The current consensus for a regulatory blueprint after today’s financial crisis is calling for increased macro-prudential supervision of financial markets. The proposals of Europe’s de Larosière working group are no exception. What is another characteristic of the discussion is that both the Fed and the ECB are quick to proclaim that they should play a “leading” role in the macro-prudential supervision. I.e. they want to have that responsibility rather than just a mere say in the process (central role) as they are conceded in the de Larosière proposals. What makes this an interesting topic is the fact that central banks over the last decade had to part from a lot of supervisory responsibilities, so they are now lobbying to get these back.
In this entry, I would like to take the view that central banks do not per se make for good regulators as there is a trade-off between the regulatory framework on the one hand and the key interest rate on the other with regard to the monetary transmission mechanism and the corresponding multiplier on economic activity. We should therefore take a moment’s pause for thought before macro-prudential supervision is assigned to the portfolio of central banks.
But perhaps a few words on the need of more macro-prudential supervision first – which I do share wholeheartedly. Today’s regulatory framework looks at one individual financial institution at a time, i.e. it is micro-prudential. As with anything micro in economics, there is a big risk of fallacy of composition generating an inflated sense of security. Let’s briefly illustrate this by an example of the risk transfer inherent in securitized credit: A bank in southern Portugal and a bank in north-eastern Poland of both roughly the same balance sheet-size and equity are both specializing in regional home mortgages. Due to sector and regional concentration of their activities, the maximum damage from rising delinquencies relative to equity would have to be relatively small before they become undercapitalized. Their individual risk of becoming insolvent would be reduced to a very high degree if they exchanged some or up to half of their extended credit books via securitization. However, the extreme case would now be for both banks’ balance sheets to look exactly the same. Therefore any shock of a magnitude that gets one bank into insolvency would kill the other at the same time. Bottom line: While risk transfer via securitization is good in reducing individual risks, systemic risk is not only not mitigated but in some cases increased.
Now back to the punchline that central banks are not prima facie suited very well to be the main macro-prudential supervisor. The prime example is the Federal Reserve’s policy from 2001 to 2005. Back in January 2006 I opined in an epitaph to the Greenspan era: “However, the fundamental problems, which had led to the 2001 recession, have not been solved. They still exist, payment day has merely been deferred.” Back then, I honestly admit, the now infamous term of subprime lending had not crossed my desk despite writing intensively about the mispricing of the US housing market. What was clear, however, is that the Fed was desperate to engineer an economic recovery in 2001 to 2003 at any price. With the benefit of hindsight, it is clear that the price the Fed was willing to pay for the recovery was the trebling of the share of subprime mortgages from 5 to more than 15 percent of total mortgage credit in the short time-span from 2004 to 2006. What makes this all the more significant is that both credit statistics as well as the Fed’s senior loan officers’ survey suggest that by 2003 demand for traditional mortgages was starting to slow significantly despite record low key interest rates. So the Fed seems to have been quite happy that non-traditional mortgages increasingly took over as an engine of increased household leverage.
Furthermore, Fed officials in general and Alan Greenspan in particular actually acted as veritable cheerleaders for both securitization and innovations in the mortgage market. For example, Greenspan opined in July 2005: “Nationwide banking and widespread securitization of mortgages make financial intermediation less likely to be impaired than it was in some previous episodes of regional house-price correction.”
To sum up: Insufficient regulation of the subprime market and the utter disregard for the systemic risk-implications of securitization have not just been a sorry mistake by the Fed but served as a substitute for even lower key interest rates/quantitative easing when the Fed tried to prevent a necessary deleveraging process after the bursting of the dotcom bubble. Longer-term financial stability considerations might clash with short-term stabilization of the economy. This is the kind of trade-off one would rather avoid than foster.