"Restraining asset and credit booms"

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Willem Buiter decided to provide some further thoughts on regulatory reform over the holiday weekend.

Given the nature of posting, and the difficulty of devising banking reforms, most proposals are going to fall short on detail. But this one falls a bit shorter than I’d like. For instance, Buiter clearly assumes international cooperation; these ideas would be easily circumvented if implemented in only one jurisdiction.

His latest suggestion revolves around one key observation: bubbles are hard to detect and contain. I’m not sure about the detect part, but as Kenneth Rogoff and Carmen Reinhart point out, financial crises are generally borne out of enthusiasm for change, usually technological change, gone too far. But the difficulty is, as a regulator, how do you prove that enthusiasm has tipped into mania? Remember, reining in the bubble reduces the wealth of those who bet on it, and they will howl like stuck pigs, arguing you did them wrong. When would you have drawn that line in the dot-com era? That one was not driven by leverage, despite the utter idiocy of valuing stocks by eyeballs rather than the expectation of future cashflow.

Buiter therefore argues against using monetary policy to try to stop runaway asset prices. Instead, he focuses on two measures: far more toughmindedness about leverage (if you are bigger than a certain size, no matter what you are, you are subject to capital constraints), and an ability for authorities to seize control of on-the-brink institutions before they actually fail. And when they are put into protectorship (or whatever Newspeak term you prefer), management and shareholders are sacrificed, perhaps even creditors. No mercy for the reckless.

Note that he proposes as one test, a simple restriction of book equity to total exposures. Some observers may howl that that punishes derivatives players, even one in fairly mundane, mature markets, versus those who focus more on cash markets. I imagine that Buiter would regard that as a virtue rather than defect of his plan.

From :

The….official policy rate should not be used to ‘lean against the wind’ of asset booms and bubbles….It would overburden the official policy rate and, since going after an asset boom/bubble with the official policy rate is like going after a rogue elephant with a pea shooter,….

That, however, leaves a major asymmetry in the macroeconomic policy and financial stability framework. This asymmetry is not that interest rates respond more sharply to asset market price declines than to asset market price increases. Even if there were no ‘Greenspan-Bernanke put’, such asymmetry should be expected because asset price booms and busts are not symmetric. Asset price busts are sudden and involve sharp, very rapid asset price falls. Even the most extravagant asset price boom tends to be gradual in comparison. So an asymmetric response to an asymmetric phenomenon is justified. This does not mean that there has been no evidence of a ‘Greenspan-Bernanke’ put, of course. In fact I believe that phenomenon – excess sensitivity of the Federal Funds target rate to sudden declines in asset prices, and especially US stock prices – to be real, unfortunately.

Fundamentally, the key asymmetry is that the authorities are unable or unwilling, whether for good or bad reasons does not matter here, to let large leveraged financial institutions collapse. There is no matching inclination to expropriate or otherwise financially punish or restrain highly profitable financial institutions. This asymmetry has to be corrected. Therefore, any large leveraged financial institution, commercial bank, investment bank, hedge fund, private equity fund, SIV, Conduit or whatever it calls itself, whatever it does and whatever its legal form, will have to be regulated according to the same principles….

We even have proposals now, that, because fair value accounting and reporting rules are procyclical when asset markets are impaired and artificially depressed – asset markets undervalue assets compared to what their fundamental value would with orderly markets – mark-to-market accounting rules be suspended during periods of market illiquidity. That would introduce a further asymmetry, because orderly and technically efficient asset markets can produce valuations that depart from the fundamental valuation because of the presence of a bubble. There have been no calls for mark-to-market accounting and reporting standards to be suspending during asset price booms and bubbles.

These asymmetries have to be corrected through regulatory measures, effectively by across-the board credit controls. Every asset and credit boom in history has been characterised by rising leverage. The one we are now suffering the consequences of is no exception. Leverage is a simple concept which may be very difficult to measure, as those struggling to quantify the concept of embedded leverage will know. In the words of the Counterparty Risk Management Group II (2005), “…leverage exists whenever an entity is exposed to changes in the value of an asset over time without having first disbursed cash equal to the value of that asset at the beginning of the period.” And: “…the impact of leverage can only be understood by relating the underlying risk in a portfolio to the economic and funding structure of the portfolio as a whole.”

Traditional sources of leverage include borrowing, initial margin (some money up front – used in futures contracts) and no initial margin (no money up front – when exposure is achieved through derivatives).

I propose using simple measures of leverage, say a measure of gross exposure to book equity, as a metric for constraining capital insolvency risk (liabilities exceeding assets) of all large, highly leveraged institutions. Common risk-adjusted Basel II-type capital adequacy requirements and reporting requirements would be imposed on all large institutions whose leverage, according to this simple metric, exceeds a given value. These capital adequacy requirements would be varied by the monetary authority in countercyclical fashion.

To address the second way financial entities can fail, what the CRMB calls liquidity insolvency, meaning they run out of cash and are unable to raise new funds, I propose that minimal funding liquidity and market liquidity requirements be imposed on, respectively, the liability side and the asset side of the balance sheets of all large leveraged financial institutions. These liquidity requirements would also be tightened and loosened by the monetary authority in countercyclical fashion.

Finally, I would propose that all large leveraged institutions that are deemed too large, too interconnected, or simply too well-connected to fail, be made subject to a Special Resolution Regime along the lines that exists today for deposit-taking institutions through the FDIC. A concept of regulatory insolvency, which could bite before either capital insolvency or liquidity insolvency kicks in, must be developed that allows an official administrator to take control of any large, leveraged financial institution and engage in Prompt Corrective Action. The intervention of the administrator would be expected to impose serious penalties on existing shareholders, incumbent board and management and possibly on the creditors as well. The intervention should aim to save the institution, not its owners, managers or creditors.

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3 comments

  1. Anonymous

    There might well be no way to avoid bubbles while we are under a fractional reserve banking system :
    1) I know of no bubble that wasn’t ‘helped’ by some form of monetary expansion
    2) As long as monetary expansion cannot be avoided by customers of banks, it will occur.

    Stricter regulation might extend to non-banking financial institutions. But because money substitutes can be created under FRB, economic actors will always seek to create new ones in a yet unregulated area. Another way to say this is that legalized monetary rent will always attract rent-seekers.

  2. Anonymous

    “The intervention of the administrator would be expected to impose serious penalties on existing shareholders, incumbent board and management and possibly on the creditors as well. The intervention should aim to save the institution, not its owners, managers or creditors.”

    Here we are at the crux of the problem. For too long the to big to fail has meant to big to be responsible for your actions. When you and I make a mistake we pay for it either with a financial hit or if we break the law we are punished. There are two classes of investors and citizens, with no big push for reform.

    But this new gilded class truly believes that they are not accountable for their actions, it was just bad market timing, yea that you stayed too long in your own Ponzi scheme.

    The hedge funds and other high leveraged pools of money distort markets, the COBT is no longer a useful tool for farmers and AgriBusiness to hedge their risk. Effectively they have turned the commodities markets into true casinos. This is not good for the overall health of the markets, but everyone wants to keep the big players happy since they represent volume and volatility with creates transaction fees for the markets, that is until the over leveraged pools of cash move on to the next market they can overwhelm.

    No invisable head here, just greed. I for one applaud his suggestions to regulate these districutive gamblers

  3. ruetheday

    While, in principle, there is a strong argument in favor of preventing (or popping) asset price bubbles, what does it mean in practice? It seems to mean that the central bank would have to somehow determine a “true” price for capital assets and use a targeted tightening of monetary policy to place a ceiling on those asset prices should they rise a certain amount above the “true” price.

    Two important questions then arise:

    1. How does the Fed determine the true price? There is no way other than to estimate the future stream of cash flows, estimate the appropriate discount rate, and then perform an NPV calculation. But isn’t that, in theory what the market is doing? Why would the Fed’s estimates of an uncertain future be more accurate than the markets’?

    2. How does the Fed “target” their monetary policy to specific asset markets? It is likely, almost certain actually, that one or more assets markets will be overvalued and others under or fairly valued at any point in time. Traditional monetary policy is far too much of a broad and blunt mechanism for handling such a situation. Would the Fed conduct OMO against specific asset classes to manipulate their specific prices? What systemic effects might that bring about?

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