Entering a brave new "macroprudential" world

This piece accompanies a Special Report on changes in central banking. For the full report: http://link.reuters.com/new68r

By Huw Jones

LONDON (Reuters) – The world’s first recorded bank panic dates back to Rome in AD 33, yet the intervening centuries don’t seem to have given top central bankers much to go on when it comes to detecting how local risks and asset bubbles become systemic, threatening the world economy.

Everyone agrees the authorities need a macroprudential or “bird’s eye view” of the risks, but no one knows how to get it, partly because even the experts can’t agree on what systemic risks are. “Systemic risk is an elusive concept,” said the Bank for International Settlements this month. “It can have significant economic consequences and is quantitatively important, yet there is no clear consensus on how it should be measured.” Some central bankers admit privately it may be impossible to detect all bubbles.

That’s hardly encouraging, since addressing the problem is a core element in the changes western central banks have been called on to make. But this hasn’t stopped bankers from trying: fast-evolving new approaches are being foisted on an unwitting public, even as central bankers themselves aren’t entirely sure how things will work.

So far, all have created bodies with reassuring names: the United States has a Financial Stability Oversight Council, the EU has a European Systemic Risk Board, and Britain’s Financial Policy Committee is already up and running — albeit in interim form after it was set up this year. It has taken months to get this far, a sign of how much it is still a work in progress.

The committee, which must wait until 2012 for the legislation needed to firm up its legal foundations, has an agreed objective. Its broad remit is to ensure the financial system stays resilient in the face of booms and busts, and any actions it takes must not frustrate economic growth over the medium to long term.

Also decided is that the committee is based at the Bank of England and chaired by the Bank’s governor, Mervyn King, turning him into one of the world’s most powerful central bankers in terms of responsibilities. It will meet at least four times a year with publication of its deliberations and decisions. Members include King’s senior colleagues and four outsiders. It will intervene in two ways: call for actual rule changes or issue recommendations, which markets will interpret as warnings. Or it will aim to “take away the punchbowl” in regulatory parlance, to ensure credit is curbed before the financial party gets out of hand.

The committee is expected to spend much of its time issuing policy recommendations to other bodies, such as the planned new Financial Conduct Authority (which will partly replace the Financial Services Authority next year) or the new Prudential Regulation Authority, which adds another new responsibility for the Bank of England in the supervision of major banks and insurers. It could, for example, call for banks to reduce their short-term liabilities, with a deadline.

That all sounds simple enough, but some of the new committee’s tactics are far from agreed. It will be given its own set of tools or “directive powers,” but what these will be is still up for debate.

Some, like FSA Chairman Adair Turner, say the new committee could be allowed to cap the proportion of a property’s value that banks can lend, to cool overheated property markets. Many central banks in Asia limit the proportion of deposits that banks can extend as loans.

Others argue the committee’s role cannot include managing the credit cycle — for an unelected body to tell households how much they can borrow would be a politically fraught endeavor, these central bankers say. The aim is not to stop over-borrowing, they argue, but to stop it from undermining the financial system. A better approach would be to slap extra capital charges on those banks that are willing to lend a higher share.

There’s plenty of time to tackle the details. Between now and the end of 2012, the committee and the government will refine its remit and tools. “That remit is likely to be more a matter of words than a single number like the inflation target, but it is the right approach to seek to set this out as explicitly as possible,” says Bank of England Chief Cashier Andrew Bailey.

Even if those details are agreed, they may mask a political minefield. For instance, the committee wants the government to say where the trade-off would lie between preserving the stability of the financial system and threatening broader economic growth by, say, curbing consumer demand.

The committee’s European counterpart is in a similar situation: its chairman Jean-Claude Trichet said this month macroprudential regulation is a new discipline with no template, and the tools needed may take until the middle of this decade to hone.

And, of course, the British committee’s effectiveness will depend entirely on good links and perhaps even coordinated steps with its counterparts in the United States and EU. This may not be easy in practice, because even regulators are human.

(Editing by Sara Ledwith)

Entering a brave new "macroprudential" world