought capitalism down in the 1930s.
    It’s not only god that works in mysterious ways, we must add the globalists to the list.

    The recipe for disaster:
    1) The belief that you are creating wealth by inflating asset prices. All that price discovery stuff gets everyone thinking you are creating wealth by inflating asset prices.
    2) Letting bank credit flow into inflating asset prices. Neoclassical economics doesn’t consider debt and so no one notices the private debt building up in the economy.

    At 25.30 mins you can see the super imposed private debt-to-GDP ratios.
    1929 – US
    1991 – Japan
    2008 – US, UK and Euro-zone
    The PBoC saw the Chinese Minsky Moment coming and you can too by looking at the chart above.
    As we can see everyone has been doing what the US did in the 1920s, and leading their economies towards Great Depressions.

    Japan was first, and they found out how to avoid a Great Depression, but kill growth for the next thirty years.
    Save the banks, but leave the debt in place.
    Debt repayments to banks destroy money, this is the problem.
    We are not as bad as Japan as we didn’t let asset prices crash in the West, but it is this problem has made our economies so sluggish since 2008.
    Our experts refer to it as “secular stagnation” and they don’t know what is causing it.

    Banks – What is the idea?
    The idea is that banks lend into business and industry to increase the productive capacity of the economy.
    Business and industry don’t have to wait until they have the money to expand. They can borrow the money and use it to expand today, and then pay that money back in the future.
    The economy can then grow more rapidly than it would without banks.
    Debt grows with GDP and there are no problems.

    It was that simple, but no one knew that during globalisation.

  4. Caterpillar

    I’m not impressed:

    The only policy that would suffice to avoid both problems is to “lean against the wind” of debt accumulation in the upswing of the credit cycle. We need a macrofinancial stability framework to do this effectively.

    What we need are higher wages and to keep the price of important things – food, health care and housing for starters – in line with wages. If we had higher wages, people would need less debt to have a home and car and so on.

    This isn’t hard.

  5. Matthew G. Saroff

    The answer to the question, “Why do international financial regulations fall short?” is a simple one: The regulatory apparatus, the field of economics, and the body politic do not want them to work.

    The reason that the regulator apparatus, the field of economics, and the body politic do not want them to work is because the quick buck artists at the big casino, along with corrupt politicians and oligarchs, do not want them to work, because their basic business model is deception and fraud, and the excess money extracted by this has allowed them to seize control of regulators, academe, and politicians.

  6. Susan the other

    Reading Wm. White’s analysis is just kind of disconcerting because he is talking about financial stability from start to finish. And The very fact that he starts his argument off with finance (debt finance OK) means he has left out reality. He’s like a theoretical physicist who begins by wondering what nature is all about and ends up believing nature is mathematics. It’s the drunk, the car keys and the light post all over again. To stabilize finance we need to stabilize society. Internationally would be excellent. Let’s do that first and see if finance doesn’t just fall into place. I’d just submit that the thing that should never “vary over time” is social stability. And the resources needed to achieve it should be entirely separate from “finance”. They should be sovereign.


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