The original Greenspan-Bernanke position that the regular monetary policy instrument, the official policy rate, should not be used to tackle asset booms/bubbles is sound. To the extent that asset booms have implications for the distribution of future outcomes for the macroeconomic stability objectives (price stability or price stability and economic growth), they will, of course, already have been allowed for under the existing approaches in the US, the Euro Area and the UK.
But the official policy rate should not be used to ‘lean against the wind’ of asset booms and bubbles beyond that, that is, in their own right. It would overburden the official policy rate and, since going after an asset boom/bubble with the official policy rate is like going after a rogue elephant with a pea shooter, Mundell’s principle of effective market classification suggests that the official policy rate not be targeted at asset booms/bubbles in their own right.
That, however, leaves a major asymmetry in the macroeconomic policy and financial stability framework. This asymmetry is not that interest rates respond more sharply to asset market price declines than to asset market price increases. Even if there were no ‘Greenspan-Bernanke put’, such asymmetry should be expected because asset price booms and busts are not symmetric. Asset price busts are sudden and involve sharp, very rapid asset price falls. Even the most extravagant asset price boom tends to be gradual in comparison. So an asymmetric response to an asymmetric phenomenon is justified. This does not mean that there has been no evidence of a ‘Greenspan-Bernanke’ put, of course. In fact I believe that phenomenon – excess sensitivity of the Federal Funds target rate to sudden declines in asset prices, and especially US stock prices – to be real, unfortunately.
Fundamentally, the key asymmetry is that the authorities are unable or unwilling, whether for good or bad reasons does not matter here, to let large leveraged financial institutions collapse. There is no matching inclination to expropriate or otherwise financially punish or restrain highly profitable financial institutions. This asymmetry has to be corrected. Therefore, any large leveraged financial institution, commercial bank, investment bank, hedge fund, private equity fund, SIV, Conduit or whatever it calls itself, whatever it does and whatever its legal form, will have to be regulated according to the same principles.
Operationally, the asymmetry is that there exists a panoply of liquidity-and credit-enhancing measures that can be activated during an asset market bust and during a credit crunch, to enhance the availability of credit and to lower its cost, but no corresponding liquidity- and credit-restraining instrumentarium during a boom. When financial markets are disorderly, illiquid or have seized up completely, the lender of last resort and market maker of last resort can spring into action.
We even have proposals now, that, because fair value accounting and reporting rules are procyclical when asset markets are impaired and artificially depressed – asset markets undervalue assets compared to what their fundamental value would with orderly markets – mark-to-market accounting rules be suspended during periods of market illiquidity. That would introduce a further asymmetry, because orderly and technically efficient asset markets can produce valuations that depart from the fundamental valuation because of the presence of a bubble. There have been no calls for mark-to-market accounting and reporting standards to be suspending during asset price booms and bubbles.
Leverage is the key
These asymmetries have to be corrected through regulatory measures, effectively by across-the board credit controls. Every asset and credit boom in history has been characterised by rising leverage. The one we are now suffering the consequences of is no exception. Leverage is a simple concept which may be very difficult to measure, as those struggling to quantify the concept of embedded leverage will know. In the words of the Counterparty Risk Management Group II (2005), “…leverage exists whenever an entity is exposed to changes in the value of an asset over time without having first disbursed cash equal to the value of that asset at the beginning of the period.” And: “…the impact of leverage can only be understood by relating the underlying risk in a portfolio to the economic and funding structure of the portfolio as a whole.”
Traditional sources of leverage include borrowing, initial margin (some money up front – used in futures contracts) and no initial margin (no money up front – when exposure is achieved through derivatives).
I propose using simple measures of leverage, say a measure of gross exposure to book equity, as a metric for constraining capital insolvency risk (liabilities exceeding assets) of all large, highly leveraged institutions. Common risk-adjusted Basel II-type capital adequacy requirements and reporting requirements would be imposed on all large institutions whose leverage, according to this simple metric, exceeds a given value. These capital adequacy requirements would be varied by the monetary authority in countercyclical fashion.
To address the second way financial entities can fail, what the CRMB calls liquidity insolvency, meaning they run out of cash and are unable to raise new funds, I propose that minimal funding liquidity and market liquidity requirements be imposed on, respectively, the liability side and the asset side of the balance sheets of all large leveraged financial institutions. These liquidity requirements would also be tightened and loosened by the monetary authority in countercyclical fashion.
Finally, I would propose that all large leveraged institutions that are deemed too large, too interconnected, or simply too well-connected to fail, be made subject to a Special Resolution Regime along the lines that exists today for deposit-taking institutions through the FDIC. A concept of regulatory insolvency, which could bite before either capital insolvency or liquidity insolvency kicks in, must be developed that allows an official administrator to take control of any large, leveraged financial institution and engage in Prompt Corrective Action. The intervention of the administrator would be expected to impose serious penalties on existing shareholders, incumbent board and management and possibly on the creditors as well. The intervention should aim to save the institution, not its owners, managers or creditors.