The new regulators:
The bubble-beaters

Consisting of “a formidable group with great experience”, the new Financial Policy Committee has a serious job on its hands, and one that requires new thinking. Shayla Walmsley reports.

“Nearly all the bank supervisors I have known have invariably been drawn towards the parts of their inbox about individual firms, for the simple reason that that is where their individual accountability is starkest,” Deputy Bank of England Governor and Financial Policy Committee (FPC) member Paul Tucker told a recent conference in New York.

“At its heart,” he says, “the FPC is a device to overcome this problem. It charges a group of policymakers to step aside from the fray, resisting myopia and synthesising the perspectives of supervision, securities regulation, market operations and macroeconomics, with the goal of identifying and addressing the big developments that could jeopardise stability.”

In short, the FPC will monitor overall risks in the financial system, identify bubbles as they develop, spot dangerous interconnections and deploy new tools to deal with excessive levels of leverage.

The 11-member committee, chaired by Sir Mervyn King, also includes central bankers Tucker, Charlie Bean and Paul Fisher,new PRA head Hector Sants and FSA chairman Lord Adair Turner – people described by King as “a formidable group with great experience”.

It has a serious job on its hands. “It’s possible to spot asset bubbles – but it’s difficult in practice,” agrees former Financial Services Secretary Lord Myners. “The wisdom has been that central banks are there to target inflation, which meant they couldn’t target asset bubbles. Former Federal Reserve Governor Alan Greenspan once pointed out that the central bank’s role is to clear up the mess once the bubble had burst, not to spot the bubble in advance.”

Assuming you can see them coming, it’s difficult to know even in theory how asset bubbles might be addressed. Former MPC member Sushil Wadhwani has pointed to “our collective ignorance of the likely efficacy of macro-prudential tools”. Daniel Samano, an economist at the Mexican central bank who has worked extensively on optimal combinations of macro-prudential instruments, likewise argues that research in the area is “pretty new and growing little by little”. (In fact, the only other country to have tested the UK’s new regulatory model is Thailand.)

At this point, says Samano, policymakers are thinking in terms of capital buffers, liquidity buffers, reserve requirements and loan-to-value ratios. “Obviously, no one is thinking of getting rid of interest rates so I guess any combination of interest rate with potentially more than one macro-prudential tool may emerge as the final outcome,” he says. “This does not mean, however, that is sufficient to have two.”

Although he says it’s “very hard” to say what bubble-beating regulation might look like, NIESR economist (and asset bubble specialist) Professor Ray Barrell has suggested that higher capital adequacy and liquidity ratios would make a significant difference to their impact.

In practice, how the FPC might detect potential asset bubbles and then lean against them is unclear. The Treasury has yet to finalise what tools the FPC will have at its disposal, but it is expected to include the power to increase loan-to-value ratios for specific sectors or banks.

“Put crudely, warnings will carry greater weight under a regime where the FPC can actually take action,” says Tucker. In the meantime, he offers an example. The FPC, he says, would have addressed underpriced risk by tightening capital requirements against exposures to property and to shadow banking.

Ensuring stability depends, according to Tucker, on the resilience of the component parts of the system, and their connections. In other words, the FPC would focus on firms, markets and infrastructure in order to address vulnerabilities in all three. Given that threats can be buried in the complex details of the system – sub-prime being one example – the task, he says, is to make the connections without getting lost in the trees.

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