Central banks would be better able to combat crises if they could be granted a new macro-prudential power to create safe assets, Yale University’s Andrew Metrick tells Central Banking.
In episode five of the post-crisis podcast series, Metrick says central banks should be able to issue securities similar to safe government debt, and be able to swap these for assets created in the financial sector, which may suffer from a loss of confidence during a crisis.
“I think that is just a really important regular instrument, and it needs to be part of the arsenal of central banks,” says Metrick, the Janet Yellen professor of finance at Yale.
Nevertheless, he acknowledges there is little appetite for giving central banks such powers. The post-crisis mandates for financial stability and broader macro-prudential toolkits handed to central banks have left some politicians wondering if they wield too much power.
“We are still a long way away from the kind of intellectual consensus that would enable us to get the authority in all places to be able to do that,” Metrick says.
Metrick is concerned the post-crisis rulemaking has focused too strongly on passive forms of prevention, like higher capital requirements, and less on the sorts of active tools needed to fight a crisis. It is impossible to prevent all financial crises without some form of financial repression, he argues, so we need tools to deal with crises when they arrive.
“There’s a limit to what we can do with prevention with the tools at our disposal, and to some extent we have pulled back, both under the formal legal rules, but also given the political climate, on our ability to take active measures,” says Metrick.
Hi, I’m Dan Hinge, news editor at Central Banking, and this is CB On Air.
In the past four episodes, we’ve been through several aspects of the post-crisis world. This week we’ll be discussing macro-prudential tools, the instruments central banks can actively wield to tackle imbalances in the financial sector.
But how should the tools be used for maximum effect, and might there be side effects? We have professor Andrew Metrick of Yale University here to unpack the issues.
Thanks for joining us again, Andrew.
Andrew Metrick: Thank you for having me.
DH: In your view, what have been some of the most successful macro-prudential innovations?
AM: Well, I would say the thing that has me most encouraged is that there has been a global effort to set up a system whereby large financial institutions can fail without taking the rest of the system down with them.
This is not so much a peacetime tool, but a tool for what to do in a time of crisis. Now, we haven’t worked out exactly how these things will operate, and with luck we won’t have the opportunity to see how they operate for a while. But there has been some thought made, and in Europe it began with the BRRD [bank recovery and resolution directive]; in the United States with titles one and two of the Dodd-Frank Act; and throughout the rest of the world in participation in supervisory colleges that cross borders much more effectively than they did – about how we could handle the insolvency of a large financial institution.
In this case a lot of the problems we saw in the global financial crisis were exacerbated tremendously by the complex and messy way large institutions failed, from Lehman Brothers to the whole country of Iceland, their largest banks, to Dexia and Fortis, and to the near-failure of AIG.
This, to me, is the most hopeful sign. I have also been very pleased to see how carefully thought out and ambitious we’ve been in terms of the bail-in rules, and the TLAC [total loss-absorbing capacity] rules that will enable banks perhaps not to fail, but to move in a much more efficient way from being slightly troubled to being well capitalised.
So in those respects I think great progress has been made. In a lot of other places, it’s too early to tell. I would say that things central banks are now imagining doing, things such as imposing counter-cyclical buffers widely, on the entire system, or changing the rules, like loan-to-value rules, around certain triggers – these things I think might prove to be very useful, but it is still too early to know. We don’t have the kind of empirical evidence that we have from years and years of monetary policy to know whether or not they are effective.
DH: I think I can probably guess the answer to the next question, but would you say central banks have enough tools to prevent the next downturn?
AM: I would say the answer to that is no, in terms of preventing, and it’s no for two reasons. I think the tool that is most important that we don’t yet have, that will most help with prevention, is some kind of tool that allows central banks, as part of their normal operations, to issue themselves safe securities and to exchange them for securities that are substitutes, but not perfect substitutes.
So, for example, the ability to issue some kind of either Treasury securities, government securities from their balance sheet, or perhaps their own interest-bearing notes, and to exchange them for things that have been manufactured by the financial sector that might be securitised bonds or high-grade corporate debt. I think that is just a really important regular instrument, and it needs to be part of the arsenal of central banks. We are still a long way away from the kind of intellectual consensus that would enable us to get the authority in all places to be able to do that.
That’s the biggest tool that’s missing, in my view, for prevention. But second, I would say it is probably not the case that we want to have a system that gives us a zero percent chance of having a financial crisis. A system that gave us a zero percent chance of having a financial crisis would almost by definition be one of great financial repression. There remains a trade-off between having a financial system that has enough flexibility to fund growth, and having a certain amount of risk that that financial system could go haywire.
I think given however much risk we want to take, there are optimal ways to set up our system to manage that risk, and I don’t think we’re there yet. The main thing missing is what I mentioned before. I don’t think the optimal number is going to be zero, and actually I think we do ourselves a disservice when we refuse to focus on what our crisis-fighting tools would be during peace time, during quiet times, because we think the only thing we can tell the public is that there won’t be another financial crisis. I think that is not true, and someday there will be, and if we’re not willing to have an open discussion outside of crisis time about what our tools will be, then we will make it ever more difficult to fight the crisis in real time.
DH: That sounds like a sensible stance to me. Is there a conflict between macro-prudential and monetary policy tools and objectives? They seem to operate, to some extent at least, through the same channels – impacting credit and risk-taking.
AM: They certainly can be in some cases. You can have a case where you think the economy is overheating a little bit, and it is overheating from the credit side, and then monetary policy and macro-prudential tools would work in the same direction.
But you can also have a situation where the monetary authority might be quite concerned about a downturn, and quite actively trying to loosen, while on the financial stability side you have a really large concern about the debt burden, and you fear that a loosening will make that worse. Or you might have concerns about some pockets, some specific markets that are frothy even if the overall economy is not.
So we can see conflict, and I think nobody has quite sorted out what those trade-offs are. I think it is quite clear that you can’t deal with those trade-offs using only one instrument – using only, say, the blunt instrument of monetary policy, or interest rate targets is not going to be sufficient to deal with multiple objectives. But we haven’t quite figured out how to balance these things, and in part we lack a really good model, a really good macro model, that enables us to know how these different instruments will interact, and get us to move forward towards all of our objectives.
DH: Lastly, how should we balance tools that need to be used more proactively against the more passive system resilience, such as higher capital requirements?
AM: Well I would say that we need both, and we have to be very careful if we rely too much on one or the other, and I do fear the pendulum has swung a little too far towards the passive system resilience tools such as higher capital. For one reason, the levels of capital that would be necessary to really prevent a financial crisis completely would be so high that they would lead to some form of repression.
But second, I think the way that we’re able to impose these passive forms of prevention do tend to force some of these financial activities outside of the traditional regulatory umbrella, so there’s a limit to what we can do with prevention with the tools at our disposal, and to some extent we have pulled back both under the formal legal rules but also, given the political climate, on our ability to take active measures.
DH: Thanks very much.
AM: You’re welcome.