The New Macro-Prudential Regulatory Agenda:

Rationale and Implications

Augusto de la Torre and Alain Ize

Miami, Florida

17 November 2015

Motivation

The sub-prime crisis kicked the board… It pulled the rug from under the blind faith in market discipline (the “efficient market” postulate) and

questioned the effectiveness of regulatory policy

It was brewed and erupted in the most advanced (deepest and most liquid) and most admired financial system in the planet, considered as the model to follow

It forced governments into unprecedented, in depth and extent, and unconventional

It fed the perception of inequity, exacerbating social tensions (Main Street vs. Wall Street)

… and unleashed a new wave of regulatory reform “Estamos haciendo mucho pero no sabemos mucho lo que hacemos”

We need to understand where we come from and the weaknesses of the pre-Lehman regulatory architecture to get a better sense on where to go from here

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The pre-Lehman regulatory architecture

Regulatory Perimeter:“line on the sand” Unregulated Financial Activity

Not subject to prudential regulation

No access to the deposit insurer or lender of last resort

Expected to self-regulate, in response to market discipline

“Regulation of [financial] transactions that are privately negotiated by

professionals is unnecessary”(Allen Greenspan)

Commercial Banks

Microprudential Regulation(Basel I y II)

Access to the Deposit Insuranceand the

Lender of Last Resort

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Rationalization #1: naïve players

It is difficult to justify (preventive) prudential regulation in world of purely rational players The classical principal-agent problems (information asymmetry and enforcement problems) are key to

understand the functions of financial markets (Arrow, Stiglitz)…

… but not sufficient to warrant prudential regulation if all players are rational

Akelrof (1970): rational players would not engage in financial transactions unless the principal-agent problem is satisfactory resolved

Financial markets naturally seek to resolve principal-agent frictions and the regulator has no durable comparative advantage to directly improve the outcome

The key roles of screening, capital/collateral, monitoring, and exit for market discipline

But the presence of naïve players opens the space for abuse and manipulation… Financial contracting flourishes, even though the principal-agent problems are not adequately

resolved (Akelrof & Shiller: “Phishing for Phools”)

… and justifies prudential regulation, the deposit insurance, and a narrow regulatory perimeter Consistent with the theory of “delegated supervision” (Dewatripont & Tirole, 1994)

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Rationalization #2: bailout expectations

Self-fulfilling runs (rational but socially inefficient) can be unleashed by a wedge between private and social interest interacting with aggregate shocks… Dimond-Dybig (1983): “Bank runs, deposit insurance and liquidity”

… justifying the financial safety net – to dissuade (ex ante) self-fulfilling runs and reduce (ex post) the social costs of systemic financial crises

But the financial safety net raises bailout expectations, which feed socially excessive risk taking… One-sided bets: heads I win, tails you loose

… justifying prudential regulation, to offset the moral hazard associated with the safety net

… and a narrow perimeter around the institutions with access to the safety net “Prudential regulation extends no further than the reach of the financial safety net”

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Weaknesses of the pre-Lehman regulatory architecture

The two rationalizations were never adequately integrated Private-social wedges and aggregate risks, which motivated the financial safety net, were not central in

the design of prudential regulation

Basel-style prudential focused on idiosyncratic risks and individual financial institutions

A limited deposit insurance may protect the naïve but does not deter runs – the larger and more sophisticated depositors/investors run first and faster

If private-social wedges matter and justify the safety net, ¿why think that such wedges will not mushroom outside the regulatory perimeter?

The profession, unwilling to abandon the rationality assumption, bifurcated Those interested in principal-agent problems and market discipline focused on moral hazard and the

costs and distortionary effects of prudential regulations

Douglas Gale: “one bad policy (deposit insurance) does not justify another (capital requirements)”

Those interested in private-social wedges (runs, sudden dry ups of liquidity) focused on systemic liquidity but tended not to address the implications for prudential regulation

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The sub-prime crisis and collapse of preconceptions

Pre-crisis

• The health of the system depends solely on the health of its individual parts

• Not all can go wrong at the same time (diversification trumps all other concerns)

• The distribution of risks is normal; hence, price history is all that is needed

• Market discipline reigns in the land of the sophisticated and well informed

• The financial safety net will remain circumscribed to the regulatory perimeter

Post-crisis

• The system is much more tan the sum of its parts

• All can go wrong at the same time (covariancesand interconnections are great amplifiers)

• Financial markets are moody; loss distributions are affected by fat tails and black swans

• Market discipline failed most visibly in the land of the sophisticated and well informed

• Shadow banking grew exponentially outside the perimeter and the safety net has to follow

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Macro-prudential regulation: ingredients

Aggregate risk and endogenous build-up of systemic risk

Amplifiers Highly-leveraged financial intermediaries that create quasi-money

Principal-agent problems => pro-cyclical loosening/tightening of collateral and capital restrictions or of information asymmetries

Expectations (inevitable) of bailouts => moral hazard

Private-social wedges => fire sales, herd behavior, Chuck Prince effects, runs, too-big-too-fail

Bounded rationality => abuse and manipulation of naïve, moody markets (euphoria and panic)

Policy failures => excessive costs & distortions leading to endemic regulatory arbitrage

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Four distinct justifications for macro-prudential regulation 1. Correct incentive distortions arising from (inevitable) expectation of bailout

Failure resolution frameworks

Pricing the safety net

2. Protect the naïve from abuse in the face of aggregate shocks Counter-cyclical capital or provisioning norms (skin-in-the-game throughout the cycle)

Reform of bonuses and compensation systems for asset managers

3. Align private and social interests – induce the internalization of externalities Penalties on short-term wholesale funding

Systemic liquidity requirements

Capital surcharges on too-big-to-fail or too-interconnect-to-fail institutions

Ceilings on size, functional segmentations, fuses, redundancies

4. Temper mood swings in financial markets Financial stability reports by central banks

Controls on financial innovation

Quantitative restrictions: credit ceilings, maximum LTV and LTI ratios, discretionary reserve requirement9

Complications

Identification problems Which financial fluctuations are OK and which are socially inefficient?

Observationally similar patterns of financial instability can reflect different underlying failures

Dominance of underlying causes change in time and space Scope for abuse and euphoria grows in times of major financial innovations

Un-internalized externalities may be greater in the shadows of the regulated field

Collateral constraints can tighten in times of economic contraction

Tensions and tradeoffs – what helps deal with one problem can exacerbate others Mark-to-market: good to help prevent abuses but can exacerbate fire sales

Penalties on short-term wholesale funding: induces internalization of fire sales externalities but takes away a key disciplining device

Limits on size, functional segmentations: help internalize interconnectedness externalities but hinder the exploitation of efficiency-enhancing synergy

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How to proceed?

There is no one perfect regulatory system – it is a question of balance

Some room should be made for the use of good judgement (discretion) Analogy with monetary policy

Two polar design options All-terrain system: a little bit of every thing

Wide scope for policy inconsistency and failures

Bi-modal system: normal times regulation vs. extraordinary times regulation

Requires an agile and independent regulator

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Thank you!