It is an occupational hazard. Central bankers believe, with a mixture of wishful thinking and empirical evidence, that their own credibility is critical to the success of monetary policy. There is little room, then, for exhibiting self-doubt, with a tendency for new policies to be grasped with gusto and the old to be quickly discarded.
It is not that critical thinking is actively discouraged – central bankers are a conscientious lot. But in practice it is disincentivized. An idea or analysis that undermines an existing policy will battle for survival until it meets a threshold of certainty that rarely visits the practice of policy.
No wonder then, that much critical analysis of central banking comes from those institutions that are close to the issues, but do not determine actual monetary policy – bodies such as the Bank for International Settlements, the International Monetary Fund, national treasuries and ministries of finance. There are also some individuals who understand central banking – often because they previously worked at such institutions – who are outspoken because they are no longer subject to, or worried by, suspicions of disloyalty. But, in the main, criticism does not come from within.
In some sects, the cult of infallibility leads inexorably to mass suicide. In central banking the consequences can also be severe. Developed-country central bankers got off lightly for their turn-of-the-century love affair with credit derivatives – despite the many warnings. Earlier seductions by the allures of demand management, money supply targets and the focus on inflation targets to the exclusion of asset prices, also came to sticky ends – long after warning signs were first dismissed. Central bankers in emerging economies are not immune from this affliction, though their love affairs are habitually with exchange-rate regimes.
Quantitative easing (QE) – the purchase of assets with electronically created cash – was the defining policy instrument of the last financial crisis. More than $3 trillion of assets were purchased in different phases by the Federal Reserve, the Bank of Japan and the Bank of England. While there are important differences, the European Central Bank’s long-term lending (long-term refinancing operations) of more than $2 trillion of electronically created cash has strong similarities with QE and could be added to the unprecedented pile of money creation. The judgement of history will be less kind to QE than contemporary analysis by central bankers.
The first round of asset purchases, in the wake of the collapse of Lehman Brothers in September 2008 was ad hoc, courageous and effective at unfreezing financial markets. The “ted spread”, a measure of financial stress, leaped from around 100 basis points just before the collapse of Lehman Brothers to almost 500bp just after, before falling below 100bp by the second quarter of 2009. Later, more ordered and focused rounds of what was then classified as QE were much less effective in the countries pursuing them, stored up challenges for the future unwinding of the newly created cash and proved troublesome for those countries not pursuing QE.
One reason to avoid financial crises is that in the descending fog, good policy formulation is quickly lost. Frantic to do something to save the financial system from falling into the abyss, desperate to be seen to be doing something to restore vanished confidence and frightened of what might happen if they stopped the policy prematurely, central bankers appealed to portfolio balance theory to justify the extension and enlargement of the emergency asset purchases.
Japan’s decade-long, uninspiring experience with QE was, conceitedly, brushed under the carpet. The Fed, the Bank of Japan and the Bank of England (the QE-3) explained that by rebalancing investors’ portfolios out of cash into non-monetary assets such as bonds, equities or real estate, QE would increase the demand for these assets, which would lead to new supply that would finance new investment in the real economy.
The obvious test of QE, then, would be the degree to which investment increased, or the issuing of corporate bonds and equities rose. But in the QE-3 there was precious little new supply of bonds and equities, and no surge in investment from 2009–12. No wonder the velocity of money collapsed.
It is in the countries not pursuing QE where there are signs of, in their case, unhelpful spillovers from QE, such as soaring currencies and a corporate borrowing spree. Yet, the QE-3’s own assessment of QE invariably focused on torturing financial market data to extract the announcement effect on government bond yields – with the unimpressive result of approximately 85bp.
The last refuge of the beleaguered policy-maker is the counterfactual. We will never know what would have happened without QE. But economics is supposed to be a science of trade-offs based on evidence, not faith. Future economic historians will be surprised at the scant discussion of trade-offs, of detailed plans for exit, or alternatives to creating trillions of dollars to hold down interest rates by a few hundredths of a percentage point.
They will wonder why the poor trade-off between the amount of cash created and the amount of new investment was not seen as evidence of an increase in the precautionary demand for cash by the public, which would imply that raising investment required more direct intervention. The reverence required of central bank policy and its policy-makers meant we had to wait for the old guard to retire, to be praised and honoured, before new brooms could start the exit from QE and experiment with alternatives such as forward guidance or negative interest rates.
After years of being considered at best aspirational – and at worse a little antediluvian – macro-prudential tools are now highly fashionable. I am not ashamed of playing a modest role in this development.If financial markets were good at predicting financial crises, they wouldn’t happen as frequently as they do. Instead, financial markets have a long and tested habit of collectively underestimating risks at the top of a boom and overestimating them in the depths of the subsequent crash.
Monetary policy is particularly ineffective at these times. When house prices are expected to rise by 20% per annum, the level of interest rates required to choke off a housing boom would decimate the rest of the economy. And when John Maynard Keynes’ “animal spirits” are low, even zero interest rates are as ineffective as pushing on a string. What is required is a macro-prudential regulatory policy that acts against these collective, self-reinforcing errors in estimating risk – in essence, counter-cyclically. Less ambitiously, limiting the scale of the boom and the ensuing crash would be worth striving for, perhaps with something akin to speed bumps.
These endeavours are complementary to monetary policy, not in conflict with it. Arguably, if regulatory policy targeted asset price booms and took that burden away from monetary policy, it could be better focused on keeping a lid on inflation. We would have two policies targeting two specific objectives, as proposed by Jan Tinbergen.
To be fair, many emerging market central banks have long pursued macro-prudential policies. Some may say that when you are prey to externally driven shifts in capital flows, or follow a fixed exchange rate, there is not much to monetary policy other than macro-prudential policy. The Reserve Bank of India has long used, perhaps to a fault, a complex array of discretionary limits to bank lending to the housing market or other sectors. It was more in the developed world where central bankers came to believe there was no point in trying to second guess financial markets, and at Basel, where supervisors fashioned bank regulation in the image of the markets.
More rules, not discretion
Today, in the developed world, reborn macro-prudential policies are still in their infancy. A common formulation is the establishment of new systemic risk committees of the wise and connected, to judge whether capital adequacy requirements should be raised or not. There are, however, more than a few challenges with the current operation of macro-prudential policy.
First, the inconvenient truth is that central bankers had the supervisory discretion to tighten lending limits before and chose not to use it. However much those chasing evil-doers in the rubble of a past boom would like to think, booms are not all fakery, hoisted upon the innocent masses by a few crooks. There is always a good, compelling, genuinely life-changing story that grips us all, such as the advent of the motor car, railroads, electrification, Asian Tiger economies and the internet. The collective inability of humanity to escape the preoccupations of the present is not easily overcome by anointing a special few to do so for us. The lesson of the crisis is that we need more rules to rein in credit growth during a boom, not more discretion. A rule, based on bank profitability or credit growth, could determine when higher-than-now capital requirements are raised during the boom or relaxed during periods of financial stress.
Second, the problem with counter-cyclical capital requirements is that raising them in a boom could lead banks to concentrate their lending in the booming sector and away from others, as the booming sectors are the ones best able to absorb higher borrowing costs – in the short run at least. In this regard, the unintended consequence of macro-prudential policy could be to undermine monetary policy, not augment it. Central bankers are alert to this tricky issue and are trying to address it in a few ways.
Capital requirements could be raised only in the booming sectors, or banks could be required to lower loan-to-value ratios to borrowers there. This appears inelegant and ad hoc (banks would try and game the definitions of the curbed sector) until you consider the rest of banking regulation. Arguably, macro-prudential is more about sectors and concentrations than aggregates. Capital requirements should rise with increased concentrations of risk on a bank’s balance sheet. This is more elegant than simple counter-cyclical shifts in capital requirements, but less practical. Statistical correlations of risk are, like almost everything else, pro-cyclical. The same world seems to be a diversified and liquid place in the boom and a concentrated, illiquid one in a crash.
A third problem is, how do you reduce capital requirements when the boom is over, allowing capital to be released and buffers used up; at the same time as everyone is realising that the world is a riskier place than they thought?
Just as raising capital requirements when the world looks to be a safer place, the politics of this is harder than the economics.
Managing risk in the system
A yet bigger problem with the current thinking on macro-prudential policy is that it is fixated with capital, dependent on the original, statistical measurement of individual risks and not with managing risk in the system.
The global financial crisis settled the debate on the need for a macro-prudential dimension to regulatory policy, but it may have done so ahead of there being common ground on what exactly is systemic risk and how best it is managed. Macro-prudential regulation is in danger of reverting to an enhanced micro-prudential exercise, with macro-prudential meaning that we have a wider set of risks to consider and to put up capital against. As the economy slows, perhaps under the burden of more unproductive capital, the collective amount of risk rises, requiring more capital. At times the new capital adequacy regime appears more pro-cyclical and not contra-cyclical as intended. Many bankers complain that lending today at a time of record low interest rates is constrained by regulation.
Risk can be hedged, spread and pooled, but it is not so easily reduced. The task of the new macro-prudential central banker is as a risk manager for the financial system. A deeper understanding of what this means would probably point macro-prudential regulation in a different direction to where it is pointed today and one that puts it far away from monetary policy.
There is not one risk but different types of risk. They are different, not because we give them different names, but because we would hedge each differently.
The liquidity risk of an asset is the risk that if you were forced to sell the asset tomorrow, you would have to accept a deep discount in the price to bring out an unwilling buyer, compared with the price you would achieve if you had a longer time to find a more willing buyer. The way you hedge liquidity risk is not by owning a wide range of equally illiquid assets, but by having the time to sell, perhaps through long-term funding or long-term liabilities. The credit risk of an investment is the risk that a counterparty defaults on its payments and principal. Credit risk is not hedged by having more time in which the default can take place (this would increase credit risks), but by spreading credit risks across diverse and short-term credits.
A pension fund or life insurance firm has the capacity to absorb liquidity risks, but no particular ability to spread credit risks. A bank that is funded with overnight deposits and has a raft of different borrowers has the capacity to absorb individual credit risks, but little capacity to absorb liquidity risks. If risks in the financial system are in the wrong place, there is no reasonable amount of capital that will save it. The right place for a risk is where there is a capacity to absorb it. One critical advantage of placing risk where, if it erupts, it can be absorbed, is that we are then less dependent on measuring it correctly – something almost all financial market participants have proved poor at doing through the economic cycle.
This could be done simply, by requiring that all financial institutions, irrespective of what they are called and what sector we think they are in, to place capital against mismatches of liquidity, credit and market risks. This would incentivize those with wells of liquidity to draw liquidity risk from others and, in return, sell them credit risks that they cannot easily match and vice versa. We would have stability-strengthening transfers of risks across the financial sector rather than what we had before. Within the banking sector, regulators have taken one step towards this goal by the introduction of the net stable funding ratio with the goal of a bank’s long-term assets being matched by an equal or greater amount of long-term or stable funding. This is one of the new regulations that bankers are most up in arms against and one of the most important from a systemic risk point of view. Regulators must not retreat.
If liquidity risks were held by those with the biggest capacity for holding them, and the same for credit and market risks, the system would be safest, it would be most resilient to mistakes in the assessment of risk – a critical issue – it would require the least amount of unproductive capital and it would be least in conflict with the inflation-targeting objectives of monetary policy. But the banks can only effectively shed liquidity risks if there is someone more appropriate to hold them. Yet, today, right under the noses of the new systemic risk committees, the new regulation of insurance and long-term savings institutions looks set to achieve the opposite. Wrongly formulated, the proposed Solvency II regulation of insurance companies with regard to valuation and capital, could force the natural holders of the financial system’s liquidity risk not to hold it. Forcing long-term institutions to behave like short-term ones will be the biggest contributor to systemic risk since Basel II.
The right home for risk
What is macro-prudential regulation if it is not a realization by central bankers that the financial system’s resilience is about where risks reside across the financial system and not just at banks? Central bankers must be drawing a sigh of relief now that the crisis appears more firmly behind them and there are signs of gathering economic recovery. But the end of a crisis period does not bring to an end the list of challenges; merely the end of the beginning.
Before we send central bankers once more unto the breach, they deserve praise for shepherding us and themselves through the past five years intact. Developed-country central banks could so easily have been part of the rubble of the crisis. Instead, central bankers were the first to dust themselves off. While politicians bickered and prevaricated, they stepped up to the table; sometimes uninvited. A defining moment of the crisis was Mario Draghi’s constitutional-straining comment that he would do “whatever it takes”. He saved the euro. Ben Bernanke, Mervyn King, Haruhiko Kuroda, Christine Lagarde, Jean-Claude Trichet, Masaaki Shirakawa and others performed similarly, tirelessly, daily. When the dust settles, we will see there is a limit to what monetary policy can do and that the goal of creating a more resilient financial system is far from secure.
Author: Avinash Persaud is Founder and Chairman of Intelligence Capital and Member of the World Economic Forum’s Global Agenda Council on the International Monetary System.
Image: The Bank of England is seen behind a flower bed in the City of London. REUTERS/Stefan Wermuth