Financial Regulation in General Equilibrium

In our recent NBER working paper, Financial Regulation in General Equilibrium, my co-authors (Charles Goodhart of the London School of Economics, Dimitrios P. Tsomocos of the University of Oxford, and Alexandros Vardoulakis of the Banque de France) and I explore how different types of financial regulation could combat many of the phenomena that were observed in the financial crisis of 2007 to 2009. The primary contribution is the introduction of a model that includes both a banking system and a “shadow banking system” that each help households finance their expenditures. Households sometimes choose to default on their loans, and when they do this triggers forced selling by the shadow banks. Because the forced selling comes when net worth of potential buyers is low, the ensuing price dynamics can be described as a fire sale. The presence of the banking and shadow banking system, and the possibility that their interaction can create fire sales distinguishes our analysis from previous studies.

The model builds on past work by Tsomocos (2003) and Goodhart, Tsomocos and Vardoulakis (2010) and uses many of the same ingredients as their general equilibrium model. In particular, the model includes two periods and allows for heterogeneous agents who borrow and lend to each other through financial intermediaries. When the borrowers default, the intermediaries suffer losses and tighten lending standards to future borrowers. Thus, the model also includes a possible credit crunch.

While extremely stylized, the model is still rich enough to compare the efficacy of several regulatory tools that are otherwise difficult to assess. In particular, the proposed framework can contrast five different policy options that officials have advocated for combating defaults, credit crunches and fire sales, namely: limits on loan to value ratios, capital requirements for banks, liquidity coverage ratios for banks, dynamic loan loss provisioning for banks, and margin requirements on repurchase agreements used by shadow banks. The paper aims to develop some general intuition about the extent to which different regulatory tools act as complements and substitutes.

Perhaps the most compelling conclusion from the analysis is the importance of taking a stand on the economic function played by the shadow banks and the precise risks that their presence creates for the rest of the financial system. This manifestation of the model embeds one rationale for the shadow banks existence and pinpoints the problems that emerge because of the way that they contribute to producing fire sales.

While these assumptions generate many specific predictions, the most general implication is that fire-sale risk can be controlled in three very different ways. One approach is to create incentives to make fewer mortgage loans initially, in which case a house prices crash generates fewer losses for lenders. A second approach is to push banks to be better capitalized in the event of a bust. This approach helps contain the follow-on effects of mortgage defaults. A third approach is to attempt to offset the spillovers between the bust and the boom. Most policies that mitigate the effects of house price decline have the unintended effect of exacerbating house price increases during a boom. Hence another policy option is to try to limit this spillover. In this model, the primary difference in the incidence and efficacy of different regulations turns on which of these channels that they operate through.

While this conclusion seems quite intuitive, this research program is just beginning and the modeling approach is very flexible. So this model is better thought of as a framework for comparing different potential financial externalities and for regulating them. Hence the longer-term conclusions about regulatory design will depend on analyzing many variants of the model and determining which are robust to the many possible formalizations of the financial system. The findings here should be viewed as provisional first steps.

The full paper is available for download here.