Home Finance Federal Reserve Macro-Prudential Regulation

Federal Reserve Macro-Prudential Regulation

by internationalbanker

By Gerren Bethel, Deputy Editor at Finance Publishing

As the US economy moved into a phase of recovery from the 2008 financial crisis, policymakers and regulators sought new and proactive measures to stabilise the financial system in an effort to avoid a similar crisis in the future. Macro-prudential regulation has been part of the arsenal of innovative efforts made by policymakers and refers to an approach in financial regulation that is specifically designed to mitigate systemic risks to the financial system as a whole. Macro-prudential policy is the combined supervisory and regulatory action applied by the central bank of a nation, or the Federal Reserve (the Fed) in the case of the US, which is used in place of or alongside monetary policy to preserve the financial and economic stability of that nation. Economic researchers and advisers have been moving towards a consensus of designing financial and regulatory policies based on a set of macro-prudential principles and perspectives. As the Fed begins to apply this new approach to the US economic regime and regulatory policy, what remains in question is whether the measures taken will prove to be effective in their purpose into the future. This puts the new macro-prudential phase of policy application under an intense spotlight as the wider global economic community watches closely to see how the policy fares in its early—and as some deem it, experimental—stage of implementation.

Many economic experts have expressed strong convictions that the US Fed must apply macro-prudential tools as a method of lessening the damages from economic turbulence within the cycles of the financial system. These experts have argued that the historically traditional choices of policymakers—those of monetary policy combined with standard regulations—have significant drawbacks that need to be addressed head-on with macro-prudential measures. Monetary policy historically has failed somewhat as it resulted in broad and blunt results from policy changes—the changing of interest rates in either direction has resulted in a broad sweeping measure for the whole economy that does not properly address the issues specifically feeding financial instability. This has made monetary policy an inefficient tool in the past given the aims of central bankers and policy setters. In addition traditional measures of financial regulation have historically targeted specific individual institutions without considering the larger sector impact and industry changes as well as broader economic measures. These financial regulatory changes are often too narrowly focussed and do not consider and incorporate the wider trends within the economy. Macro-prudential measures aim to overcome these shortcomings—set up in a way so as to address the financial system as a whole from a wide to a narrow scale of impact and consideration.

The goal of the macro-prudential tools is to be far reaching whilst reducing the ripple effects of potential damage to other parts of the economy. Macro-prudential policy is a valuable tool but must also be applied cautiously—as it too has its limits. Policymakers and regulators need to be aware of these limitations when setting and applying policy in order to develop a sustainable framework for financial stability for the future. As a relatively new policy measure, it should be applied and developed gradually and iteratively so as to better employ the tools in operation.

Although new in its current form of application, there have been historical precedents of macro-prudential policy in action. In particular in the US, macro-prudential actions over the past decades have had a certain degree of success in their applications. Over time the wider understanding and application of macro-prudential action has developed and deepened—it is much improved today compared to its past applications thanks to continued research in this area. This should afford policymakers the chance to optimise and maximise the results of policy action in ways that were not available in the past.

Currently, American regulators and policymakers are viewing macro-prudential tools more favourably than ever; however, there is as yet the proper framework and infrastructure to get the systemic-risk management system in place and successfully operating to the best and most efficient extent. In addition to this, and perhaps most importantly, an increasingly comprehensive structure of good governance also needs to be put in place for macro-prudential measures to take best effect.
The resources applied to macro-prudential policy need to be sizeable enough so that the tools and policies have a full and wide impact. Currently the resources being allocated to macro-prudential policy are lagging other areas of regulatory development, such as The Dodd Frank Act and its implementation.

Although it is widely accepted by economic and regulatory experts that the application of macro-prudential policy framework will not, and does not, necessarily need to be exactly right, in the first instance and application it will need to be closely monitored, and policymakers should be stealthy in adapting the choices made as policy application develops. At a stage not too much further down the line, policymakers will indeed have to make tougher and firmer choices as to how and whether to apply tighter macro-prudential tools in much more specific ways and cases.

Under discussion currently and of pressing concern to the financial sector and economic regulatory community are a core set of tools that are designed to provide a buffer to counter cyclical economic behaviour in addition to tools that provide a buffer to counter cyclical liquidity squeezes. In addition the measures taken will aim to limit LTV (loan to value) ratios for debt and mortgage contracts and improve capital requirements to provide more stability across the financial system. Also under consideration in the US economy is a measure to set minimum collateral requirements, also known as “haircuts”, for certain transactions that may involve securities-lending agreements as well as repurchase agreements. Policymakers must proceed with caution as macro-prudential policy, like all others, has its own limitations in what it can achieve through its application alone.

In addition, as a holistic, systemic approach to risk management, macro-prudential policy cannot necessarily be implemented effectively with ease. As we continue through this preliminary phase of macro-prudential policy, economists and relevant parties worldwide are understandably watching the results and impact most keenly, not unlike the phase change in monetary policy of the 1950s that garnered much attention, speculation and scepticism. Macro-prudential policy will only be able to evolve through direct application, and this will allow relevant statistics to be gathered so that theory and tools may be refined and optimised toward their purposes. The tools and policy will only improve after this phase of experimentation—and this poses a risk in the near term as measuring the related uncertainty remains a substantial difficulty; however, with the correct approach the economic impact may be harnessed effectively. Although this risk of uncertainty is present, it does not outweigh the need for a systemic approach to risk. If applied moderately and carefully, these macro-prudential tools should improve the financial stability of the economy—a change that is needed and welcomed at all levels of society across the globe.

Those who are most in favour of macro-prudential actions argue that without the application of macro-prudential policy, regulators will have at their disposal only the usual selection of monetary-policy actions, which as mentioned earlier have proven too broad and blunt in their applications to the economy. The global outcry remains ever present for political and regulatory action to prevent a repeat of the financial crisis the world experienced in 2007-2008. Not making a change is not an option for policymakers given the lingering sentiment in the wake of the global credit crisis. Although some involved parties are currently suggesting that quantitative easing has actually acted in the opposite direction of this aim, with the creation of an economic bubble rather than restoring a real level of financial stability, there is still a need for policy action to create a more financially stable economic system. The global economy, in particular that of the US, is in a phase of transition and needs to take steps to counteract any future credit bubbles and guard against drastic, dramatic market reversals and the knock-on effects. Macro-prudential policy may aid substantially with this if applied properly.

Macro-prudential policy may currently be a “hot button” topic in the arena of regulators and economic experts and advisers; however, investors and relevant parties are not quite as fully aware of just how much the US economy has at stake when it comes to the application of macro-prudential policy. Broader awareness needs to be enhanced with regards to the measures central banks and the Federal Reserve are taking towards reducing the risk of systemic disaster and damage to the financial sector. This increased awareness will in itself work towards restoring faith and stability to the financial system.

Macro-prudential policy is designed to reduce the probability and costs of financial disasters and accidents through the enhancement of the resilience and robustness of the system. Macro-prudential tools are designed to implement circuit breakers that prevent problems in one area from spreading into others and, at the extreme, contain the detrimental impact on the wider economy when financial failures do occur. In the aftermath of the financial crisis, the efforts in the area of macro-prudential regulation have been ramped up significantly. Authorities across the world have imposed more intelligent and more stringent capital requirements, and they are requiring financial institutions to value their assets more conservatively. In addition, these institutions have been made to hold easy-to-sell assets to a higher degree to provide liquidity buffers. Policymakers have also placed constraints on risk-taking, enforced more stable funding restrictions and required improved provisions to protect against bad and toxic loans.

The wave of new regulation since the financial crisis has had an impact outside of banks and financial institutions to only a limited degree. Central banks have also acted in bolder ways towards stimulating credit and monetary areas of the economy, which has boosted stock prices as well as prices of bonds and other asset classes. These central bankers, including the Fed, have gained confidence in the macro-prudential approach and are keen to persist in this direction of policy action. However, continuing fervently in this direction without the appropriate measure of caution may create a new set of risks of financial instability down the road. This is the trade-off of implementing new policy measures—that of balancing the need for innovative action and impact with the uncertain subsequent risks.

The Fed has been supporting markets and driving stock, bond and asset prices up to what many are speculating are levels at which the concern of a bubble is a real and significant one. The Fed took these measures under the expectation that this support will lead to improved consumer spending and increased investment and employment across the US economy. This has been the justification for the measures put in place, and there is still a realistic expectation that this convergence will take place in the next few years. However, the Fed’s policy aim of nearing full employment and a two-percent inflation target is still not in immediate reach, and in the meantime the gap between economic reality and capital-market asset prices is alarmingly sizeable. Stock market prices are reaching new highs as the year progresses, whilst wage and inflation data remain proportionately suppressed. There is now a danger that the economic recovery, particularly in the US, will eventually fail to substantiate the artificially bolstered high asset prices, and in fact this will lead to significant financial instability, an adverse result for the US economy and an outcome that the measures set out to prevent in the first place.

Further exacerbating the risks in this area is the fact that the relevant authorities are growing increasingly comfortable in their abilities to contain potential instability with these measures, albeit some may argue superficially, and this has increased policymakers’ appetites for continuing with these lines of stimuli. Understandably economic advisers are growing concerned about the risks posed by this current blend of macro-prudential and monetary policy and its efficiency over the horizon.

Many economic experts are purporting that macro-prudential regulation or supervision creates an artificial sense of confidence and stability. In its current format, macro-prudential policy can be circumvented, and this has created a false sense of impact in some areas—action should be taken to broaden and deepen policy measures. There is furthermore a risk that the Fed is now playing too large a role in the economy for it to stabilise successfully of its own accord. The Fed’s success in fighting deflation and depression risks in the aftermath of the 2007–2008 financial crisis has been significant and efficient in its purpose; but there is a risk that the Fed has overstayed its welcome in intervening in market behaviour. The markets and wider economy need some room to stabilise independently. The Fed policy to lift the economy out of the crisis and counteract a possible deflationary spiral has been successful, but the economy is now in a better position, and policy should be adapted to meet this changing phase of financial activity. Interest rates are low, and there is an abundance of credit available in the non-deposit based market. Consequently capital-asset markets have seen a surge in speculative activity. Macro-prudential regulation aims to safeguard the economy from financial instability, which may in fact eventually result from this surge in speculative market activity. However, macro-prudential supervision entails the thorough and close monitoring of capital and liquidity ratios as well as more stringent restrictions on banking practices, and it also requires banks to carry out periodic stress tests. These measures are trickier and less effective in practice than in theory. As one example, the Federal Reserve would previously oversee the credit markets and system function by regulating depository institutions; however, depository institutions now account for less than 20 percent of all credit market activity, leaving the Fed unable to properly supervise a major share of the market.

This concern has not escaped Fed Chair Janet Yellen, who noted in her recent lecture at the International Monetary Fund that she is “also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macro-prudential measures to address these and other financial stability concerns”. She added that “accordingly, there may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability”. Many economic advisers are concerned that that time is approaching sooner than expected. These experts are suggesting that reducing asset-purchasing will not be effective as a measure alone and that the Fed should additionally consider tapering the reinvestment of maturing securities and begin incrementally shrinking the Fed’s balance sheet.

The economy is in a much stronger position now than it has been over the last couple of years—wages and employment figures are improving (albeit gradually), and the housing market is also strengthening. Given this positive movement, the Fed may consider raising interest rates in small increments from the start of 2015 and allow the economy to function with reduced intervention. In the meantime, the primary question remains as to whether the recent strengthening in macro-prudential regulation is sufficient to warrant the risks that the Fed is taking with respect to future financial instability. Macro-prudential policy success and progress, although noteworthy, has fallen short of what the Fed had initially envisaged. Furthermore, international coordination has failed to reach the levels that are needed to make macro-prudential regulation a true success; actions should be taken to make the policy operationally cohesive on a global platform. Investors and market participants need to consider this balance of factors in their decision-making—in particular when making decisions directly impacted by Fed policy as they may prove volatile and difficult to reverse in the short-to-medium term.

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