Money and banking – realigned efficiently

Hans Gersbach 12 October 2011

a

A

Like price stability, a sturdy banking system is an economy-wide objective. In macroeconomic policymaking, realigning money and banking requires a novel architecture and a new macro instrument to safeguard financial stability. There are two major issues that urgently need to be addressed. First, what kind of instrument could be devised and put into use? Second, how should macroprudential policies be coordinated with monetary policy and bank-specific regulation?

The framework

Put briefly, my new CEPR Policy Insight (Gersbach 2011) suggests the following policy framework for monetary, macroprudential, and microprudential policies:1

1.   Instruments

  • Macro level: Minimal aggregate bank-equity–capital ratio (henceforth ACR) and short-term interest rate.
  • Micro level: Bank-specific capital requirements are set such that the ACR is met and individual banks are supervised.

2.   Organisation

  • The central bank conducts monetary policy via short-term interest rates.2
  • A macroprudential policymaker sets the ACR.
  • The bank regulator determines bank-specific capital requirements and supervises banks.

3.   Objectives

  • The central bank minimises a loss function consisting of inflation and output deviations.3
  • ­The macroprudential policymaker minimises output fluctuations caused by lending cycles or banking crises.
  • ­The microprudential regulator focuses on the soundness of individual banks.

In this framework, the ACR is defined as the ratio of total equity in the banking sector (held by non-banks) to total end-borrower lending plus other non-bank assets. At a particular point in time, the ratio is a single number. The microprudential regulator takes it as given. As detailed in the Policy Insight, there are at least three different ways of determining bank-specific capital requirements:

  • Non-risk-sensitive bank-specific capital requirements,
  • Simple risk-adjusted bank-specific capital requirements,
  • ACR-consistent risk-sensitive capital requirements (à la Basel III).

In the form proposed here, the framework requires three institutions. If the framework is implemented with two institutions, aggregate bank-equity policy has to be delegated either to the central bank or to the bank-specific regulator. In the Policy Insight I argue that, in such cases, a judicious consideration of the pros and cons tips the balance toward the central banks, putting them in charge of conducting both monetary and macroprudential policies.

Rationale

As I explain more fully in the Policy Insight, there are various lines of argument supplying a rationale for this policy framework.

  • First, current macroeconomic policymaking suffers from an inadequate range of instruments. Even if we leave other objectives out of account, the short-term interest rate is not an effective instrument for the pursuit of financial stability objectives. The ACR is a macro instrument, ie its variations affect the entire economy. It operates largely through other transmission channels than the short-term interest rate.
  • Second, the appropriate choice of the time path of ACR reduces systemic risks, fosters the resilience of the financial system, and can moderate lending cycles in comparison to the current state of the banking system. These benefits have to be traded off against the potential aggregate output and welfare losses that would tend to become more pronounced if the ACR were much higher than it is today.
  • Third, monetary policy and aggregate bank-capital policy can jointly stabilise shocks in the economy and can anchor expectations regarding inflation and the robustness of the financial system. The ACR can be used to moderate rapid credit growth and asset-price increases. The optimal mix between the use of the short-term interest rate and ACR depends on the current and expected rate of inflation and on the combination of supply, demand, and vulnerability shocks in the economy.
  • Fourth, the policy framework assigns clear responsibilities to macroeconomic policymaking and defines how the pursuit of financial stability should be divided between the macro- and micro-sphere. The use of ACR can also temper or altogether avoid the procyclicality of traditional capital requirements.
  • Fifth, although the pre-crisis view of monetary policy with the sole focus on numerical inflation objectives and the use of short-term interest rates requires serious revision, various lessons from past decades continue to be important for both monetary and aggregate bank-equity policymaking. For instance, flexible rules and solutions in connection with commitment problems are insights gained in monetary policymaking that will play a major role in macroprudential policymaking.

Both history and close inspection suggest that while ACR is a suitable instrument for lowering the risk of banking crises, it is by no means a panacea.4 Moreover, macroprudential policymakers face challenges similar to those encountered by monetary policymakers, and it will take time to arrive at a mature state of knowledge regarding aggregate bank-equity policies. In particular, it will require experience to identify the macro policy function that determines current aggregate bank-capital policies and to assess how short-term interest-rate setting interacts with aggregate bank-equity policies. Money and banking have constantly evolved since the 1950s, and they will continue to do so. Accordingly, it will be impossible to specify a fixed formula for the aggregate bank-capital function. Nevertheless, it will be essential for such functions to be as systematic, transparent, and accountable as traditional monetary-policy functions.

Conclusion

Financial systems, economies, or even states are more fragile than some of our thinking in the past decades has suggested. Macroeconomic policymaking has to react to these challenges. Even if we leave the excessive indebtedness of states aside, safeguarding price stability, the resilience of the banking system, and the stability of the real economy is a daunting task. It is thus of the utmost importance to arrive at a consistent perspective on how monetary policy, macroprudential policies, and microprudential regulation should be conducted in our economies. I hope that the present proposal is a step in the right direction.

References

Gersbach, H. (2011): “A Framework for Two Macro Policy Instruments: Money and Banking Combined”, CEPR Policy Insight 58. 


1 By adding fiscal policy, we would obtain a comprehensive macroeconomic policy framework. 

2 In exceptional circumstances, e.g. when short-term interest rates are constrained by the zero lower bound, unconventional monetary policy could be added to the tool box.

3 Typically, inflation has a much higher impact than output in the loss function.

4 For instance, even if the ACR were used in the best possible way, it might still not prevent excessive accumulation of liquidity risk. Containment of that factor would require additional policy tools.

a

A

Topics:  International finance Macroeconomic policy Microeconomic regulation Monetary policy

Tags:  monetary policy, banking, macroprudential

Professor at CER-ETH - Center of Economic Research at ETH Zurich and CEPR Research Fellow