Under the FDR Framework, not a lot is expected of macro-prudential regulatory authorities.
Governments are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants are responsible for all gains and losses on their exposures and therefore have an incentive to use this information in assessing the risk of their exposures.
With the responsibility for all losses, market participants have an incentive to not have a larger exposure in any area than they can afford to lose. As a result, the peak of the credit cycle should be lower.
With the responsibility for all gains, market participants have an incentive to increase their exposure when risk is low relative to returns. As a result, the trough of the credit cycle should be higher.
Potentially, macro-prudential regulatory authorities could step in if they think that market participants are mis-pricing risk (at the peak and trough of the credit cycle).
The financial regulator cautioned on Thursday not to expect too much from a new breed of watchdog that seeks to spot and tackle system-wide risks before they destabilise markets....
"We should be very cautious of expecting too much of macro-prudential policy: if it manages to dampen excesses of the upswing of the credit cycle, that in itself will be a major achievement, making future downswings less harmful," Financial Services Authority Chairman Adair Turner said....
Turner said in a speech at Southampton University it was a more difficult question whether macro-prudential policy could actually help revive the economy.
"A crucial issue at this point in the cycle is, therefore, whether macro-prudential policy has a role to play in stimulating rather than constraining credit supply and demand, whether it can be used to 'push' as well as to 'pull'," Turner said.
Turner said the FPC would have to become far more involved in judging the "socially optimal" level of credit at the more micro sectoral level, as he was "not very confident" that market mechanisms can get it right.
Regulators also need to take further action to curb risks from newer areas in the financial system such as structured securitised credit and trading, Turner said.