Central banks: an expanding regulatory toolkit
Following my latest post on central banks as the new central planners, a very recent New York Fed Staff Report by Adrian, Covitz and Liang demonstrates the extent of possible central banks’/regulators’ involvement in financial markets, and therefore in what ways they can control, or attempt to control, the allocation of resources within the financial system. Here is a summary of various classes of tools (most of them discretionary) that monetary and financial authorities can play with:
– Monetary policy: the authors classify monetary policy as a “broader tool” that “would affect the rates for all financial institutions”. Indeed, central banks not only set the short-term refinancing rates and reserve requirements and run open market operations, but now also have in place interest rates paid on excess reserves, fixed-rate full allotment reverse repos, as well as various temporary long-term lending facilities such as the BoE’s Funding for Lending Scheme or the ECB’s LTRO and TLTRO, and temporary liquidity facilities such as the ABCP MMF liquidity facility, and can decide what collateral to accept and what securities to purchase, way beyond the traditional Treasury-based OMO.
– Asset markets: central banks can regulate what they view as ‘imbalances’ in the valuation of some asset markets by tightening underwriting standards as well as “through regulated banks and broker-dealers by tightening standards on implicit leverage through securitization or other risk transformations, or by limiting the debt they provide to investors in either unsecured or secured funding markets, if the asset prices are being fuelled by leverage.” In the case of real estate markets and household burdens, central bankers can impose LTV restrictions* and other similar macro-prudential policies.
– Banking policies: central banks have under their control all traditional micro-prudential regulatory tools. In addition, Basel 3 provide them with some flexibility in setting macro-prudential regulatory tools that apply specifically to the banking system, such as counter-cyclical capital requirements (capital conservation buffer, equity systemic surcharge…). Other ad-hoc tools include: sectoral capital requirements (higher/lower capital charges/RWAs for specific asset classes), dynamic provisioning, stress tests…
– Shadow banking policies: harder to regulate, central banks could “address pro-cyclical incentives in secured funding markets, such as repo and sec lending, […] propose minimum standards for haircut practices, to limit the extent to which haircuts would be reduced in benign markets. Other elements of this proposal include consideration of the use of central clearing for sec lending and repo markets, limiting liquidity risks associated with cash collateral reinvestment, addressing risks associated with re-hypothecation of client assets, strengthening collateral valuation and management practices, and improving report, disclosures, and transparency.” Other direct tools include “the explicit regulation of margins and haircuts for macroprudential purposes.”
– Nonfinancial sector: “Tools to address emerging imbalances in asset valuations likely would also address building vulnerabilities in the nonfinancial sector. For example, increasing* [sic] LTVs or DTIs on mortgages, which could reduce a leverage-induced rise in prices, could also limit an increase in exposures of households and businesses to a collapse in prices, thereby bolstering their resilience.”
Given the increased scope of central banks’ operations, it is clear that market prices can be manipulated and distorted in all sort of ways. To be fair however, not all those powers are currently concentrated in the central bankers’ hands. In many countries, there are still a few different institutions that perform those tasks. Nevertheless, the trend is clear: most of those powers are increasingly taken over by and aggregated at central banks.
While this new paper advocates the use of such tools, it admits that their effectiveness and effects on the financial system and the broader economy remains untested and uncertain:
New government backstops to address the risks arising from shadow banking, of course, can be costly. First, an expansion along these lines would require a new regulatory structure to prevent moral hazard, which can be expensive and difficult to implement effectively. Second, an expansion of regulations does not reduce the incentives for regulatory arbitrage, but just pushes it beyond the beyond the existing perimeter. Third, there is a limited understanding of the impact that such a fundamental change would have on the efficiency and dynamism of the financial system.
In a subsequent guest post, Justin Merrill will investigate macro-prudential policy tools more in depth.
* The paper mistakenly describes those potential measures as “increasing” LTV ratios to mitigate house price and household indebtedness increases. I believe this is a typo, even though the same claim reappears several times throughout the paper (if not a typo then the authors have no clue how LTVs work…).