A Better Way to Regulate Financial Markets

There
is widespread recognition that the financial crisis which triggered the Great
Recession was significantly due to financial excess, particularly related to real
estate. Now, policymakers are looking to reform financial systems in hope of
avoiding future crises. But like the drunk who looks for his lost keys under
the lamppost because that is where the light is, policymakers remain fixated on
capital standards because that is what is already in place.

There
is a better way to regulate financial markets through asset based reserve
requirements (ABRR) which would extend margin requirements to a wide array of
assets held by financial institutions. ABRR are easy to implement, use the tried
and tested approach of reserve requirements, are compatible with existing
regulation (including capital standards), and would fill a hole regarding adequacy
of financial policy instruments.

The
toleration of periodic bouts of financial excess over the past two decades
reflects profound intellectual failure among central bankers and economists who
believed inflation targeting was a complete and sufficient policy framework. It
also reflects lack of policy instruments for directly targeting financial market
excess. With central banks relying on the single instrument of short term
interest rates, this supported the argument using interest rates to target
asset prices would be like using a blunderbuss that inflicts massive collateral
damage on the rest of the economy. ABRR offer a simple solution to this problem
by providing a new set of policy instruments that can target financial market
excess, leaving interest rate policy free to manage the overall macroeconomic
situation.

ABRR
require financial firms to hold reserves against different classes of assets,
with the regulatory authority setting adjustable reserve requirements on the
basis of its concerns with each asset class. One concern may be an asset class
is too risky; another may be an asset class is expanding too fast and producing
inflated asset prices.

By
obliging financial firms to hold reserves, the system requires they retain some
of their funds as non-interest-bearing deposits with the central bank. The
implicit cost of forgone interest must be charged against investing in a
particular asset category, reducing its return.
Financial firms will therefore reduce holdings of assets with higher
reserve requirements and shift funds into other relatively more profitable asset
categories.

The
effectiveness of this approach requires system-wide application. If applied
only to banks, ABRR would simply encourage lending to shift outside the banking
sector. To succeed, reserve requirements must be set by asset type, not by who
holds the asset.

A system of ABRR that covers all financial
firms can increase the efficacy of monetary policy. Most importantly, it enables
central banks to target sector imbalances without recourse to the blunderbuss
of interest rate increases. For example, if a monetary authority was concerned
about a house price bubble generating excessive risk exposure, it could impose
reserve requirements on new mortgages. This would force mortgage lenders to
hold some cash to support their new loans, raising the cost of such loans and cooling
the market.

A
similar logic holds for stock market bubbles. If a monetary authority wanted to
prevent stock market inflation from generating excessive consumption, it could
impose reserve requirements on equity holdings. This would force financial
firms to hold some cash to back their equity holdings, lowering the return on
equities and discouraging such investments.

ABRR also act as
automatic stabilizers. When asset values rise or when the financial sector
creates new assets, ABRR generate an automatic monetary restraint by requiring
the financial sector come up with additional reserves. Conversely, when asset
values fall or financial assets are extinguished, ABRR generate an
automatic monetary easing by releasing reserves previously held against assets.
In all of this, ABRR remain fully
consistent with the existing system of monetary control as exercised through
central bank provision of liquidity at a given interest rate.

At
the microeconomic level, ABRR can be used to allocate funds to public purposes
such as inner city revitalization or environmental protection. By setting low (or no) reserve requirements
on such investments, monetary authorities could channel funds into priority
areas, much as government subsidized credit and guarantee programs and
government-sponsored secondary markets have expanded education and home
ownership opportunities and promoted regional development. Conversely, ABRR can
be used to discourage asset allocations that are deemed socially
counterproductive.

ABRR
also have other significant policy benefits. First, ABRR increase the demand
for reserves which should prove helpful as central banks seek to exit the
current period of quantitative easing to avoid future inflation. By introducing
and gradually raising asset reserve requirements central banks can implement a
form of reverse quantitative easing that smoothly transitions the financial
system to a new sounder regime.

Second,
by increasing the demand for reserves ABRR will increase seigniorage revenue
for governments at a time of fiscal squeeze. To the extent required reserves
constitute a tax on financial institutions, that tax is economically efficient
given the costs of resolving financial crises. It will also shrink a financial system
that many believe is bloated.

In
the late 1990s, US policymakers completed the repeal of America’s "New
Deal" segmented system of financial regulation but they created no framework of
matching comprehensiveness. That failure created a regulatory vacuum,
particularly regarding the activities of the secondary banking system, and was
a major contributing factor to the financial excesses that caused the crisis. Applied
uniformly to all domestic financial firms, a system of ABRR can help fill this
vacuum.

For the euro zone, ABRR are additionally
attractive because they can help address the instrument gap created by the
euro’s introduction. The euro’s establishment represents an important step in
the creation of an integrated European economy. Over time it should yield
dividends as increased competition and lower transaction costs generate
increased efficiency. However, member countries have had to give up their own
exchange rates and interest rates, which have created problems for economic
management by reducing the number of policy instruments. ABRR can fill this
policy instrument gap because they can
be implemented on a geographic basis by national central banks.

Property lending,
which has been a major focus of concern, is particularly suited to this. If
Euroland is suffering excessive house price inflation, the ECB could raise
reserve requirements on mortgage loans secured by property. However, national
central banks should have the power to set reserve requirements above (but not
below) the rate established by the ECB. Thus, if Spain
or Ireland
is suffering excessive house price inflation, their national central banks could
raise reserve requirements on mortgage loans secured by property in those
countries. That would raise mortgage loan rates in Spain
and Ireland
without raising rates in other countries.

Nationally contingent ABRR will
create some incentive to shop credit across countries. That means ABRR will
work best when linked to geographically specific assets that cannot evade the
regulatory net. This includes mortgage lending that is secured by
collateralized property, and shares for which legal title is registered where
companies are incorporated. That said, jurisdictional shopping is costly and
that cost enables ABRR to create cross-country interest rate differentials for
wide categories of assets.

This paper has been prepared for a forthcoming
book, "After the crisis – towards a sustainable growth model", that is being prepared by the European
Trade Union Institute, Brussels,
Belgium.