Is Central Bank Experimentation Key to Averting the Next Crisis?
“The financial crisis demonstrated clearly that supervisory and regulatory practices must consider overall financial stability as well as the safety and soundness of individual firms…For our part, the Federal Reserve has restructured its internal operations to facilitate a macroprudential approach to supervision and regulation and to monitor systemic risks.”
The role of central bankers around the world has expanded in the wake of the financial crisis. Economic problems of the previous decade, and the monetary tools developed to address them, are increasingly irrelevant in an increasingly complex global financial system. Central bankers around the world — U.S. Federal Reserve Chairman Ben Bernanke among them (quoted above) — have been forced to expand their thinking and adopt unconventional tools and strategies in their efforts to competently regulate financial markets and guide monetary policy.
Some observers have described this change as the latest fad in central banking: a fashionable shift toward experimental macroprudential policy.
Speaking in May 2011, Bernanke took a crack at defining macroprudential policy in the context of the Dodd-Frank Wall Street Reform and Consumer Protection Act. He highlighted features of the act that are aimed at helping the regulatory system adapt over time to changes in the market, “an approach that supplements traditional supervision and regulation of individual firms or markets with explicit consideration of threats to the stability of the financial system as a whole.”
The most visible threats that fall into this category are bubbles, and most prominently in equities and real estate. Americans don’t need a history lesson to remind them of the substantial damage that bubbles and poor regulation can cause — just half a decade ago, we experienced the worst financial crisis in 75 years. During the crash, unemployment shot up to 10 percent, millions of homes were foreclosed on, and equities fell nearly 40 percent.
The recovery to date has been tedious, to say the least. Headline unemployment currently sits at 7.6 percent, foreclosure horror stories still capture headlines, and everywhere there is concern that the next bubble is already inflating. Record-low interest rates — driven to the zero bound by the Fed to spur economic activity — has fueled some of the same risky behavior that contributed to the crisis. Home prices are rising rapidly, as much as 20 percent in some areas like San Francisco, and flippers are on the prowl.
The U.S. isn’t the only place with these concerns. Fear of inflating housing bubbles in South Korea, Canada, Israel, Indonesia, Switzerland, and Hong Kong have prompted central bankers around the world to pursue macroprudential policy, which has had mixed results.
“The explicit incorporation of macroprudential considerations in the nation’s framework for financial oversight represents a major innovation in our thinking about financial regulation, one that is taking hold abroad as well as in the United States,” Bernanke said in the 2011 speech. “This new direction is constructive and necessary, I believe, but it also poses considerable conceptual and operational challenges in its implementation.”
The best example of these conceptual and operational challenges in the U.S. may be the Dodd-Frank Act. The Act’s implementation has been anything but straightforward — the Dodd-Frank itself is 849 pages long, with thousands of additional pages of regulations written for it — and its effectiveness has been highly debated. Still, even its critics can agree on the spirit of the initiative: in order to prevent another crisis, regulators have to innovate. Central bankers, some proponents would argue, need to become dynamic participants in the economy, not reactive ones.
This, of course, is not easy. One reason the free-market system works so well is because it solves any number of enormously difficult information problems by using prices as signals. “Relative to traditional regulation and supervision, executing a macroprudential approach to oversight can involve heavier informational requirements and more-complex analytic frameworks,” commented Bernanke.
There are political problems as well as logistical problems with the Federal Reserve, say, telling car dealerships that they have to institute a minimum down payment on vehicles. This is not a power currently granted to the U.S. Fed, but it is a practice that has been adopted by other central bankers in places like Indonesia, where a surge in credit-only purchases of motorcycles led to a glut of bad debt.
In the U.S., implementation of macroprudential policy look like the establishment of the Financial Stability Oversight Committee. Bernanke commented that the committee “is charged with monitoring the U.S. financial system, identifying risks that threaten the stability of that system, and promoting market discipline and other conditions that mitigate excessive risk-taking in financial markets.”
The committee hosts a diverse council, an arrangement designed to break down silos between agencies and to allow policy making to cut across jurisdictions. The Dodd-Frank Act also created the Office of Financial Research within the Treasury department, which is designed to raise the bar for financial information available to policymakers.
If you’re interested in the FSOC’s current diagnosis of U.S. financial stability, here is its full 2013 annual report.
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