Leaning, Cleaning, and Macroprudence

The following post comes to us from Robert Hockett, Professor of Financial and International Economic Law at Cornell Law School.

Since the mid-1990s, and particularly since the global financial dramas of 2008-09, authorities on financial regulation have come increasingly to counsel the inclusion of macroprudential policy instruments in the standard ‘toolkit’ of finance-regulatory measures employed by financial regulators. The hallmark of this perspective is its focus not simply on the safety and soundness of individual financial institutions, as is characteristic of the traditional microprudential perspective, but also on certain structural features of financial systems that can imperil such systems as wholes. Systemic ‘financial stability’ thus comes to supplement, though not to supplant, institutional ‘safety and soundness’ as a regulatory desideratum.

Evidence of this shift from a once primarily microprudential to a now macroprudential-inclusive focus in financial oversight can be found not only in a wealth of scholarly and policy papers – including a great deal of work produced by the Bank for International Settlements (BIS), the Financial Stability Board (FSB), the International Monetary Fund (IMF, ‘Fund’), and sundry central banks worldwide over the past decade and a half – but also in many new treaty-based, statutory, and administrative provisions agreed or enacted in multiple jurisdictions over the past several years. One recent Fund paper, in fact, reports that some 50 jurisdictions, including all of the world’s most developed economies, have formally adopted one or more macroprudential finance-regulatory measures since early 2009. [1]

The move from primarily micro- to combined micro- and macroprudential finance-regulatory regimes is surely to be welcomed, for reasons that I and others have elaborated at length in many articles. [2] ‘Leaning,’ as Fed Chairman Martin would have called it, always has been just as crucial as, and often indeed more effective than, ‘cleaning’ – and used to be recognized as such. [3] In that sense, renewed appreciation of macroprudential considerations is less innovation than renovation – even restoration.

Leaning also, however, raises certain legal challenges to which predominantly microprudential finance-regulatory regimes are not typically subject. These are challenges of which regulators, other lawyers, and economists sensitive to institutional constraints will wish to be mindful.

With an article recently posted on SSRN, The Macroprudential Turn: From Institutional ‘Safety and Soundness’ to Systemic ‘Financial Stability’ in Financial Supervision, I hope to assist, however humbly, in the cause of developing and maintaining the mentioned mindfulness. I aim to do so by systematically cataloguing and provisionally addressing all mentioned legal challenges. My hope is that interested parties might thereby find comprehensive treatment of the subject in one place.

The article commences by first briefly rehearsing what distinguishes the macroprudential from the microprudential approach to financial regulation that dominated from the mid-1980s until recently, in the process explaining just why the shift has occurred. In essence, I argue, the reason is that careful post-crisis inquiry has led many at last to appreciate that modern financial markets are not just the sums of their parts. Our markets also include the particular structures that unite all the parts. These structures, in turn, are rife not only with liability linkages that transmit fragility from unregulated to regulated institutions and subsectors, as is now widely recognized, but also with what I call ‘recursive collective action problems’ that underwrite equilibrium-challenging procyclicalities and resultant high-amplitude oscillations – something not yet as widely recognized as one might hope. [4]

After thus characterizing and justifying the move to macroprudence in financial supervision, I turn to elaborating the principal legal issues and tradeoffs that the change of perspective implicates, then delineate and provisionally assess the available options for addressing them. I argue in particular that the recursive collective action problems that pervade financial markets and thereby warrant macroprudential regulation necessitate several distinct requirements the fulfillment of which has not until recently been prominent in the finance-regulatory landscape.

The first such requirement is collective agency on the part of the financial regulator or regulators, including the central bank or monetary authority; some singular authority or set of authorities must unitarily oversee and react to the financial system as a whole, because only collective agents can solve collective action problems – recursive or otherwise. The second requirement is regulation that is preemptive in character, because ‘leaning’ is all about preventive medicine, not merely triage that often amounts to mere ‘pushing on strings.’ Finally, the third requirement is regulation that is dynamic in character, in that continually changing conditions – as particularly characterize the financial markets – require counterpart high frequency responsiveness on the part any regime that would be preemptive.

When all three of these requirements are met, financial supervision takes on the attributes of a distinct model of regulation. Per this model of what I call ‘regulation as modulation,’ the regulator or regulators must be of one mind both in continually monitoring credit and leverage buildups throughout the financial sector, and in continually adjusting credit- and leverage-modulatory reserve, capital, margin and cognate requirements responsively. But this in turn bears consequences both for the way in which regulatory decision-making is structured, and for the forms of authority that must be conferred upon macroprudential regulators. Classic tradeoffs long familiar to central banking and monetary policy come to be implicated, save much more poignantly even than in those long fraught arenas.

From cataloguing the mentioned tradeoffs and provisionally assessing the options available for addressing them, I turn to providing a representative sampling of macroprudential finance-regulatory regimes now either in place or in the process of enactment in a number of representative jurisdictions – including the EU, the UK, and the US. In so doing, I highlight how these regimes address and resolve the particular issues and tradeoffs that I have elaborated. The ultimate aim is to afford some measure of concrete appreciation of the options available to jurisdictions that seek to supplement their microprudentially oriented finance-regulatory regimes with macroprudential policy instruments.

I then conclude and look forward, highlighting in particular certain still unresolved finance-theoretic issues whose resolution will likely invite revisitation of issues only provisionally resolved in the article.

The full paper is available for download here.


[1] See International Monetary Fund, Macroprudential Policy: What Instruments and How to Use Them? Lessons from Country Experiences, discussion paper, October 2011, available at www.imf.org/external/pubs/ft/wp/2011/wp11238.pdf.
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[2] See, e.g., Robert Hockett, A Fixer-Upper for Finance, 87 Wash. U. L. Rev. 1 (2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1367278; Robert Hockett, Bailouts, Buy-Ins, and Ballyhoo, 52 Challenge 39 (2009), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1276285; Robert Hockett, Bubbles, Busts, and Blame, 32 Cornell Law Forum 1 (2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1805930; and Robert Hockett, Recursive Collective Action Problems, 5 J. App. Econ. 1 (2013) (forthcoming).
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[3] The reference here is to the choice between ‘leaning’ against the winds that are asset price bubbles on the one hand, and simply allowing such bubbles to grow while then cleaning up after they burst on the other. As for past preferences for leaning, historians of central banking will recognize at once that central banks used to pursue ‘financial stability’ and, therefore, bubble-preemption, while ‘price stability’ came to be interpreted in narrower, consumer and not asset price terms only after the ‘stagflationary’ late 1970s. See Hockett, sources cited supra, note 2; also Robert Hockett, Bretton Woods 1.0: A Constructive Retrieval, 27 N.Y.U. J. Legis. 1 (2013) (forthcoming), available at http://papers.ssrn.com/sol3/papers.cfm? abstract_id=1805962; and Robert Hockett, What’s the Fed For? Making Sense of a Mandate, working paper, on file with the author.
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[4] A collective action problem characterizes a situation in which multiple individually rational decisions aggregate into collectively destructive outcomes. A recursive such problem is one in which such decisions also prompt further iteration, thereby underwriting equilibrium-challenging ‘feedback’ effects. Bank runs, bums’ rushes, arms races, liquidity traps, paradoxes of thrift, debt-deflations, and consumer price hyperinflations all are familiar examples. So are asset price bubbles and busts, which are but hyperinflations and hyperdeflations in respect of asset rather than consumer prices.
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