How Will We Regulate Risk?

Remember the word: "Macroprudential"

It's not the nebulous name of the latest bank to go bust. Macroprudential describes one of the suggested paths for getting us out the mess the banks caused. Broadly, it's a system-wide, holistic approach to monitoring the financial sector, and a plan that would undoubtedly mean aggressive new international regulation of the entire global finance system.

For a good summation, read BIS research head Claudio Borio at VoxEU who defines macroprudential thusly:

The macroprudential approach has two distinguishing features. It focuses on the financial system as a whole, with the objective of limiting the macroeconomic costs of episodes of financial distress. And it treats aggregate risk as dependent on the collective behaviour of financial institutions (in economic jargon, as partly “endogenous”). This contrasts sharply with how individual agents treat it. They regard asset prices, market/credit conditions and economic activity as independent of their decisions, since, taken individually, they are typically too small to affect them.

That top-down view is a seedling for what could become new tools used to manage systemic risk at a global level, and the idea is gaining traction among more policymakers and pundits (see, for example, hedge funder Andrew Lo with some similar thoughts here). The FT outlines why such radical changes are even being considered: Banking and national regulation are out of synch:

Bankruptcy is capitalism: it makes you bear the costs of the risks you choose to take on. But the incapacity of national governments to manage international markets has sheltered the largest financial institutions from this capitalism.

As finance grew global, national rules could not prevent some companies from becoming too large for bankruptcy. We have discovered that to close down financial giants we must bail out their creditors or risk a global recession. At the same time, those too large to fail may also be too large for national governments to save, for fiscal and political reasons. Few countries can even afford to rescue truly global institutions. Taxpayers may in any case refuse to meet failed institutions’ liabilities to foreigners.

The biggest question raised by the crisis is how to resolve this contradiction. The current mismatch of globalised finance and national governance is unsustainable. Either governance becomes more globalised or finance less globalised.

Making those decisions won't be simple, as the G20 are set to find out. Venturing into the realm of global regulation means wading into a marsh. As the Economist points out, macroprudential intervention assumes "the idea that a group of wise men can focus on systemic risk, rather than get bogged down in the details of individual firms’ finances. In theory, such a council of wisdom would have spotted that the American housing boom was causing banks to become overexposed to the finances of subprime borrowers." But there's a catch or six:

The creation of this global watchdog has required the Financial Stability Forum to be transformed into, wait for it, the Financial Stability Board. The FSF was associated with the unrepresentative G7; the FSB will represent the whole G20. That it shares the initials of the Russian secret service might be an attempt to make it a bit more scary. It needs to be.

Collaborating with the IMF, it is meant to ferret out macroeconomic and financial risks. But if it warns, who will listen? Imagine the scene in Congress in 2015. The economy is booming, but Americans cannot get mortgages because some pen-pusher in Basel says the banks are taking too much risk. The banks would be freed faster than you can say “swing voter”.

Even at the national level, macro-prudential regulation is hard. First, regulators tend to be captured by the industry. Second, the seeds of disaster are sown when all looks well; the economy is booming and banks have healthy profits. It takes an iron will to be contrarian at such times.

It's also worth asking whether local regulation should expand to accommodate giant banks, or whether banks should simply shrink. The opposite side of the argument is that banks need not be regulated at a global level because they shouldn't be world-spanning enterprises at all (see banking analyst Meredith Whitney, who contends the future of banking will be local).

The debate on global rules will be messy but instructive. Attempting to navigate the politics, logistics and basic logic of a global framework will be fascinating to watch. What will emerge from any attempt at international regulation will be a clear view of the willingness of nations to cooperate with the U.S. and each other during a crisis. Unfortunately, whatever they decide, the new structure won't have a chance to be tested until the next bubble forms.