Preventing financial instability

Macroeconomics can provide important insights into these problems, but in order to do so, it must move on from the assumption of free competitive markets and the negative feedback loops that ensure equilibrium reversion in those models. In fact, none of the above-mentioned problems can be modelled with such control dynamics. For example, following the dot-com crash, the behaviour of the price level gave the US Federal Reserve no clue that it was keeping the interest rate far too low for far too long. Cheap imports from countries with weak currencies kept US consumer goods prices in check during the economic recovery, leading policymakers to believe that the interest rate had been set at the “right" level.

Illustration: Jayachandran / Mint

Likewise, debt leverage can grow for years without corrections. When investors increase their leverage, asset prices rise and market participants book profits. These dynamics are reinforced by incentive structures of financial firms and analysts—and regulation. In the recent boom-bust cycle, existing capital requirements have acted as macroeconomic amplifiers. The increase in asset prices opened up room for further expansion of the balance sheet. During the ensuing downturn, capital requirements made deleveraging even more imperative.

Not for the first time, economists have fallen into a fallacy of composition. For the individual bank, the maxim holds true that it is best “not to put all your eggs in one basket". It turns out, however, that when financial institutions diversify in every direction they see fit, the nature of systemic risks changes.

As the connectivity of the network of financial agents increases, disturbances arising somewhere in the system may percolate through the entirety of it. To be sure, whether a disturbance propagates or dissipates depends on several further properties of the network—for example, leverage level of agents, volume and distribution of “toxic" assets in the economy, and existence of critical nodes in the network that cannot fail—but from a macroprudential standpoint, this means all the eggs have ended up in the same basket. At this time, we have one giant omelette that cannot easily be unscrambled. The challenge is how to structure a governable financial system for the future.

There are no easy, or uncontroversial, solutions to these three systemic problems. In my view, the solution to the instability of the price level and the instability of the overall leverage in the financial system lies in reintroducing effective reserve requirements as well as establishing counter-cyclical capital requirement. The lack of defined boundaries for the responsibilities of central banks, however, raises more difficult questions than can be answered. Beyond difficulties with inflation targeting, serious inflationary pressures in a few years’ time may further confirm that the bank rate alone is too weak an instrument of monetary policy. Reimposing effective reserve requirements would reinvigorate market operations as a tool of monetary policy.

Reserve requirements would have to be extended in two directions. First, they should cover non-bank institutions that issue demand liabilities. Second, they should extend to the non-deposit short-term liabilities, such as repurchasing agreements and notes.

Monetary authorities should raise capital requirements above “normal" in periods when asset prices rise above the trend of consumer goods prices, and reduce them in episodes when deleveraging is the order of the day among financial institutions. The cyclical average should be set at probably no more than half of the leverage levels that the big investment banks reached in the recent boom.

The financial industry may not welcome such a development. A lid on leverage is a lid on the bank’s rate of return. Moreover, such a proposal would turn capital requirements into a tool of monetary policy, thus giving authorities discretionary power and introducing a new type of risk for banks. However, as long as counter-cyclical capital requirements reduce the likelihood of needing future Toxic Asset Relief Programmes, governments may consider them a desirable option.

We should consider establishing a two-tiered financial regulation system that distinguishes between “core" and “peripheral" financial institutions. While core institutions would be subject to stringent reserve and capital requirements and strict supervision, they would be eligible for central bank lender-of-last-resort assistance. “Peripheral" institutions would be less regulated and supervised but would be outside the umbrella of central bank protection.

An obvious problem with the core-periphery idea is that big international conglomerate banks cut across any such dividing line. Would it be feasible to achieve a “core-periphery" structure without infringing greatly on the present structure of the very big banks? If they are not to be broken up into smaller units that would not individually pose serious systemic risk, financial conglomerates must be closely regulated. In either case, their prospective profits are bound to be adversely affected. They will certainly resist any measures that would have that effect—and they have the resources to make their resistance politically effective.

Edited excerpts, published with permission from VoxEU.org. Axel Leijonhufvud is professor of monetary theory and policy at the University of Trento, Italy. Comment at theirview@livemint.com

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