Central banks need to be aware that “simply piling on multiple regulations because there are multiple channels of financial contagion can damage the economy,” says Dimitrios Tsomocos of Saїd Business School, Oxford. “Wise regulation requires that considerable care is taken to anticipate the ways in which policies will interact and to guard against creating perverse incentives and reactions.”
Tsomocos is co-author of a new paper analyzing the most effective mix of financial regulations to increase stability and ensure the availability of credit. The paper appears as regulators and governments worldwide are looking beyond short-term interest rate policy to achieve these goals. Tsomocos and his fellow writers – Charles Goodhart, director of the LSE’s Financial Regulation Research Program, Alexandros Vardoulakis of the Banque de France and E.C.B., and Anil Kashyap of the University of Chicago, Booth School of Business – all have current or past experience advising central banks.
“The best regulatory combination that we identify includes raising capital requirements ahead of an asset price boom or bust,” explains Tsomocos, a former economist at the Bank of England and economics adviser to the Prime Minister of Greece, Antonis Samaras. “This restriction reduces risk-taking by banks without too severely limiting the overall supply of credit, and also lowers the burden of requiring higher capital during bad times.”
The authors’ base their conclusions on results from an analytical model they developed which explicitly assumes the possibility of credit supply shocks, in contrast to the ‘workhorse models’ used by central banks before 2008. Another distinguishing feature of their model is the inclusion of both a traditional banking and a “shadow banking” system, each of which helps households finance their expenditure with loans and thus expedites their consumption between different time periods. As in the 2008-9 financial crises, the model expects that if asset prices collapse, consumers will default, and the consequences will be ‘amplified’ by traditional and shadow lenders.
From this starting point, Tsomocos and his colleagues explore the potential impact of five regulatory tools aimed at limiting the impact of a property bust, when used in different combinations. The measures include limits on loan to value ratios, capital and liquidity requirements for banks, and margin requirements on shadow banks’ repurchase agreements. “It appears easier to find a bundle of regulations that makes everyone better off when margin requirements are used, instead of larger down payments,” says Tsomocos. “Stricter loan to value regulation depresses the supply of credit and makes borrowers worse off.”
As financial regulators search for the best way to balance the need for stability while helping growth, the authors suggest that margins, capital ratios and initial liquidity ratios are the ‘most promising’ set of tools to consider in combination. Tsomocos adds that “margin requirements are a valuable complement to other regulations because they contribute to the stability of the shadow banking system.”