Macro-prudential regulation

Prof. Philippon summarizes three reports on financial regulation and reviews proposed changes to regulation. My favorite paragraph:

I very much doubt that we can agree on a set of objective measures of ‘excessive’ credit expansion (let alone bubbles). I think that the best we can expect is a powerful regulator running systemic stress tests based partly on historical data and partly on subjective forward looking scenarios. The critical issue in my view does not lay in the construction of an appropriate cyclical index, but rather in making sure that the regulator is powerful enough to enforce tighter prudential regulations based in part on subjective and debatable interpretations of economic data. The financial industry will not like it, and it has a strong track record of capturing its regulators, so this will not be easy.

He suggest the powerful regulator should be the Fed. He seems frustrated that there’s not more specific policy proposals and the ones that exist are bad: “I would therefore consider any future report that does not include tables, figures, numbers, equations, and specific proposals to be useless rhetoric.” Here are his concluding remarks:

This issue reminds me of the paradox of free trade. The benefits of free trade are widespread and difficult to grasp, while its costs are concentrated and easily publicized. Public support for free trade is therefore structurally weak. Moral hazard created by implicit guarantees is also widespread and difficult to grasp. It shows up in spreads lowered by a few basis points here and there, in slight distortions of comparative advantages, and in overall weaker governance. But the costs of LCFI [wa: firms that are “too-big-to-fail”] failures are large and concentrated. It is therefore tempting for regulators to focus too much on bailouts, and too little on incentives. But this is clearly the wrong policy for the long run. Incentives and accountability must be improved, even if it means fighting a regulatory battle with the industry.
Sir Winston Churchill famously remarked that “Britain and France had to choose between war and dishonour. They chose dishonour. They will have war.” If in the hope of ending the crisis quickly, we choose to bail out the banks without making their managers, shareholders and creditors accountable, then we choose dishonour, and we will have more devastating crises.

5 thoughts on “Macro-prudential regulation”

  1. It seems like this is somewhat along the lines of Arnold Kling’s “Spirit of the Law” approach to regulation.

  2. ssendam, nope. The idea would be to have rules in place to prevent asset bubbles, identify them when they happen and determinate rules for popping them. No discretion.

    For example, the Fed could hold mortgage-based securities and commit to a rule to buy or sell them in large numbers if the case-shiller index gets out of a certain range.

    “Spirit of the law” isn’t really an economic idea so I can’t really comment (and I don’t think Kling is a law scholar so I’m not sure his judgment should be given special status on this subject). By whatever mechanism the rules are determined (by the Fed, by Congress or by lawyers and judges) the economic analysis doesn’t change. Policy makers credibly committing themselves to rules leads to better economic outcomes than not. An apolitical and powerful policy maker, like the Fed, would seem to have more credibility than policy makers constantly subject to the changing winds of politics.

  3. I wasn’t saying Arnold’s ideas are special. I was just noting the confluence of ideas from two pretty different points on the political spectrum. I always find that interesting.

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