29 February 2012

VoxEU: Preventive macro-prudential policy

The column, written by Charles A E Goodhart and Enrico Perotti, argues for assigning responsibility and novel tools to micro-prudential regulators for supervising individual liquidity and capital ratios, and to central banks those tools for aggregate liquidity-risk management, with overall control switching to fiscal authorities once intervention appears to require fiscal means.

Micro-prudential standards target risk choices and resilience at the level of individual intermediaries. In contrast, macro-prudential policy needs to target propagation risk, aiming to prevent at least as much as to contain crises. As Andrew Crockett (2000) had said early on: “The received wisdom is that risk increases in recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materialising in recessions.”

To shift emphasis towards preventive policy, rather than ex post intervention, preventive tools need to be provided to prudential regulators. This would ensure a clear mandate to act in a timely fashion to avoid excessive forbearance and risk-shifting across countries. Nowhere is the need more urgent than for liquidity risk, the critical transmission mechanism for both the 2007–08 and 2011 bank crises.

The EU ratification of Basel III offers a unique opportunity. Coordinated rate-setting ensures a common convergence process, in place of each country setting its own incompatible transition rules. Rate flexibility at the national level in the transition would also reinforce the cohesion of the eurozone, reducing the rigidity imposed by a single currency. It would enable the authorities to contain credit risk creation in individual countries. At present, bank solvency is a national responsibility, but a common currency within the eurozone causes unstable bank funding to spill over to other countries. A specific financial stability tool, distinct from interest rates, also avoids having the common monetary policy carrying a dual responsibility, which puts ambiguous pressures on the ECB.

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