Progress and Confusion

4. A Note from the Session on Systemic Risk and Financial Regulation

Olivier Blanchard, Kenneth Rogoff, and Raghuram Rajan
Published Date:
April 2016
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Paul A. Volcker

Three participants—two distinguished academics and a prominent ex-central banker and financial executive—presented overlapping analyses of the challenge for “macroprudential” supervision.

Several themes stood out. One was common and not unexpected: the fundamental importance of strong capital requirements for commercial banks, and more generally, concerns about excessive leverage throughout the financial system.

Within that context, however, substantial differences in analysis were evident. One was concern about the potential weakness of relying on “risk-based” measures of capital, given the difficulty of identifying the sources of risk, current and potential. The usefulness of contingent capital instruments (i.e., those characterized by mandatory convertibility at times of stress) was debated, as was the role of stress tests in varying circumstances.

More fundamental differences were apparent in concerns about the stiff regulation of commercial banks inducing other financial institutions to undertake more maturity and credit transformation outside the regulatory framework. That concern may be more evident in the United States, with its more developed shadow banking system.

Though session chair, I could not refrain from expressing my own concerns. Years ago, I was a strong proponent of the view that, if a strong banking system could be assured by official oversight or otherwise, then other financial institutions and markets could be lightly supervised, and left free to fail. That view, in my mind, is no longer tenable when non-banks in the United States have come to account for more total financing, often with high leverage, than commercial banks themselves.

Finally, there was discussion of the importance of shifting cultures in financial institutions toward an emphasis on short-term performance and impersonal “counterparty” trading as opposed to building customer relationships. It is a difficult area. Some hope was expressed that in practice, a better “culture” could be encouraged by sensible regulation and supervision. A small ray of hope thus emerged to conclude the session.

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