Macro-Prudential regulation is the regulatory embodiment of PhD Economist Derp.

The ECB offers a quick guide into what it is and what it is suppose to achieve:

Macroprudential authorities monitor the financial system and identify risks and vulnerabilities. Policies addressing such risks and vulnerabilities can be put in place and limit them from building up further and spreading across the financial system.

In other words, the policies can be put in place to prevent risks from affecting the financial system more broadly, or becoming systemic….

So, in essence macroprudential policies are there to promote financial stability. If we have a stable and sound financial system we are better placed to withstand shocks and avoid the worst effects of financial crises.

This sounds so good in theory.  What could possibly be wrong with it in practice?

In theory, the authorities are going to monitor the entire financial system and identify risks and vulnerabilities.  In practice, how can the authorities see the buildup of risk hidden in the opaque parts of the global financial system?  They cannot.  Based on how they have pursued monitoring the financial system to date, the authorities are just like the drunk who has lost his car keys and is looking for them under the street light because that is where the light is.

Regular readers know financial instability originates in the Blind Betting quadrant of the Information Matrix.

Information Matrix

Investments in this quadrant are valued based on a story told by Wall Street.

While investors are suppose to Trust, but Verify Wall Street’s valuation story, the opacity of these investments prevents any investor performing their own risk/return assessment.  As a result, if the valuation story of these assets is ever called into doubt, there is no logical stopping point in the downward valuation of these assets other than zero. Investors in opaque investments know this and they know to engage in “bank runs” to try to get their money back as soon as the valuation story is called into doubt.

Much to the macro-prudential regulators’ dismay, these “bank runs” appear as financial instability.  Why?  Because unsecured bank debt and bank equity are among the opaque investments investors engage in bank runs on.

In case any PhD Economist and/or macro-prudential regulator doubts me, let us look at what happen in late 2008 as the Great Financial Crisis entered its acute phase. The unknown exposure of banks to subprime securities created doubt about the bank valuation story.  Wholesale investors responded by engaging in a “bank” run.  The interbank lending market froze as the banks with deposits to lend could not determine if the banks looking to borrow could repay their loans.  So rather than rollover existing loans, they collected the proceeds at maturity.  Institutional investors did the same thing as they stopped reinvesting their money in unsecured bank debt.

The real world implementation problem with macro-prudential regulation should have been obvious to any PhD Economist.  It should have tempered their enthusiastic support for macro-prudential regulation. Instead, these PhD Economists are out there saying macro-prudential regulation can do something (promote financial stability) it cannot possibly currently do given all the opaque segments of the global financial system.

And that is the very definition of DERP.