Macro prudential regulation is bad in theory and even worse in practice.

In theory, financial regulators are suppose to scan the financial system, identify potential systemic risks and then defuse these risks before they metastasize into a financial crisis.  Hmmm…. did anyone consider this makes the financial system dependent on the financial regulators?  Why is this a problem?  Anytime there is a single point of failure in a system, the single point of failure will fail over time.  The result in this case will be another global financial crisis.

In practice, it is impossible for the financial regulators to do what needs to be done.  Much of the global financial system is opaque.   As a result, the financial regulators cannot possibly see where the risk is hiding.  Instead, they are like a drunk who looks for the lost car keys under the street light because that is where the light is.

So who are the big advocates of macro prudential regulation?  PhD Economists, particularly those working for financial regulators (think central bankers).  They trotted out the concept of macro prudential regulation as their excuse for why they didn’t prevent the acute phase of the financial crisis in 2008/2009.

Is there any indication Economists are aware macro prudential regulation doesn’t work?

Not really.  Here is an example of what passes for their thinking on the subject:

What is required from true macroprudential stress tests (MaPSTs)? They should recognise that systemic risk is driven by the interaction of the variety of financial institutions that make up the system and amplification factors to which such institutions are exposed. Thus, interactions and the severity amplification factors define the way shocks are amplified or dampened. …

Designing such MaPSTs, however, is not straightforward.

• First, they need to consider the interaction of all the various entities that make up the financial system, from regulated banks to other types of financial institutions, including in the domestic and global financial system.

• Second, they need to account for amplification factors to which institutions might be exposed to. These usually manifest as financial imbalances in the form of excessive leverage, liquidity and maturity mismatches and exposures to overvalued assets.

Once they finished describing what a true macro prudential stress test needs to do, it is easy to see just how absurd the idea is.  As the authors themselves point out, for these stress tests to be of any value they need to include every regulated and unregulated domestic and foreign financial entity.  Then, the stress tests need to consider every way these entities could trigger a financial crisis.  Talk about mission impossible.

Of course, this does highlight why the global financial system is based on transparency.  Transparency allows every financial entity to limit its exposure to every other financial entity to what it can afford to lose.  Transparency enlists market discipline to enforce these limitations on each financial entity.  This ends the risk of financial contagion.