A central lesson of the 2007-09 financial crisis is that we should be much more worried about financial intermediation performed outside the banking system. Even if banks are resilient, with capital buffers sufficient to withstand all but the largest shocks, other parts of the financial system can make it fragile. Indeed, making the banks safe may simply shift risk-taking elsewhere.
So, to reduce the frequency and severity of financial crises, we must contain systemic risk that comes both from banks and from outside the traditional banking system. To do so, we need regulation of market activities – of economic function – regardless of an intermediary’s legal form. That is, we need macroprudential regulation for banks and for nonbanks.
Over the past few weeks, the two highest-ranking Federal Reserve officials have highlighted the “primary role” macroprudential tools have in promoting financial stability. In a July speech, Chair Yellen discussed the efficacy of tools like limits on leverage and short-term funding, as well as stronger underwriting standards, as the first line of defense (our terminology) in confronting systemic vulnerabilities. More recently, Vice Chairman Fischer spoke about the complexity of employing macroprudential tools, noting the uncertainty over their effectiveness, the political fallout likely to arise from their use, and the need for coordination among the agencies that are authorized to use them.
Putting these two together, an uncharitable critic might summarize the Fed’s position as “we have a theory for achieving financial stability, but we don’t really know how to implement it.” That’s surely an exaggeration, but it captures an important element of uncertainty. The Fed knows the variety of tools – loan-to-value ratios for mortgage originators; loan-to-income ratios for borrowers; capital and liquidity requirements, risk weights, and stress tests for banks; margin and haircut requirements for repo and derivatives transactions; et cetera. But it doesn’t have the information to calibrate these tools or (in some cases) the clear and exclusive authority to use them.
In an earlier post, we discussed the use of time-varying, discretionary regulatory tools and came to conclusions completely consistent with Vice Chairman Fischer’s position: the combination of high information requirements, long transmission lags and significant political resistance tip the balance in favor of a rules-based approached focused on ensuring sufficient systemic resilience.
The good news is that the Fed has the legal authority and the tools to set rules for banks and bank holding companies, should it wish to do so. If policymakers decide to tighten conditions on the supply of bank credit using non-interest rate instruments, they have a myriad of options: they can increase capital requirements, change risk weights, or impose stricter stress testing, to name just a few. Or, if they wish to reduce banks’ wholesale funding, they can adjust liquidity requirements. And, so on.
But what about nonbanks? What are the tools available for addressing systemic risk outside of the traditional banking system? Who has the authority to employ those tools in the service of financial stability policy? To what extent do the various agencies that have macroprudential tools have an incentive to use them in a cooperative fashion?
As Vice Chairman Fischer observes, macroprudential regulation and supervision raise a host of coordination problems. Different countries have addressed these challenges in different ways. If we were sitting and writing this in London, the overarching structure of interlocking committees at the Bank of England – for monetary policy, financial policy, and prudential regulatory policy – would lessen our concern substantially because this governance arrangement promotes policy coordination (see chart).
Membership of the Bank of England Policy Committees
But in the United States, the worries about coordination are deep and bipartisan (see, for example, this Wall Street Journal contribution from a former Treasury Secretary and a former head of the Council of Economic Advisers). We have over 100 regulatory authorities. To the extent that there is any coordination at all, it is through the Financial System Oversight Council (FSOC), which has no tools other than to designate systemic intermediaries and little implementation authority of its own. As we have written recently, the experience with the SEC’s ineffective regulation of money market funds does not engender confidence in the FSOC’s coordination powers.
Looking back at the list of macroprudential tools, in the U.S. system, the allocation of authority over nonbank activities is both unclear and untested. Start, for example, with the loan-to-value ratio for mortgages. How would we enforce a reduction in the maximum level? Would it be up to Fannie Mae and Freddie Mac to change what qualifies for their guarantees? Or, should the Consumer Financial Protection Board act in order to protect debtors? Neither has a macroprudential mandate.
Other examples are no less complex. Take the case of margin and haircuts on repo. Can the Federal Reserve, which supervises the clearing banks that run the tri-party repo market, impose these? Or is it the SEC, which regulates securities dealers and investment companies? (Never mind hedge funds, whose activities are mostly unregulated.) What about margin and collateral requirements for derivatives? Can the Fed act through its Dodd-Frank authority to set risk-management standards for FSOC-designated financial market utilities (such as the Chicago Mercantile Exchange and The Options Clearing Corporation)? Or, is this a prerogative of the direct supervisory agency (CFTC or SEC, depending on the institution)?
Needless to say, we could go on. We doubt that anyone knows precisely how systemic risk management tools for nonbanks are shared in the United States, let alone how they will be used (or even which important tools are still missing from the toolbox). Yet, if macroprudential supervision is to be the first line of defense in promoting financial stability, such awareness and precision is vital. As one of us has discussed elsewhere, interactions among the various prudential tools, combined with overlapping responsibility for their use, makes coordination of paramount importance. Only when each regulator understands the behavior of the others – the timing and conditions under which they will act – will there be a reasonable chance that they will meet their stability objectives, financial and otherwise. And, only if those being regulated know the rules and are confident of their enforcement will they have the incentive to act in ways that limit systemic risk.
All of this leads us to conclude that the next essential step is for the leading federal regulators to disclose their plans – what macroprudential tools they intend to use with regard to nonbanks and the conditions under which they would use them. They need to do this both so that we know they have such plans and so that their FSOC colleagues will know what they are.
Will the regulators show their cards? Will they specify in a transparent and comprehensive way their specific roles in the systemic risk management of nonbanks? FSOC can start this process by calling on Treasury’s Office of Financial Research to gather this information and report. Then we can all begin to judge who’s playing the game in our collective interest.