Following a major crisis, such as the one we’ve just experienced, it is easy to get into a situation where the goal of policy is to “avoid another crisis”. However, this is not a trap that our fine readers fall into – so we don’t need to worry about it here 😉 .
This isn’t to say that we shouldn’t take things from a crisis – far from it. A crisis gives us information about the behaviour of the macroeconomy, about the feed-back loops that may exist that we may not previously pay attention to, and about the process people use for forming beliefs. But we still need to say why these things occur – and hopefully make our given hypothesis testable – before we can decide to do anything.
So well prior to the crisis there was a string of micro-prudential policies introduced. In truth, the retail banks have been grappling with the introduction of many of these policies during the crisis – and the Reserve Bank has stated that part of the reason the OCR is so low is because these policies have, in of themselves, tightened credit conditions.
Now all this is fine, when it comes to cyclical policy the impact of both micro and macro-prudential regulation has been widely discussed. However, what bugs me is the lack of heavy discussion and analysis is the lack of significant discussion around the structural impact of said policy.
I can see a reason for monetary policy, micro-prudential policy, and macro-prudential policy – sure. But my concern is that they are all being looked at within the same frame too much. There are cyclical issues, financial stability issues, and broad structural issues that come out of these types of policies.
What do I mean? Lets focus just on micro-prudential regulation for now. Say that the Bank decides to base some set of reserve requirements for retail banks on the basis of the risk associated with the asset classes they hold – and assume that the Bank SAYS what it believes the associated risks are when setting up the reserve ratio. Well then their weightings on risk have an impact on what bank’s lend out (their asset position) and this in turn changes the availability of funds for different markets, leading to a change in the allocation of investment and general resources.
It becomes more than an issue of “security” – there is a trade-off where normal market signals are being blunted.
In my opinion, the reason we like such policies is because retail banks have a lender of last resort – they will be bailed out in the case something goes wrong, and this leads to a moral hazard problem. The idea of something like “microprudential” regulation is to solve some of the excesses that come from this moral hazard – under the presumption that the “first-best” market alternative isn’t realistically available. In this case, a central bank CAN’T commit to not bailing out banks, and so they regulate them more directly as a means to solve the implied moral hazard issue.
I can agree with this, but there is a cost. It will impact on allocative efficiency (it will change where resources are allocated relative to where they are most valued, for those who don’t like the wonkishness of the term 😉 ). And whatever organisation is responsible for financial stability, the micro or macro-prudential framework, or any sort of structural policy, needs to take responsibility for this.
And that is why I think the function of financial stability and associated regulation should be functionally separate from monetary policy – in the same way that fiscal and monetary policy are separate. Monetary policy and the monetary authorities should solely follow a cyclical frame – other organisations (which they will in turn communicate with, and intrinsically co-operate with) will deal with structural issues.
This is the only way to ensure policy is transparent. It is the only way to ensure the relevant organisation have to take responsibility for their actions and the outcomes associated with them.