Bank of England Economists Find Macro-prudential Regulation Won’t Work
Since the Committee to Save the Banks under Ben Bernanke first proposed macro-prudential regulation, I have said it would never work.
Why?
There is no chance the current cast of financial regulators can deliver on the over-hyped promise they can prevent the next financial crisis.
There are a number of reasons for this.
First, financial crises emerge from the Blind Betting quadrant of the Information Matrix. As we saw in 2007/2008, when Wall Street’s valuation story for these opaque securities is called in to doubt, the value of these securities plummets as investors race to get their money back.
The opacity of the securities in this quadrant prevents anyone from assessing their risk. If no one in the market can see what the risk of these securities is, there is no reason to think the financial regulators can. If they cannot see the risk, there is no reason to think the financial regulators can take steps to prevent the next crisis triggered by this risk.
In the absence of the macro-prudential regulators championing transparency across the global financial system, the whole idea of macro-prudential regulation is absurd.
Please note, macro-prudential regulators could champion transparency. A simple step would be for them to support the Transparency Label Initiative.
Until such time as they do, it is safe to say the next financial crisis will emerge from the Blind Betting quadrant and the macro-prudential regulators will wonder what hit them.
Second, the Nyberg Report on the Irish Financial Crisis showed financial regulators won’t take away the punch bowl of good economic times as they fear reprisal from the elected politicians. The Bank of England economists highlighted this fact in explaining why macro-prudential regulation is over-hyped and unlikely to deliver on its promise.
Finally, fourth, how do societies ensure that macroprudential regulators have the power to take meaningful actions, but are also sufficiently accountable to sustain legitimacy in the long-run? Crises are infrequent, so the success of a macroprudential authority is hard to verify. Does the fact that there has not been a financial crisis during the past 5 years constitute strong evidence that the U.K. and U.S. regimes have been effective? Probably not. This “verifiability problem” is more pronounced than comparable problems faced by monetary policy makers (Broadbent (2018)). It means that extending the remit or granting additional powers to an independent macroprudential regulators comes with accountability challenges. The U.K.’s FPC addresses these by putting a lot of emphasis on communicating its actions to Parliament and the wider public. But while helpful, this does not fully address the fundamental problem.
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