In the wake of the global financial crisis, policymakers everywhere have put greater emphasis on “macroprudential” regulation of the financial system—looking at the system as a whole, putting extra protection in when borrowing is on the upswing, and making the system resilient to unexpected developments such as the nationwide plunge in house prices that undermined US lenders in 2007-09. But Donald Kohn, Robert S. Kerr Senior Fellow in Economic Studies and former vice chair of the Federal Reserve Board, says the U.S. is not doing a good-enough job of systemic financial regulation. In remarks made at the Boston Federal Reserve Bank’s recent conference, Macroprudential Monetary Policy, Kohn worried that shortfalls in macroprudential regulation would put extra pressure on the Fed’s policy-setting Federal Open Market Committee (FOMC), which sets short-term interest rates, to use monetary policy to fight financial bubbles. Monetary policy is a “blunt instrument,” and it’s not clear how much it can affect “risks to financial stability arising from mispricing of assets, leverage, and maturity mismatches.” Kohn expressed concern that chasing a financial stability target with potentially ineffectual monetary policy tools could force the FOMC to deviate from its focus on keeping inflation low and stable and employment as high as sustainable, damaging the economy unnecessarily.
The United Kingdom has adopted a two-pronged approach: Separate monetary policy and financial-stability policy committees with some membership overlap between the two. Kohn is an external member of the latter, the Bank of England’s Financial Policy Committee. Kohn recommends that approach for the U.S. The FOMC should continue to make monetary policy, but the Fed Board of Governors (appointed by the president and confirmed by the Senate) should have their hands on the tools and requisite mandate to combat financial instability. This division of labor would keep policymakers’ focus where it should be and also avoid the conflicts of interest that come with having presidents of the Fed regional reserve set regulations: “The reserve banks are owned by the banks in their district, which elect 6 of the 9 members of the boards of directors… Having the presidents vote on an aspect of setting of regulations could well entail a change in law.” If reserve bank presidents were given macroprudential authority, “at a minimum the optics would be terrible… and concerns about the influence of bankers and interested parties… would be accentuated, understandably in my view.”
But the tools that the Fed has aren’t up to the task, especially as regulation of banks and other major intermediaries induces regulatory arbitrage into other corners of the financial markets. The Dodd-Frank law created the Financial Stability Oversight Council (FSOC), comprised of the heads of U.S. financial regulatory agencies, to coordinate among the agencies. Kohn said this isn’t sufficient. “The creation of the Financial Stability Oversight Council has been helpful in bringing forward analysis of risks…and stimulating coordinating action,” Kohn said, but it “has no real powers beyond SIFI [systemically important financial institution] designation and making recommendations.” Moreover, many members of FSOC are too focused on protecting their regulatory turf and not enough on how their action—or lack of action—might affect the stability of the system and its propensity to generate crises that entail major losses of jobs and output.
So what tools would a U.S. financial-stability committee have? Kohn looks to England. Whereas much of U.S. post-crisis regulatory change has focused on structural changes (which don’t alter with the financial cycle), in the U.K., the Financial Policy Committee has power over several countercyclical tools. It can set or modify “countercyclical capital buffers on risk-weighted and leverage basis; sectorial capital requirements in the real estate area; and LTVs [loan-to-value ratios] and LTIs [loan-to-income ratios] on mortgages for owner occupied housing.” Kohn stated that when looking at the current U.S. system’s deficiencies, he is “particularly struck by the lack of countercyclical tools for real estate credit” since that’s been the source of so many financial crises.
Ideally, he said, this would be done as part of a legislative package of broader regulatory overhaul “to consolidate agencies and make financial stability an integral part of their remit and to create a macroprudential regulator with authority that matched its responsibility.” Kohn calls the current regulatory regime “fragmented, Balkanized…beset by gaps and overlaps.” But he is doubtful this will happen soon, given the history of scuttled reform. Instead, he proposes agencies come together to do a “stock take” of what macroprudential tools are already available, and what stands in the way of our using them. “What we need is an assessment of where the holes are in coverage and how they might be filled. What can be done under current legislation?” The published results should “foster understanding that [macroprudential regulations] should tighten in the good times and ease in the bad, and that such actions would enable the monetary policymakers on the FOMC to concentrate on achieving their maximum employment and stable price objectives as rapidly as possible.”