-- John Kemp is a Reuters columnist. The views expressed are his
By John Kemp
LONDON Jan 26 UK Prime Minister Gordon Brown's
call today for a new G20 charter of principles on financial
regulation [ID:nLQ293854] reflects an emerging consensus among
policymakers that, once the immediate crisis has passed, the
regulatory framework must be fundamentally redesigned.
In particular, policymakers are concerned with how to
correct the basic moral hazard problem in which bankers have an
incentive to extend too much credit, while private firms and
households have an incentive to take on too much debt.
A consensus is emerging that the volume of credit expansion
needs to be restrained and managed as a separate policy
objective. This marks a sharp break with past practice -- in
which central banks attempted to control the cost of credit by
manipulating short-term interest rates, but have increasingly
left its quantity to decisions by individual banks and
There is also something of an emerging agreement that if
credit control is a separate economic objective alongside
"internal balance" (output-inflation) and "external balance"
(trade and capital flows) then a new instrument needs to be
developed to achieve this target.
With three targets (internal balance, external balance and
financial balance) Tinbergen's Rule says there need to be three
independent policy instruments -- fiscal policy, monetary
policy, and a distinct credit policy.
In his recent speech to the CBI Annual Dinner in the East
Midlands last week, Bank of England Governor Mervyn King alluded
to the need to develop a new policy instrument to achieve
credit-policy objectives. He stated a strong preference it
should not be interest rates. King argued rates should continue
to be used to target output and inflation.
The clear implication is the "new policy instrument"
referred to by King will have to be some form of direct
quantitative control, so as not to interfere with interest-rate
strategy, and allow the authorities to manipulate the volume of
credit for any given level of interest rates.
SECOND GENERATION CONTROLS
In 1945-1975, banking crises were few, but credit was
expensive and unavailable to many households and businesses. The
banking system was tightly controlled and the quantity of credit
was rationed through a variety of direct mechanisms (reserve
requirements, intensive bank examinations, margin requirements
and a host of other direct lending controls).
Most of these were dismantled during the 1980s and 1990s.
They could be resurrected but this would face stiff opposition
from within the industry. It would also face hostility from
within the economics establishment (broadly in favour of market
solutions) and among politicians (worried about the impact of
reduced access to credit for many households, and voters, in the
lower half of the income distribution).
Fed Vice-Chairman Don Kohn and Prof Lawrence Summers (now
head of the Obama administration's National Economic Council)
both poured scorn on what they saw as a rose-tinted view of the
heavy regulatory past at the Fed's annual Jackson Hole symposium
Both men are presumably chastened by the subsequent
meltdown. But their personal opposition to intensive
quantitative controls is probably still intact, and shared by
many policymakers at the top of the new administration, in
Congress, and among the wider regulatory community.
So the search is on for a compromise. The idea is to create
a new instrument or instruments that would work with the grain
of the market, rather than cut against it, and enable regulators
to exercise some control over the quantity of credit being
extended while preserving flexibility for banks to innovate.
If the old pre-1980 quantitative controls are seen as "first
generation" methods, the hunt is on for more sophisticated
market-friendly "second generation" methods that promote
stability while protecting growth.
The first design issue for these new quantitative controls
is whether to impose them directly or indirectly.
First-generation quantitative controls were formulated
within the central bank and consisted of a series of
prescriptive lending ratios.
The trend in recent years has been towards a more indirect
approach, in which the central bank and other regulators set out
general principles and a flexible framework; banks are then free
to manage their business and risk-taking within this. One key
question is how far second-generation controls will build on the
modern principles-based indirect approach, or revert to a more
prescriptive command-and-control one.
The second design issue is how to make quantitative controls
"active" rather than "passive". First-generation controls were
largely specified in passive terms: fixed capital and lending
ratios that were invariant over the cycle. But there is an
emerging consensus second-generation controls should be more
active and capable of varying over the cycle, limiting credit
growth during the expansion phase, but also mitigating the
collapse of credit during a contraction.
Contra-cyclical bank regulation policies are especially
popular at the moment, because the industry is in the
contraction phase, and contra-cyclicality implies a loosening of
policy. The real challenge is to create a contra-cyclical
approach that is sufficiently robust it can compel the banks to
increase their capital cushions during an upturn.
One option is to impose reserve requirements or
risk-weightings which rise above the long-term mean during
expansions and are allowed to fall below it during the
contraction phase. But that raises thorny questions of who
measures the cycle and how. Dating and measuring business and
credit cycles, and identifying turning points are notoriously
difficult in real time.
To take a recent example: the start of the most recent
expansion is controversial, with many commentators now arguing
the Fed missed the beginning of the upturn and failed to raise
interest rates in a timely manner. If the Fed, or another
regulator, had been responsible for adjusting reserve
requirements or risk-weightings, as well as interest rates,
would the adjustments have been any more successful?
If relying on regulators' discretion to identify turning
points in the credit cycle is problematic, is there a way to
make contra-cyclical controls endogenous to the lending system?
The aim would be to make reserve requirements,
risk-weightings or other instruments depend on the volume of
credit extended in the immediate past period(s). Credit controls
would be progressively tightened the longer and faster credit
expands, and progressively loosened the longer and further
The problem with endogenous credit control policies (like
endogenous interest rate policies) is that they do not work well
around cyclical turning points. In the summer of 2007, an
endogenous contra-cyclical policy would probably still be
tightening conditions in response to the explosive credit growth
in 2004-H12007 rather than loosening them to forestall the
calamitous collapse of credit that occurred later in the year.
In practice, credit is hard to define, measure and restrict.
Conventional bank lending is only one element of an
increasingly complex and diverse credit-creating system.
Finance companies, commodity brokers, special investment
vehicles, and even hedge funds, all of which are increasingly
active in wholesale money markets, may be engaging in
The question of what types of credit to control is analogous
to the debate during the 1980s about what measure of the money
supply to target. Moreover, Goodhart's Law suggests any
statistical or economic relationship between the chosen target
measure and the wider economy will tend to break down once
pressure is applied for control purposes.
In fact, as soon as the authorities decide on which forms of
credit are subject to regulation and control, there is an
immediate incentive to create other forms of credit in other
institutions that are not subject to control and therefore more
profitable. This was precisely the reason for the huge growth in
the "shadow banking system" during the 1990s and 2000s.
To have any chance of being effective, the new credit policy
will need to cover the whole range of institutions which create
credit, not just commercial banks, and need to be applied on a
fairly international basis, to prevent this sort of
institutional and jurisdictional arbitrage.