Macroprudential policy tools: a primer (guest post by Justin Merrill)
In case you hadn’t heard, there’s a new fad in central banking called “macroprudential regulation.” During the Great Moderation there was a belief that low and stable inflation would be sufficient to stabilize financial markets and the economy. When the Great Moderation turned into the Great Recession, this paradigm shifted, but I’m afraid that the wrong conclusions are being drawn. In a series of posts, I shall explain what macroprudential policies are, who some popular people making the arguments for them are and what the risks of the policies are.
Most places I’ve read about macroprudential policies are vague in their description and only list a couple of the tools that central bankers/regulators can use. The policies are intended to prevent systemic risk by preventing/diffusing concentrations of risk. I hope to provide here a nearly comprehensive list of the tools. Conceptually, the tools can be categorized into four categories and theoretically all of the following risks may contribute to asset bubbles or financial instability:
- Leverage/Market Risk
- Reducing leverage is intended to reduce the risk of insolvency in case of a fall in asset prices.
- Increasing liquidity reduces the risk that payments won’t be made to creditors and may curb fire-sales from credit crunches.
- Credit Quality
- Controlling credit quality intends to prevent future non-performing loans from debtors that would be most susceptible to economic shocks.
- FX/Capital Controls
- FX/Capital controls attempt to prevent hot money from pushing up asset prices and prevents firms from being over-exposed to FX risk from unhedged positions.
Also note that time-varying/dynamic/counter-cyclical rules are a popular concept and can be applied to possibly all of the following tools.
- Debt/equity ratios: Also commonly referred to as “capital” in the banking sector. Requiring more funding from equity reduces the risk of insolvency.
- Margin requirements: Determines how much investment can be made with borrowed money. There is a high correlation between margin debt and asset prices.
- Provisioning: Banks account for loss provisions in their financial statements. If they expect losses or are required to hold higher provisions, they will hold a higher equity buffer to offset the losses. If actual losses are less than expected, the bank records a profit.
- Restrictions on profit distribution: If debt/equity ratios are above what regulators want, they may require the firm to retain earnings instead of pay dividends.
- Collateral, hypothecation and haircuts: Regulators may determine which assets may be used as collateral, how much collateral is required for lending, and how much of a haircut is applied to the asset in the repo market. If market prices fall below the repo price the seller may not buy it back. Haircuts (over-collateralization) and margin calls are used to mitigate this risk. Repos and reverse-repos are being increasingly used by central banks as a new tool for an exit strategy from QE and since QE has drained the private markets of credit-worthy assets. Repos also can have broader participation than open market operations (OMOs), the Fed Funds market or deposits at the central banks. OMOs are restricted to primary dealers and deposits at the Fed are restricted to members of the Federal Reserve System and membership is restricted to qualifying commercial banks.
- Too Big To Fail (TBTF) taxes: TBTF taxes have been proposed to reduce the concentration of risk or political power of a single firm as a sort of Pigouvian tax to offset externalities. The taxes could be an assessment on firms whose assets are above an arbitrary cutoff (such as $1 trillion), on firms whose assets exceed a percentage of GDP, or on firms that own above a certain percent of market share.
- Reserve requirements: Reserve requirements are a unique item on this list since they are considered a traditional monetary policy tool. Even though use of changing reserve requirements fell out of favor as a traditional tool, it has gained renewed interest in conjunction with QE, especially in countries with pegged currencies, such as China. This allows the central bank to increase the monetary base without creating price or asset inflation.
- Limits on maturity mismatch: Financial intermediaries such as banks generally engage in maturity transformation by borrowing short and lending long. This can create a funding risk if they are unable to roll over their debts at a reasonable rate. Also, the long dated assets they hold will have more convexity, which means they will be more sensitive to changes in interest rates.
- Liquidity Coverage Ratios (LCR): Basel regulations require financial institutions to hold a level of highly liquid assets to cover their net outflows over a period of time.
- Caps on the loan-to-value (LTV) ratio: Requiring a larger down payment reduces the risk that the borrower will walk away in case of a decline in property value. It also helps the bank profitably resell the property in case of foreclosure.
- Caps on the debt-to-income (DTI) ratio: DTIs help gauge the borrower’s ability to repay the loan.
- Lending Policies- “No second homes” and risk weighting: Lending policies can target specific sectors of the economy or have specific goals. These can include requiring a larger down payment on second homes, increased risk weightings for real estate, discouraging foreign buyers, and discouraging house flipping by having higher taxes on short term sales.
- Caps on foreign currency lending: Foreign currency lending that is unhedged exposes the borrower to FX risk.
- Limits on net open currency positions/currency mismatch: Borrowing and investing in different currencies exposes FX risk.
- Capital controls: Capital controls are used to prevent hot money flows in and out of a country that could fuel a boom and bust. Controls are also used for financial repression and increasing domestic investment. Additionally, capital controls are often used in conjunction with a fixed exchange rate, like in China. This is due to the Trilemma. If China wants to peg its currency to the USD and control its domestic interest rate for monetary policy, it must have capital controls. Otherwise, the higher interest rate in China would attract hot money deposits from abroad and there would be an asset boom. The alternatives to a pegged currency with capital controls are a floating exchange rate with free capital or a currency board with free capital.