Bank Supervision To Insure Financial Stability Through Business Cycles

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by: Martin Lowy

Summary

Macro-prudential bank supervision is the goal of many central banks.

But supervisors still see their job in micro-prudential terms.

Their micro-prudential approach can do the macro-prudential job better than fancy modeling can do it.

The other day, I heard an excellent talk by a senior supervisor at one of the Federal Reserve Banks. "We are still micro people," the supervisor said, "trying to do macro-prudential supervision in a micro-prudential world."

Please, please, please, my friend, stay micro in order to do macro. I will explain.

But you are not alone in beating yourself up about your inability to do macro for macro's sake. Here is a quote from Neil Irwin of the New York Times, a very good economic commentator: "The impossible job for the regulators (and journalists, and credit rating agencies) of the future is to better understand how the pieces within the infinitely complex economy and financial system connect with one another." Although I admire both the supervisor and Irwin, I think they misunderstand the regulators' job. The idea of macro-prudential supervision has been foisted on the supervisors, but as designed, it is impossible to do-and it is quite unnecessary.

Macro-prudential supervision of that sort is not their job, and regulators should not let themselves be euchred into agreeing that is their job. Let them take the advice of Claudio Borio, Head of the Monetary and Economic Department of the Bank for International Settlements, to the effect that macro-prudential supervision of the sort that seeks to model the financial world and to influence it based on that model is impossible to do well.

Regulators' macro job vis-a-vis the banking system is far simpler than that: it is to assure that banks in general have enough capital to survive even quite severe negative economic events. The regulators need not know when those events are going to occur; they need not forecast what they are going to be. They merely have to make sure the banking industry as a whole is ready at all times.

That was not generally understood until quite recently, although some of us have been advocating that mission for quite a long time. And even recently, regulators and commentators have not embraced the full implications of that simple statement.

The two new things that have made the mission possible are higher capital requirements and rigorous stress tests. As long as the stress tests include severe situations and the capital standards are high enough, the banking system will be prepared to meet the challenges. It matters little if in any given year, the stress tests miss a risk factor, such as a sharp decline in the price of energy (see here for discussion of the Fed's assumptions on oil prices as part of stress testing). If over numbers of years, the tests pose severe standards, they can be successful.

There are two sets of forces battling to prevent the regulators from doing the job of making sure the banks have adequate capital. One is the way that central banks seek to regulate the economy-that is, through encouraging or discouraging bank lending. Stress tests do discourage riskier types of lending. That is what they are supposed to do. The Fed and foreign central banks have to grapple successfully with that conflict of interests and come down on the side of letting stress tests do their natural job.

The second force is the banks themselves. They resist high capital requirements on the ground that they are unnecessary and prevent beneficial business from being transacted. Many bankers believe they can manage credit risk and other banking risks quite well enough without regulatory interference. Maybe even a few of them are correct in believing that. But history tells us that, on the whole, such belief is unwarranted.

So my plea to my supervisor friend is to do the possible job of capital policing. In fact, that micro focus will do more for the macro picture and will protect the world from financial crises better than anything else supervisors could do. Please do not be ashamed to be a micro-prudential supervision person.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.