Sunday, June 12, 2011

Andrew Haldane: Mission of the Financial Policy Committee

The Guardian carried a column by Andrew Haldane, the Bank of England's Executive Director Financial Stability, on the mission of the Financial Policy Committee.

The mission can be summarized by that famous statement that the role of central banks is to take away the punch bowl just as the party is getting going.  In particular, it has responsibility for reducing the peaks and valleys of the lending cycle.
... [Financial] crises have a common cause – credit. Or, more accurately, the boom and bust in credit. In the run-up to the crisis, credit rose faster than incomes in many advanced economies. Banks' balance sheets became bloated with debt. Credit growth became a juggernaut which, having picked up pace, then ran out of control. When the juggernaut crashed, credit feast turned to famine, starving the real economy of growth. 
That has been the story of this time's crisis. But it is an old story. For credit booms have sown the seeds of almost all historical financial crises. As pride comes before a fall, excess credit comes before a crisis. 
This boom-bust cycle in credit is as regular as the cycle in output – and is, if anything, more virulent. The typical peak-to-trough cycle in real incomes is 5-10%; for credit, it is double that, and for asset prices double that again. It has been that way, in the UK and internationally, for well over a century. 
So is history condemned to keep on repeating itself, not as farce but as tragedy, and, if not, who is to break the cycle? In the past, the answer was nobody. Keeping credit in check and the financial system sound was in no one's job description. The credit juggernaut had no driver. Little wonder, then, that it had all too often been on a collision course. 
That is all about to change. The government recently put in place a financial policy committee (FPC), housed in the Bank of England. It meets for the first time on 16 June. It can be thought of as the twin of the Bank's monetary policy committee, which sets interest rates. 
The FPC will aim to keep the financial system strong and stable, as its contribution to keeping the economy strong and stable. Success will mean that savers feel confident about their deposits and credit keeps flowing through the arteries of the economy in bad times as well as good. In time, this will form part of an international regime. 
The FPC will need some tools – so-called macro-prudential regulation. That means applying the brakes when credit is running out of control to reduce the risk of a financial pile-up. For example, it might increase the amount of capital or liquidity banks are required to hold. On these matters, the FPC will advise the government on tools, which it will ultimately decide. The aim would be to take the heat out of credit markets. 
But, as importantly, it may also mean the FPC releasing the brakes when credit is stalled at the roadside. That might call for a loosening of the regulatory reins to inject some life into credit markets. If the FPC does its job, future credit feasts may be less raucous, but financial famines will stunt growth less often. 
The stakes could scarcely be higher. In the UK, and a number of other developed countries, we cannot afford another credit crunch. Quite literally cannot afford, for the credit crunch has stretched sovereign sinews to the limit. The scars from this time's crisis will be borne by our children, perhaps grandchildren. That should serve as a reminder of the need to break the risk-taking loop. 
With the FPC at the wheel, we hope to make the financial road safer.
I wish the FPC the best of luck.  As Mr. Haldane observes, we cannot afford another crisis.

With that much at stake, how is the FPC pursuing its mission?

Is it relying on the UK's financial regulators?  This would seem unlikely given that Mr. Haldane has previously observed in a Wall Street Journal article that
The FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information ... rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data."
If not the regulators, then who?

In the same article, Mr. Haldane suggests that the Bank of England and by extension the FPC will pursue its mission by placing
a greater emphasis on understanding macroeconomic issues and on requiring the banks to disclose more information to the markets.
This blog has repeatedly made this point that it is not macro-prudential regulation that would give us the best chance of avoiding the next financial crisis.  Rather, it is requiring disclosure in every opaque corner of the financial system.  Without all the useful, relevant information in an appropriate, timely manner, market participants cannot analyze risk and adjust the price and amount of their exposure to this risk.

Simply put, there is no reason to believe that the members of the FPC would be better at knowing when to pull back on credit than the market.  The market also has a better mechanism for pulling back on credit.  It is called market discipline and takes the form of increasing price and decreasing access to funds as risk increases.

My confidence in the FPC's performance of its mission would be greatly enhanced if it in fact championed disclosure starting with eliminating the financial regulator's information monopoly on all the current asset and liability-level data for financial institutions.

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