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2013-06-07 08:49:01
History shows the limits of macroprudential policy in curbing dangerous
risk-taking
Jun 1st 2013 |From the print edition
AMERICA S Federal Reserve faces a dilemma: to put the economy back on its feet
it is keeping interest rates at zero and buying bonds; but in doing so, it
worries, it is egging on dangerous risk-taking. Cue macroprudential policy.
In theory, central banks would use regulatory and supervisory authority to
stamp out excesses in specific markets while leaving monetary policy to take
care of inflation and employment.
History suggests this is easier said than done. Macroprudential may be new
jargon, but America has tried variants of it for decades, from credit controls
to down-payment limits. And the record is not a ringing endorsement for
macroprudential policy, according to a new working paper by Douglas Elliott of
the Brookings Institution, Greg Feldberg of America s Treasury Department and
Andreas Lehnert of the Fed. They found controls were often circumvented by
regulatory arbitrage. And when controls worked, political pressure sometimes
led to their repeal.
As the authors note, evaluating the record of macroprudential policy is
complicated by sketchy data, numerous regulators and markets, and the blurred
line between permanent and cyclical regulatory changes. Broadly, the
macroprudential controls aimed either to regulate the supply of credit or the
demand for it.
Supervisory pressure, reserve requirements and interest-rate ceilings have all
been used to control the supply of credit, but success at suppressing bank
lending often merely led other lenders to fill the void. In 1929 the Fed,
alarmed at the speculative surge on Wall Street, instructed banks to curtail
lending to stockbrokers. Bank loans duly declined, but total loans still rose
as corporations, attracted by the high interest rates on offer, stepped in.
From 1935 the Fed had the power to use reserve requirements the portion of
deposits banks must keep on hand as cash to manage the business cycle. The
authors find that from 1948 to 1980 higher reserve requirements modestly
reduced the growth of bank credit. But the impact on overall credit growth was
muted as non-banks made loans that banks no longer could. In the 1960s and
1970s large banks found sources of funding that escaped the requirements,
forcing the Fed to rejig the rules.
Interest-rate ceilings had similar problems. As market interest rates began to
rise in the 1950s, banks lost deposits to other institutions not covered by the
ceilings. This helped restrain lending and inflation, but over the years it
mostly affected small banks; large banks diversified their funding sources. The
advent in the 1970s of money-market funds, combined with dramatically higher
interest rates, led to massive outflows of deposits and, eventually,
legislation abolishing the ceilings.
Regulators had more success controlling demand for credit. In 1941 Franklin
Roosevelt invoked the Trading With the Enemy Act of 1917 to authorise the Fed
to restrict consumer-instalment loans. The idea was to suppress consumption and
free resources for the war effort. The Fed, which administered controls through
its Soviet-sounding Division of Selective Credit Regulation , used them to
suppress inflation while interest rates were subordinated to the Treasury s
funding needs. The authors found that tightening the controls generally caused
credit growth to slow.
In 1950 the Fed s authority was extended to home loans. In October that year it
set out a specific target: reduce home construction by one-third over the
coming year. To do so it set limits on loan-to-value ratios and maturities that
became more restrictive with the size of the loan. At the same time the Federal
Housing Administration and Veterans Administration, which guaranteed
residential mortgages, raised down-payment requirements and reduced loan
limits. Home construction consequently fell, albeit by a quarter, not a third.
Succeeding too well
Though they worked, credit controls were deeply unpopular. At one congressional
hearing bankers called them a long step in the direction of government
planning . In 1952 Congress stripped the Fed of its authority to use the
controls.
In 1969 Congress restored that authority with the Credit Control Act, hoping
that the Fed could target inflation-prone sectors while sparing the broader
economy the pain of higher interest rates. Republicans attacked the bill for
establishing a complete credit police state. One Fed official promised never
to use the authority short of a national war. The act was not invoked until
1980, as part of President Jimmy Carter s battle against inflation. The Fed
imposed higher reserve requirements on banks advancing credit cards and
personal loans, and (for the first time) on money-market funds.
The controls succeeded spectacularly: credit plummeted, even in exempted
categories such as car and home loans. America tumbled into a short, sharp
recession, prompting the controls to be lifted. The experience soured the Fed
and Congress on credit controls; the law was repealed shortly afterwards.
Indeed, by the mid-1980s, most direct restraints on credit had been repealed
and the Fed came to rely on interest rates alone to regulate demand and
borrowing. Supervisors continued to issue warnings: they did so about subprime
lending in 1999, home-equity lending and commercial property in 2005, and
exotic mortgages in 2006. None had much impact on overall credit growth. This
was partly because so many lenders were not regulated as banks. But it was
also, the authors note, the first major credit expansion in Fed history when
supervisory guidance was not backed up by direct actions such as tighter
monetary policy, interest-rate ceilings or credit controls.
Although such controls are popular elsewhere, there is little talk of bringing
them back. To work, they would require multiple regulators co-ordinating across
multiple markets, in the face of fierce political opposition. Instead,
regulators simply hope to make the financial system more resilient should a
bubble one day burst.