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BANKS mimic other banks. They expose themselves to similar risks by making the same s - January 6th, 2010

BANKS mimic other banks. They expose themselves to similar risks by making the same sorts of loans. Each bank’s appetite for lending rises and falls in sync. What is safe for one institution becomes dangerous if they all do the same, which is often how financial trouble starts. The scope for nasty spillovers is increased by direct linkages. Banks lend to each other as well as to customers, so one firm’s failure can quickly cause others to fall over, too.

Because of these connections, rules to ensure the soundness of each bank are not enough to keep the banking system safe. Hence the calls for “macroprudential” regulation to prevent failures of the financial system as a whole. Although there is wide agreement that macroprudential policy is needed to limit systemic risk, there has been very little detail about how it might work. Two new reports help fill this gap. One is a discussion paper from the Bank of England, which sketches out the elements of a macroprudential regime and identifies what needs to be decided before it is put into practice*. The other paper, by the Warwick Commission, a group of academics and experts on finance from around the world, advocates specific reforms**.
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The first step is to decide an objective for macroprudential policy. A broad aim is to keep the financial system working well at all times. The bank’s report suggests a more precise goal: to limit the chance of bank failure to its “social optimum”. Tempering the boom-bust credit cycle and taking some air out of asset-price bubbles may be necessary to meet these aims, but both reports agree that should not be the main purpose of regulation. Making finance safer is ambitious enough.

Policymakers then have to decide on how they might achieve their goal. The financial system is too willing to provide credit in good times and too shy to do so in bad times. In upswings banks are keen to extend loans because write-offs seem unlikely. The willingness of other banks to do the same only reinforces the trend. Borrowers seem less likely to default because with lots of credit around, the value of their assets is rising. As the boom gathers pace, even banks that are wary of making fresh loans carry on for fear of ceding ground to rivals. When recession hits, each bank becomes fearful of making loans partly because other banks are also reluctant. Scarce credit hurts asset prices and leaves borrowers prey to the cash-flow troubles of customers and suppliers.

Since the cycle is such an influence on banks, macroprudential regulation should make it harder for all banks to lend so freely in booms and easier for them to lend in recessions. It can do this by tailoring capital requirements to the credit cycle. Whenever overall credit growth looks too frothy, the macroprudential body could increase the minimum capital buffer that supervisors make each bank hold. Equity capital is relatively dear for banks, which benefit from an implicit state guarantee on their debt finance as well as the tax breaks on interest payments enjoyed by all firms. Forcing banks to hold more capital when exuberance reigns would make it costlier for them to supply credit. It would also provide society with an extra cushion against bank failures.

Each report adds its own twist to this prescription. The Bank of England thinks extra capital may be needed for certain sorts of credit. If capital penalties are not targeted, it argues, banks may simply cut back on routine loans to free up capital for more exotic lending. The Warwick report says each bank’s capital should also vary with how long-lived its assets are relative to its funding. Firms with big maturity mismatches are more likely to cause systemic problems and should be penalised. The ease of raising cash against assets and of rolling over debt varies over the cycle, and capital rules need to reflect this. Regulators should also find ways to match different risks with the firms which can best bear them. Banks are the natural bearers of credit risk since they know about evaluating borrowers. Pension funds are less prone to sudden withdrawals of cash and are the best homes for illiquid assets.

The Warwick group is keen that macroprudential policy should be guided by rules. If credit, asset prices and GDP were all growing above their long-run average rates, say, the regulator would be forced to step in or explain why it is not doing so. Finance is a powerful lobby. Without such a trigger for intervention, regulators may be swayed by arguments that the next credit boom is somehow different and poses few dangers. The bank frets about regulatory capture, too, but doubts that any rule would be right for all circumstances. It favours other approaches, such as frequent public scrutiny, to keep regulators honest.
When banks attack

No regulatory system is likely to be fail-safe. That is why Bank of England officials stress that efforts to make bank failures less costly for society must be part of regulatory reform. That includes making banks’ capital structures more flexible, so that some kinds of debt turn into loss-bearing equity in a crisis. Both reports favour making systemically important banks hold extra capital, as they pose bigger risks when they fail.

The Warwick group also thinks cross-border banks should abide by the rules of their host countries, so that macroprudential regulation fits local credit conditions. That would require that foreign subsidiaries be independently capitalised, which may also be necessary for a cross-border bank to have a credible “living will”, a guide to its orderly resolution. This advice will chafe most in the European Union, where standard rules are the basis of the single market. But varying rules on capital could also be used as a macroeconomic tool in the euro area, where monetary policy cannot be tailored to each country’s needs. Regulation to address negative spillovers that hurt financial stability might then have a positive spillover for economic stability.

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