ECB Discovers Macro-Prudential Regulation Doesn’t Work

16 Jan 2018

One of the worst ideas to emerge from the Great Financial Crisis was macro-prudential regulation. Under macro-prudential regulation, regulators are suppose to decide where risk is building in the financial system and then take steps to reduce this risk.

Sounds great in theory, but clearly is destined to be worthless in practice. A fact the ECB’s staff inadvertently stumbled upon when it looked at the best ways to deflate a credit bubble.

Let’s begin at the beginning.

This paper introduces the new Macroprudential Policies Evaluation Database (MaPPED), which aims at closing this gap. MaPPED offers a comprehensive data source of regulatory policy instruments and actions of a macroprudential nature targeting the banking sectors in the EU member states from 1995 to 2014. The data set covers eleven categories and 53 subcategories of regulatory instruments, and almost 1,700 policy actions, i.e. events of introduction, recalibration or cancelation of these instruments. The set of policy instruments includes capital requirements, capital buffers, risk weights, leverage ratios, provisioning systems, lending standards restrictions, limits on credit growth, taxes on financial activities, limits on large exposures, liquidity requirements, and limits on currency and maturity mismatch.

And what did it find?

The newly collected data set makes an important contribution to the discussion on the effectiveness of different macroprudential instruments in addressing systemic risk. In particular, the descriptive analyses presented in this paper reveal that there has been significant variation in the use of instruments of a macroprudential nature both across EU countries and over time. Moreover, the analyses suggest that a share of instruments available in the present macroprudential toolbox, such as capital buffers, regulatory lending standards or liquidity caps, may have had an impact on credit to non-financial private sector in the EU. [emphasis added]

If found macro-prudential regulation may have had or it may not have had any impact on credit being extended to the non-financial private sector.

This finding isn’t in the least bit surprising.

First, banks are in the business of making loans. Limiting the ability of banks to hold the loans on their balance sheet doesn’t stop banks from making loans. Banks simply sell them on to either other banks or third parties like insurers, pension funds, ….

Second, it says even if the regulators stumble upon an area of rapidly rising risk, they are unlikely to be able to do anything about it. They are the equivalent of a carpenter where every problem is solved with a hammer.

Finally, as you read through the lists of possible regulatory responses, you realize why the financial system is based on transparency. It is a whole lot easier to slow credit growth when investors know they will be responsible for losses. This gives the investors, which includes banks, an incentive to restrain their risk taking to what they can afford to lose.