The credit crisis of 2007-2008 could lead central banks to be charged with the task of ensuring financial-market or financial-institution stability, and it is a role that central bankers seem reluctant to take.
Last night in Hong Kong, a discussion led by Charles Evans, president and CEO of the Federal Reserve Bank of Chicago, brought out the tension between a perceived need for central banks to preempt the next financial crisis by identifying and addressing asset bubbles, and a reluctance to attempt this. The dinner was organised by the Institute of Regulation & Risk.
Evans makes the point that, even with hindsight, it requires a huge amount of data and analysis to determine when and how the Federal Reserve could have stepped in during America's real-estate boom to prevent it from turning into a credit crunch that threatened the very fabric of society. Even if it had been able to identify the danger -- which it didn't, because banks' loan officers could so easily argue that banks had everything well under control -- the frenzy of a boom market would have rendered the Fed's moral suasion toothless.
Nonetheless, the sum of individual banking institutions' risks proved less than the systemic risk that was building up within the financial universe. Even if a few rather clever bankers ran for the exits in time, the macro economy faced losses that proved unbearable.
So there is a need for "macro prudential regulation", which is the term for giving central banks the ability to identify and prick asset bubbles before they become too big. This naturally begs the question of how this is done, and assuming bubbles are identified, what tools are used to deflate them safely.
"Monetary policy is too blunt a tool for pricking bubbles," opines Evans. "It can't be targeted precisely and it will affect other financial and macroeconomic variables in addition to the suspected asset bubble."
Evans believes the way forward is to rely on multiple levers. Partly this is a diversification strategy; when there's little certainty about which lever will prove effective, then use several. However, this ends up sounding like more of the same: higher standards for capital and liquidity. It also means a resolution authority to wind up big, failed institutions in a way that preserves certain elements, such as deposit-taking. And it means macro prudential regulation.
Examples of this could include dynamic capital requirements and loan-loss provisions that vary over a credit or business cycle, which could temper boom-bust trends. Evans says the "stress tests" carried out on the 19 largest US banks by the Fed in early 2009 was a successful precursor to such requirements, as it gave regulators and the market an idea about the sector's health in totality, as well as on an individual basis.
Nonetheless, this still raises a host of uncertainties about using such regulation to understand what the Fed should be looking for and when. Macro-prudential regulation is no easier than regulating financial institutions one by one, but it's meant to be done at a systemic level.
The fact that regulators in America in the 2000s, and in Japan in the 1980s, could never be fully confident of their hunches during boom periods at a micro level (remember those very convincing bank loan officers) suggests macro-prudential work will never be obvious.
Andrew Haldane, executive director for financial stability at the Bank of England, says the notion of an omniscient regulator is "fanciful". But he suggests moral suasion could be one tool used by central banks to ward off the worst, self-destructive behaviour of market participants.
Haldane quotes former Citi CEO Charles Prince's infamous remark: "As long as the music is still playing, you've got to get up and dance." It is this inability among banks to sit out a boom even if they suspect it will end badly that central bankers can address. Macro-prudential regulation could work by coordinating expectations, force one or two of the more exposed firms to exit a booming business, and therefore make it acceptable for other banks to reduce activity.
Haldane quickly notes that this requires the central bank's warnings to be seen as credible. The risk is that this sort of suasion might just prompt some banks to simply take advantage of others' forced exit from the market.
Despite these concerns, Evans and Haldane say that a macro-prudential role is necessary. In particular, Evans says that if the Fed is invested with a mandate to control financial exuberance, it cannot rely just on monetary policy; such responsibility must come with the power to supervise, regulate and, if necessary, dismantle big firms.
Stephen Roach, chairman of Morgan Stanley Asia and once an economist at the Fed, says central banks need to be able to use monetary policy to "lean against the wind" in order to avoid future crises.
He is critical of discussions around regulation, however, and argues that central bankers need to be accountable for monetary policy. For example, Roach says the Fed's prolonged loose money supply following the tech-stock crash in 2000 led to the excesses in the real-estate market.
He is sceptical that macro-prudence can actually prevent crises, but he accepts that monetary authorities need a fresh approach.
One option being debated today is to add financial stability to the Fed's mandate, along with price stability and economic growth, and hardwire its accountability with regard to future asset bubbles. But Roach thinks the bigger question is monetary, and challenges the Fed's current accommodative position of zero interest rates despite the credit crisis having ended.
Evans replies that the stubbornly high level of unemployment and modest level of core inflation, and the Fed's mandate to promote economic growth, requires rates to be low. "The only reason they're at zero is because we can't go below zero," he says.
This leads to a comment from Kazuo Ueda, professor at University of Tokyo and a former executive at the Bank of Japan, who says his fear now is that if inflation in America and Europe declines further, the world could face a Japan-style deflationary spiral.
The Fed faces a liquidity trap now, as it can't lower interest rates any further, and its non-traditional tactics to address the crisis have been only partly effective.
The conclusion these central bankers leave is that they have little choice but to accept some form of macro-prudential, systemic authority. It is a role they feel ill-suited for, but they know another crisis of this magnitude is unacceptable.
The evening's discussion involved a fudge: Acknowledging the need for such asset-bubble skills, yet warning that central bankers can never act with certainty.
They can access some traditional measures, such as raising or lowering capital and liquidity requirements, and perhaps can do so in a 'dynamic' fashion that is counter-cyclical -- but they are reluctant to have such measures formalised or mandated.