In a Friday speech at the 12th annual Bank for International Settlements annual conference, Stephen Cecchetti, Head of the Monetary and Economic Department at the BIS, had some interesting lessons on how he thinks about policy and the shape of regulation to come. We provide an abbreviated version of his comments. Our emphasis in bold.
First Lesson: Quantities in Monetary Policy
“The crisis reminded us that quantities tell us something important about the behaviour of individuals and the system as a whole; something that is not contained in prices. Quantities reflect exposures, constraints and vulnerabilities. This point becomes clear when we think about the role quantities play, or will play, in our models. Take the familiar structure where we have impulses and propagation mechanisms. In this standard formulation, quantities are going to enter as state variables that affect the nature of the propagation mechanism. A vulnerability is then a situation in which some quantity gets large in a way that amplifies the propagation of a shock so as to create a large movement in welfare.
“So, prices are not enough; think about quantities. And, net is not enough; think about gross.”
We think this is really important. Its a different way of looking at monetary policy. The more that Central Banks think about quantities as Cecchetti recommends, this will change their own perspectives on fiscal policy.
Second Lesson: Moral Hazard
“The second lesson I have learned in my time in the BIS tower is that the nature and size of the risks financial institutions take on are much bigger than we thought. This really comes as no big surprise.
“The problem with incentives is compounded by the increase in opportunities to take risk. That is, financial innovation has made things even worse. In the past, payment streams and risks tended to come bundled together. Today, you can purchase or sell virtually any payment stream with any risk characteristics you want – that’s what financial engineering is all about. This ability to separate finance into its most fundamental pieces – the financial analogue to subatomic particles – has profound implications for the way in which risk is bought and sold. While it is true that risk can go to those most able to bear it, the ability to sell risk easily and cheaply comes along with the ability to accumulate risk in almost arbitrarily large amounts. The result is that small numbers of firms or individuals have the potential to jeopardise the stability of the entire financial system.”
Policy Recommendations
1) Short-term interest rates are not enough.
“We will have to work hard to understand exactly how the monetary transmission mechanism works. How is it that the central bank can best stabilise the financial system and the real economy? What is clear is that the supply of central bank reserves remains the anchor of monetary control. But beyond that, many questions will have to be answered, including the role of interventions along the yield curve, collateral frameworks, and the role of central banks as lender of last resort.”
2) High debt levels are a drag on growth. Enough said.
3) Market discipline is not enough.
“We now know that the pre-crisis regulatory regime left the financial system vulnerable. Banks that found ways around the capital requirements had virtually no effective capital buffers at all. This prompted a switch in both the definition of capital, to ensure its quality, and the level of capital, to ensure resilience. Large global banks that face a capital surcharge will be required to hold capital equal to nearly 10% of their risk-weighted assets. Taking account of the changes in the definition of capital and the treatment of assets, this is an increase of roughly 10 times.
“One way to control moral hazard is to create a resolution system where managers, owners and liability holders are forced to face the consequences of their actions. Each of these groups must know ex ante what their responsibilities will be in the event that the institution gets into trouble.
“The best way to figure out whether banks can weather a large macro shock without resorting to any asset sales or capital raising is through stress tests. When they can, that’s fine. The issue, then, is how high capital levels need to be to meet that test.
“I believe that stress tests are the most powerful tool we have discovered in the past five years. Policymakers should focus on understanding how to use them.”
Now to just make sure that bank RWA models are apples to apples, otherwise stress tests look great on paper but don’t do much in practice to understand relative bank financial strength.
The full speech is here.