TAMING BUBBLES FOR FINANCIAL STABILITY / THE WALL STREET JOURNAL

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SEPTEMBER 5, 2009.

Taming Bubbles for Financial Stability

By SIMON NIXON


The financial crisis has spawned its fair share of jargon, but few expressions as ugly and as important as "macroprudential supervision." Everyone agrees individual banks can act prudently yet collectively contribute to systemic risks. But how regulators should mitigate this, or if tools can even be devised to do it, remains far from clear.

There are two schools of thought. Most policy makers would like macroprudential tools embedded into the system via new capital rules. The current system tends to encourage banks to become most extended as a boom peaks -- and higher asset prices, higher liquidity and falling risk perceptions encourage riskier behavior.

But some, most vocally Bank of England governor Mervyn King, have demanded discretionary tools, allowing regulators to remove the punch bowl when they see a bubble. That could mean imposing higher capital requirements or placing other restrictions on the lending of institutions.

Both approaches have problems, as a recent paper by Claudio Borio of the Bank for International Settlements acknowledges. To embed the rules, regulators will need models capable of identifying risks across the financial system, not just in banks. And those models would need to be sophisticated enough to map the linkages between different asset classes and counterparties, while also calculating the likelihood of a boom turning to bust.

Needless to say, neither the models nor the data required to make these tools exist. Simply focusing on market prices won't work. After all, during the boom years, credit-market prices and reduced volatility signaled that global risks were actually falling as the world headed to the brink.

But tools that rely on discretion pose even bigger challenges. Will policy makers really be willing to pit their judgment against the markets? Would it have made much difference to the crisis if the BOE had tried to cool the U.K. housing market earlier in the decade? After all, U.K. house prices have so far fallen only 14%, hardly the systemic threat to the U.K. banking system that many feared.

What's more, policy makers would need teams of bubble-spotters analyzing asset classes as diverse as U.S. housing, tech stocks and emerging-market currencies. And that would need global coordination.

But even if such macroprudential tools can be developed, they aren't likely to be enough to prevent future instability. Monetary policy must share the load, as Bank of Canada governor Mark Carney noted last month. That will mean adapting central-bank inflation targets to take account of asset prices and balance the demands of price stability and financial stability. That may be anathema to traditional inflation-focused central bankers such as Mr. King and Ben Bernanke. But it may be the one tool that really works.

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