A Better Way to Regulate Financial Markets

by Dollars and Sense

From sometime D&S author Thomas Palley, in the Financial Times's Economists' Forum series:

A better way to regulate financial markets: Asset based reserve requirements

By Thomas Palley | November 10, 2009

There is widespread recognition that the financial crisis which triggered the Great Recession was significantly due to financial excess, particularly in real estate lending. Now, policymakers are looking to reform the financial system in hope of avoiding future crises. But like the drunk who looks for his lost keys under the lamppost because that is where the light is, policymakers remain fixated on capital standards because that is what is already in place.

There is a better way to regulate financial markets through asset based reserve requirements which would extend margin requirements to a wide array of assets held by financial institutions. ABRRs are easy to implement, use the tried and tested approach of reserve requirements, are compatible with existing regulation (including capital standards), and would fill a hole regarding adequacy of financial policy instruments.

The toleration of periodic bouts of financial excess over the past two decades reflects profound intellectual failure among central bankers and economists who believed inflation targeting was a complete and sufficient policy framework. It also reflects lack of policy instruments for directly targeting financial market excess. With central banks relying on the single instrument of short-term interest rates, this supported the argument using interest rates to target asset prices would inflict large collateral damage on the rest of the economy. ABRRs offer a simple solution to this problem by providing a new set of policy instruments that can target financial market excess, leaving interest rate policy free to manage the overall macroeconomic situation.

ABRRs require financial firms to hold reserves against different classes of assets, with the regulatory authority setting adjustable reserve requirements on the basis of its concerns with each asset class. One concern may be an asset class is too risky; another may be an asset class is expanding too fast and producing inflated asset prices.

By obliging financial firms to hold reserves, the system requires they retain some of their funds as non-interest-bearing deposits with the central bank. The implicit cost of forgone interest must be charged against investing in a particular asset category, reducing its return. Financial firms will therefore reduce holdings of assets with higher reserve requirements, and shift funds into other relatively more profitable asset categories.

The effectiveness of this approach requires system-wide application. If applied only to banks, ABRR would simply encourage lending to shift outside the banking sector. To succeed, reserve requirements must be set by asset type, not by who holds the asset.

A system of ABRRs that covers all financial firms can increase the efficacy of monetary policy. Most importantly, it enables central banks to target sector imbalances without recourse to the blunderbuss of interest rate increases. For example, if a monetary authority was concerned about a house price bubble generating excessive risk exposure, it could impose reserve requirements on new mortgages. This would force mortgage lenders to hold some cash to support their new loans, raising the cost of such loans and cooling the market.

A similar logic holds for stock market bubbles. If a monetary authority wanted to prevent stock market inflation from generating excessive consumption, it could impose reserve requirements on equity holdings. This would force financial firms to hold some cash to back their equity holdings, lowering the return on equities and discouraging such investments.

ABRRs also act as automatic stabilisers. When asset values rise or when the financial sector creates new assets, ABRRs generate an automatic monetary restraint by requiring the financial sector come up with additional reserves. Conversely, when asset values fall or financial assets are extinguished, ABRRs generate an automatic monetary easing by releasing reserves previously held against assets. In all of this, ABRRs remain consistent with the existing system of monetary control as exercised through central bank provision of liquidity at a given interest rate.

At the microeconomic level, ABRRs can be used to allocate funds to public purposes such as inner city revitalisation or environmental protection. By setting low (or no) reserve requirements on such investments, monetary authorities could channel funds into priority areas, much as government subsidized credit and guarantee programs and government-sponsored secondary markets have expanded education and home ownership opportunities and promoted regional development. Conversely, ABRRs can be used to discourage asset allocations that are deemed socially counterproductive.

Finally, ABRRs have other significant policy benefits that are especially valuable now. First, ABRRs increase the demand for reserves which will prove helpful as central banks seek to exit the current period of quantitative easing to avoid future inflation. By gradually raising asset reserve ratios, central banks can implement a form of reverse quantitative easing that smoothly transitions the system to a new more stable regime.

Second, by increasing the demand for reserves ABRRs will increase seigniorage revenue for governments at a time of fiscal squeeze. To the extent required reserves constitute a tax on financial institutions, that tax is economically efficient given the costs of financial crises. It will also shrink a system that many believe is bloated.

Thomas Palley is Schwartz economic growth fellow at the New America Foundation

Labels: ABRRs, asset-based reserve requirements, financial crisis, financial regulation, Thomas Palley

 

Please consider donating to Dollars & Sense and/or subscribing to the magazine (both print and e-subscriptions now available!).
11/17/2009 03:18:00 PM