MACROPRUDENTIAL POLICY CHALLENGES: HOW BEST TO … Stability/FinStab_Research... · independent actions by people unable to coordinate could lead to a tragedy of the commons. And

MACROPRUDENTIAL POLICY CHALLENGES: HOW BEST TO RESPOND?

Presentation to the Financial Stability Research Conference, “KEY ISSUES FOR EFFECTIVE MACROPRUDENTIAL POLICYMAKING”, South African

Reserve Bank Conference, October 26 and 27, 2017

Peter Sinclair and Greg Farrell

(University of Birmingham; Reserve Bank of South Africa)

(email: [email protected]; [email protected])

mailto:[email protected]

mailto:[email protected]

Outline

• Financial markets have certain flaws. Macropru and micropru try to helpto rectify them.

• But policy interventions can be imperfect too.

• Beware the Long Run Policy Cycle.

• Financial Stability Policy differs from monetary policy.

• Macropru and micropru differ too, yet they can overlap; they arecomplementary in principle.

• Do financial cycles correlate with housing or business cycles? How likely isit that monetary and macropru instruments could point in oppositedirections? And what should be done if they did?

• Macropru instruments affect real estate and credit, and financial stabilitymore broadly – and with varying strengths and weaknesses.

• Fiscal policy has macropru dimensions as well.

• “ME”

Why can financial markets can malfunction?

• Incompleteness. This arises because contracts between agents cannot cover or even specify

all eventualities. Futures markets are thin, and non-existent at distant horizons. Even

sophisticated insurance contracts can never identify or describe all contingencies. So an

Arrow-Debreu economy is unattainable in practice. Insurance opportunities are limited; risks

cannot be fully diversified; so contracting is incomplete. Partly reflecting later imperfections,

ignorance and illiquidity, moral hazard and adverse selection often combine to prevent an

insurance market from clearing. They also underlie potential gaps and inefficiencies in loan

markets. Moreover, limited liability enshrines incompleteness, and the risky lending it may

spur, within the law.

• Ignorance. Agents can usually hide actions from principals. This moral hazard incentive

problem matters for all-debt contracts with a liability ceiling under risky conditions. The

incidence of risk burdens differs: agents normally get upside risks, but in bad enough states

this passes to the principal. No borrower or bank seeks to go bust. But the cost of going bust,

however big, is a constant. So unseen gambles can be attractive if close to the edge. They

might pay off. Kinked outcomes can spur a bank’s borrowers to incur too much unobservable

risk: “Heads I win, tails the lender loses”. Diagram 1 (next slide) refers.

A's payoff,B's payoff B's

payoff

A's payoff

Σ payoffs

Here, A is a bank and B is a borrower

Diagram 1

Financial market malfunctions, 2

• Indirect effects - externalities. Third parties can be helped or hurt by events in financial

markets, and bargaining with prime actors is often infeasible. A’s deposit withdrawal

from bank B could harm another depositor, C, if it depleted B’s reserves, and worse still,

triggered a run, for example. More generally, financial stability is a public good;

independent actions by people unable to coordinate could lead to a tragedy of the

commons. And some banking system adverse externalities may be traced to the notion

that, as Kiyotaki and Moore (2002) claim, “evil is the root of all money”.

• Illiquidity – with information deficiency. Cash is anonymous but adverse selection can

make credit scarce. Just asking for credit from someone who does not know you well

suggests you may be a lousy borrower. Offering to pay more (higher interest), a usual

response to shortage, may be counterproductive. Added force comes from the

possibility that some potential borrowers are improvident – the next imperfection.


• Improvidence - e.g. present bias. Suppose utility now (at date 0) =(1+θ)u(c(t=0))+Σβ𝑡u(c(t>1)). The present bias term here is θ>0 (a major expert on thissubject is Laibson, e.g. AER 2015); β (0<β<1) is the discount factor, and c denotesconsumption. Financial market transactions involve intertemporal choice. If you “reallywant it now”, you may not yet see you’ll “really want it now” tomorrow too, and ofcourse, later on, as well. That means you could be an eager but eventually insolventdebtor, soon bitterly regretting that you had consumed much too much in the past, andunable now to do anything about it. Similarly, improvident bankers may congratulatethemselves on clever credit allocation when low policy rates or good times bring lowdelinquency rates – and react by loosening standards. Fast bonus payments, whichlargely reward luck, and short horizons, may reinforce myopia for bank staff at all levels.

• Imitation. Some actions are overt, with information sets (believed to be) diverse. Thiscan trigger herding – following others thought to be “in the know”. Various kinds ofasset market bubbles might result – sometimes seemingly rational (e.g. Doblas-Madrid,2012).


• Incontestability in markets with indivisibilities and increasing returns. Sunk costs (plusspeedy undercutting any entrant) for producers, and switching costs facing buyers, maylead to persistently high mark-ups for many customers. This is likely to infringe standardmarket efficiency conditions, and lead to widespread under-provision. This may beacute in some financial intermediation markets.

• Irreversibility. Unlike many decisions a banker may take, pulling the plug on a borrowercan’t be undone. Hence the bias towards procrastination and forbearance, in hope ofbetter times. This threat can bedevil banks.

• Injustice. Pareto efficiency is distribution-blind. But financial markets may entrenchinequalities. The poor may be less lucky, less insured, and worse advised, paying morefor credit and earning less (“…whosoever hath, to him shall be given…but whosoeverhath not, from him shall be taken away even that he hath”- Matthew 13:12) on assets.There can also be injustice in another sense: unjust behaviour by agents – impropriety,and illegality.

But policy interventions might fail, too: 1

• Brunnermeier and Sannikov (2016) propose a powerful and persuasive “I Theory ofMoney”. By way of complementing it, we have tried to sketch a little “9 Is Theory ofFinance”.

• Financial stabilizers merit sympathy. They are suspects in the scapegoat hunt, and riskgetting blamed, after a crisis that could well have been far worse without them. If therehas been no crisis for some while, they might face redundancy. The value of theirmarginal product is invisible. It’s tails they lose, heads others win. In Scotland, this iscalled McPherson’s Law; in Ireland, it’s Murphy’s Law – you just can’t win.

• Ignorance (hidden action gambles by a troubled bank) may bamboozle a supervisor:“heads the bank wins, tails the taxpayer loses” (see Diagram 2, the next slide).

• Another of our 9 Is can be critical: irreversibility. Pulling the plug on a bank can’t beundone. The option value of waiting for better news can be seductive. It can lead toexcessive forbearance by supervisors. And, after a crisis, to a plethora of zombies.

• Other potential problems include: suspicion of challenger banks, sometimes justly butsometimes not; luddite reactions to financial innovation; threats of regulatory capture;fondness for lexicographic ordering, with safety first at the potential cost of excessivemark-ups, and hence the likelihood of too little investment in innovation and training,and, consequently, of slower growth (see Diagram 3).

• And history warns us of a policy cycle.

A's payoff,B's payoff B's

payoff

A's payoff

Σ payoffs

Diagram 2

Here, A is the taxpayer and B is a bank

Diagram 3: The Safety – Growth trade-off?

The Ramsey equation for households: r=1-β+ακ

The Romer (1990) equation for growth: g declines as R rises

R= real rate of interest for borrowing firms

Real rates of interest

Q

S

T

Growth rate g

ST: financial friction gap: increases safety,

but squeezes growth

g1g0

(households accumulate deposits)

α=coefficient of relative risk aversion

κ = consumption growth

1-β=r

Policy Intervention can fail too, contd: the policy cycle

• Politicians are amnesiac and preoccupied, as are voters, andthe media that interact with them. (And one doesn’t need toleave the Northern Hemisphere to see recent examples ofhow democratic decisions may sometimes have imperfect andunforeseen consequences).

• Soon after a financial crisis, governments typically respond byenacting a host of complex, not always well designedrestrictions on the systems of financial intermediation rulingat the time, which, they say, might have stopped the crisis,had they been in force. Politicians eschew more sophisticateddeterrents; they prefer “Thou shalt not!” So they hastily passlaws, which legislators set in stone for some while.

Policy Intervention can fail too: the policy cycle, 2

• Eventually, decades later perhaps, when memories of the lastbig crisis have faded, governments start to succumb to the(not wholly implausible) blandishments from financiers whohave been pleading incessantly for release from their chains.

• As a result, some of those shackles may then get taken off.This might well be beneficial, at least in certain respects.Short term, it would seem so. But …… (Glass Steagall? DoddFrank?)

Policy Intervention can fail too: the policy cycle, 3

• With financiers unfettered, the credit feasting begins inearnest. The macroeconomy is buoyant, and may lookoutwardly quite calm. The reduction of capital marketfrictions is very popular. It seems to be both pro poor and probusiness. Some welcome investment and innovation mayensue. If it does, that will help to offset upward pressures onunit labour costs. There will probably be fewer defaults, for awhile. Goldilocks?

• But can policymakers muster the chutzpah to tighten, ordemand provisioning, in this apparently benign environment?And which policymakers?

Some Implications

• Who does what must be crystal clear. Some decisions have to be taken veryquickly. But by whom?

• No taxpayer funds should ever be deployed without specific government approval.Resolutions can be costly for the fiscus. And some macropru instruments aredefinitely fiscal. But credibility may be enhanced if government mainly sets theobjectives and the framework - while delegating implementation and resolutiondetails to other bodies, most prominently perhaps, the central bank among them.

• Macropru (and micropru) policy rules should be flexible enough for details to berevised as the institutional environment evolves. But explicit enough for actors toanticipate them, and for discretionary overruling to be observed - and prevented.Regulators can forbear too much. Whether to pull the plug is hard; and how istough. When to do so is hardest of all. If too early, you get law suits; too late, andcontagion and burgeoning future fiscal burdens may ensue.

Differences between monetary and financial stability policies

• Unlike monetary policy (mp), transparency about financial stability policy (fsp) can go too far. The slightest hint about incipient bank stresses or runs, for instance, is dangerous.

• Another difference: mp is concerned mostly with (guesses about) first moments of probability distributions, however elegantly embellished by fancharts; fsp deals only with risks of black swans, left tails and rare disasters. So goals appear to differ. But in fact do they?

• And a third: mp and fsp instruments affect goal variables differently.

• And a fourth, instruments: in normal times, there is mainly just one for mp. But there are almost embarrassingly many for fsp, as we shall see.

But do goals differ?

• Superficially, yes. The aim of mp is to keep inflation close to target and outputclose to “natural”; of fsp, in the view of most, to keep crises as rare and mild aspossible. (But Hayekians could contest that – a crisis episode may, in their view, bethe best way, early on, of ridding the body economic of an ailment that mightotherwise fester unchecked, and metastasize).

• Nonetheless, severe crises disturb prices and can drag output down for manyyears; the unifying goal is arguably to maximize some social welfare function theexpected (and weighted?) double integrals of agents’ discounted utilities. Financialstabilizers can also challenge one of the central doctrines of orthdodox monetarypolicy – viz, that policy rate rises curb output and inflation (Cochrane (2017) andSchmitt-Grohe and Uribe (2014) argue this and the jury is still out).

• But this unifying goal is (as yet) too abstract and general to serve as a unifyingframework for mp and fsp. And fsp is molecular. Deposit insurance; fiscal policy;legal codes; and critically, between macropru and micropru. Helpfully?

Differences between macropru and micropru

• The general view is this. Micropru means supervision of individualfinancial firms: inspecting the books; watching for any signs ofstress; consultation; regular visits; and (on rare emergencies) sitevisits. Micropru supervisors’ tasks have something in common withrating agencies and auditors; but they serve a wider purpose, andinspect a much larger volume of data.

• By contrast, Macropru is held to focus on banking and otherfinancial intermediation aggregates (credit, assets, liabilities,profits),and by extension, to banks deemed sufficiently connectedwith other intermediaries, and hence capable of threatening thehealth of the macroeconomy, to warrant special attention. The termfor sufficiently connected is “systemic”. Systemicity is not asynonym for size, but there is correlation.

Differences between macropru and micropru, 2

• Distinguishing systemic from non-systemic banks calls for an arbitraryincision into a continuum. Even an almost isolated bank in sufficientdifficulties is capable in principle of infecting the health of the rest of acountry’s financial system; and a heavily connected bank may actuallyabsorb shocks, and need not initiate or transmit them. The epithet“systemic” can be seen as a helpful guide to Macropru regulators,enabling them to prioritize what goes under their microscopes, ratherthan a strict boundary.

• Before it comes to the ultimate challenge of a resolution (where theboundary between Macropru and Micropru disappears), anotherMacropru / Micropru difference is that the former are chiefly concernedwith what could soon happen (to the system as a whole), and Micropruwith what is now happening (to particular firms within it).

Financial, business and housing cycles

• In 2007, Leamer claimed that, in the US, the housing is the business cycle. Leamer(JMCB, 2015) confirmed this was just as true of the 8 years that followed. For theUS all the 3 cycles (finance, housing and business) have correlated closely forseveral decades, he showed.

• In South Africa, however, we find hardly any correlation between finance andbusiness cycles. See Diagram, drawn from Farrell and Kemp (2017).

• So is South Africa exceptional? Not really, according to Borio (JBF, 2014) andClassens et al (JIE, 2012). And important new research by Barrell et al (2017) goesfurther. They explore degrees of association between credit, house prices, GDPand other variables, in a large group of OECD economies, on data over half acentury. Country by country, house prices (HP) and credit (CR) correlate veryclosely, but Granger causation runs most strongly from HP to CR.

Financial, business and housing cycles, 2

• As in the South African data examined by Farrell and Kemp (2017), houseprices tend to lead credit, and not to follow it (see Diagram).

• Bidirectional causation is attested in just half the countries, Barrell et alfind. In several, a nation’s CR-GDP ratio dynamics do not help to predictits financial crises. It may be that a more continuous variable, such as afinancial stress index, would give different results, and that lag variability,and breaks, could alter the Granger causation findings. And in the GFC, USreal estate volatility certainly disturbed finance and GDP in othercountries.

• But as things stand, Leamer’s claims cannot be safely generalized to theOECD area as a whole. And in particular, not to South Africa.

The financial cycle in South Africa

The financial and business cycles in South Africa

Do monetary policy and macropru decisions clash?

• If the financial and GDP cycles coincide, as they appear often to do in the US, the answer is “rarely”. Butwhen they are less well correlated, as Barrell’s results imply for some other countries, the risk of thisbecomes appreciable. A slack macroeconomy with overheated credit, for example, may require aninterest rate cut and a stiffening of restrictions on credit.

• What should be done in such circumstances? The transmission mechanism of monetary policy (TMMP)depends to no small degree on how real estate and other forms of private expenditure react to interestrate changes; but with macropru, those elements in TMMP would be subject to influences in the oppositedirection.

• The worst answer may be to do nothing; the best, quite possibly to consider doubling the dose of eachpolicy instrument that would have been chosen had the other target been met. Coordination mightachieve that, especially if both instruments are in the hands of a single authority, and with overlappingmembership of key committees, through gubernatorial chairmanship for example.

• The Beau-Clerc-Mojon diagram on the next slide illustrates various possibilities: it is the red cells in thematrix that will challenge policymakers.

• What about South Africa? Our analysis of the historical data since 2000 suggests that mp and macroprucould point red - in opposite directions - as much as 30% of the time. SEE DIAGRAMS.

Possible Complementarity and Conflict between Monetary and

Macroprudential policies (after Beau, Clerc and Mojon (2012))

Expected Inflation Expected Inflation Expected Inflation

Over target Near target Under target

Finance overheatingComplementary Independent Conflicting

Finance in normal temperature range Independent Independent Independent

Finance too cool Conflicting Independent Complementary

Change in the repo against SRISK: 2003-17

-2

-1.5

-1

-0.5

0

0.5

1

0 5 10 15 20 25

Ch

ange

in t

he

re

po

(p

erc

en

tage

po

ints

)

SRISK

Mean SRISK: June 2000 - October 2017

Feb 2009

Apr 2009

May 2009

Mar 2009

The financial and business cycles in South Africa

Macropru Instruments: real estate measures, 1

• We turn now to explore the main weapons in the Macropru armoury, beginning with real estate measures.

• Unlike equities and bonds, real estate is still very largely a non-traded asset. Links between different national housing markets do sometimes exist – but may well be slow and very weak. Bursting any equity bubble in a relatively small country with free capital movements would probably be a task for the Fed and the ECB, not national central banks or finance ministries. But precisely because real estate markets are so poorly integrated internationally, they should be of direct interest, above all, to national macropru authorities.

• There are ceilings on loan to value ratios (LTV) and loan to income ratios (LTI), and on mortgage repayment periods (RP). Their advantages are threefold: (i) the simplicity and ease of implementation and communication; (ii) the fact that the US housing boom of 2002-6, like previous episodes there and elsewhere, coincided with generous ceilings; and (iii) the tendency for high LTV and LTI mortgages to sour first and most.


• Yet there are snags. Ceilings are crude, arbitrary thresholds. You can’t say there are magic numbers that divide safe from dangerous lending. Financial stability risks will presumably go up with the value of these ratios – the relationship might well be non-linear, but should be continuous. So why not find a way of permitting and taxing high LTV / LTI mortgages (or removing fiscal subsidies), rather than seeking to ban them? Furthermore, relaxing these ratios is at best only permissive, and may work very slowly. Interestingly, Sing (2017) notes that some countries’ LTV limits have the status of recommendations, though most are binding maxima, with few exemptions (Romania softens them for some first time buyers).

• Worse, anticipation of changes in these ceilings will tend to destabilize mortgage provision. Borrowers and lenders will go all out to beat predicted deadlines for increases. This is in sharp contrast to the way monetary policy is normally held to work – agents’ knowledge of the central bank’s reaction function helps to do the central bank’s work for it.


• And perhaps saddest of all, the main impact of tighter ratios will fall on thoseyoung couples with modest incomes who just happen to be scrabbling to meet thedeposit on a dwelling at the moment they go up. These ceilings do not greatlyimpress on the justice criterion.

• This said, the snags do not justify burying such instruments. There is enoughevidence of large credit-fuelled (as well as credit-generating) jumps in real estateprices, and of consequent stress in the banking system, to keep them in thearmoury for the time being – faute de mieux, at least.


• Should there be a ceiling for RP? Here the case is much stronger than for LTV andLTI. An interest-only mortgage is equivalent to an RP of infinity in the simpleststeady state (ss); and out of ss, plus a big gamble attached, on how (nominal)house price have evolved by the unknown date of the occupants’ next move. Thisis pure helotry, compounded with disagreeable insurance features. It cries out fora ban.

• More generally, the binary distinction between tenancy and ownership, inherent instandard mortgages, seems archaic and wholly avoidable. Why should delinquentsbe liable for sudden dispossession and eviction, particularly when this follows arise (possibly unpredictable) in real or nominal interest rates? Why are the tilt, andthe frontloading of real amortization burdens, that may reflect inflationexpectations, allowed to deprive stressed borrowers of at least some share in theownership of their dwelling?


• In some jurisdictions (Hong Kong, Singapore, the UK) housing transactions taxes(such as stamp duty) are employed as macropru instruments. Ease of collection istheir main attraction. Like LTV / LTI ceilings, their anticipation could be adestabilizer: transactions will hot up before stamp duty is expected to jump.

• Furthermore, large stamp duty rates will deter labour mobility. They may imposesubtle but substantial efficiency costs, which relate, however, more to their levelthan to any change in rate. And they offer scope for redistribution. The ratestructure can be progressive. Yet redistribution is more away from those unluckyenough to have to move, than from high wealth tax payers as a group. And if oneaim of such measures is partly to reduce house prices faced by buyers, its effectswill be perverse.

Macropru instruments: capital requirements, 1• Capital requirements are the central macropru concept. These have evolved from

Basel I in 1988 towards Basel III, now being adopted (and refined) in manyeconomies. There is some variation in levels across countries. The centrepiece isthe Capital Adequacy Ratio (of Tier 1 plus 2 capital, to risk weighted assets (RWA)).The new elements, to be implemented in full by 2019-2020, include thecountercyclical capital buffer (CCCB). The CCCB may vary, rising when nationalcredit aggregates grow strongly and slipping when falling or flat. It may floatbetween 0 and 2.5% of RWA. It is designed to stabilize the credit/GDP ratio.

• There are also to be a minimum 3% leverage ratio (tier 1 capital to total assets),and minimum ratios for capital conservation, net stable funding and liquiditycoverage, which all banks should respect. As all terms in these ratios can wobble,banks will tend to operate, in the stochastic environment, above these minima, in(s,S) fashion.

• Regulators are right to argue that enforcement of these minimum ratios wouldhave prevented the GFC. Micropru supervisors are to monitor banks to ensurethat the minima are obeyed (occasionally subject to a secret, bank-specific add-onfor institutions thought to be sailing too close to the wind), while nationalmacropru policymakers will decide on setting the CCCB.

Macropru instruments: capital requirements, 2

• But questions abound. Are the minima set at the right levels? Is there a trade offbetween risk and macroeconomic variables such as trend growth? Is capitalmeasured correctly? Will transgressors be punished, and if so, by whom, andhow? Are minimum thresholds the wrong concept? Are they too complex?Should there be more focus on reserves?

• “Capital” is like an elephant – rather easier to recognize than define. Foraccountants, it is the excess of assets over liabilities (A-L). While most liabilities areunambiguous, valuing assets is notoriously difficult. Measures may well bebackward looking. For irreversibility reasons, banks may be too optimistic in badtimes. So the A-L gap is spongy. It is also not wholly immune from manipulation.

• The Basel definition of a Tier 1 bank’s capital depends partly – and justifiably - ontangible reserves. But it depends largely on its paid-up capital, which might byaccident be close to current market values, but will often not.


• Brownlees and Engle (2017) propose SRISK, a market-based measure of acompany’s contribution, in the form of a capital shortfall, to overall risk given asteep decline in macroeconomic conditions. It is driven by the market value ofequity, and pinpoints what happens to net assets measured this way in adversecircumstances. A firm is more “systemic” if it is riskier, more leveraged, and larger.Their model unveils Bear Stearns, Fannie Mae, Freddie Mac, Lehman and MorganStanley as the most vulnerable and systemically risky financial firms in the US - in2005, a full three years before Lehman collapsed.

• For us, the key idea here is that the current market value of a firm’s equity places areasonable – perhaps optimistic - guess about what it could hope to raise throughequity dilution in an emergency. The fact that equity prices can move around somuch shows that such values are volatile. But at least they are forward looking,and likely to be a more meaningful and up to date measure of capital than theaccountant’s formulae, or the reported level of paid up equity capital.


• It would be interesting to compare the evolution of an equity measure of capitalwith the orthodox alternative in practice, for both healthy and vulnerable financialfirms, and over a reasonable time span. We hope to do this ourselves in the caseof a number of South African banks.

• Conditional upon the outcome of such studies, we would recommend adoptingsomething like a weighted geometric mean of the traditional accounting measureof equity capital, and the current market value of shares. Perhaps one might startwith a weighting of 0.75 to 0.25, and then consider moving gradually to 0.5 and0.5. A benefit of a geometric mean is that it values capital more conservativelythan an arithmetic mean. The market value of equity component varies day by day.So it rings alarm bells at once, as it should, about a bank’s future when its marketshare price slumps.

• The volatility of market equity prices is an argument for a somewhat higher capitalrequirement base.

• CoCos have supporters and critics, and it may be too early to conclude what theyhave actually succeeded in doing to make the financial system safer. Avdjiev et al(2015) are judicious but not unfavourable to them. Like deposit insurance, theyshould serve to increase the financial resilience of banks facing stress.


• After Basel III has settled down, when capital requirements change in the form oftighter or lighter CCCB, market actors should come to predict them. In time, theCCCB offers the prospect of a macropru reaction function, not unlike a monetarypolicy Taylor Rule, which financial market participants can learn. Importantly, ifand when this stage is reached, anticipation of CCCB changes will cause banks torespond in advance – and in a stabilizing direction. This is in contrast to the LTV/LTIratio ceilings, where market participants’ predictions will tend to destabilize.

• There are other advantages: capital requirements affect all types of lending bybanks, not just those forms related to housing, so their impact should be broaderand less sector specific; and they may well work faster in spurring or restraininglending, than LTV ceiling changes could. Against this, LTV / LTI / RP maxima areeasy to understand and communicate. The general public will be mystified byCCCB announcements until they have learned more about them, and what theymay entail.


• In the longer run, banks might not be as “safe as houses”. They face four growingthreats. These are fines, e.g. for alleged money laundering or marketmanipulation; electronic fraud, that deters customers from banking on-line andlimits the chance of saving costs by selling branches; fintech, which is starting toerode their large profits from certain financial services; and, in many emergingeconomies and certain parts of Europe, some retreat towards “families” as moreknowledgeable credit providers, better able (than distant bank managerial staff) toassess the quality of loan applicants. Of these threats, the shadow bankingsystem – fintech – may prove to be the greatest challenge to their future health.Farhi and Tirole (2017, CEPR 12373) are eloquent on this.

• Supervisors are constrained by the possibility of cross-border regulatory arbitrage,and the difficulties of arranging multinational colleges to supervise large, complexmultinational banks. This task may become still more Herculean in the future. Andit reminds us that disorderly conditions in a foreign financial market may betransmitted almost instantaneously to others. Macropru cannot be applied innational silos.

Fiscal macropru: 2 suggestions

• Debt interest is subject to the recipient’s relevant income tax rate,and failure to index for inflation can make this tax quite onerouswhen inflation is (expected to be) rapid.

• But in most jurisdictions, corporation tax (CT) is levied on profits netof debt interest. Dividends are paid out of taxed profits, and usuallyattract some additional income tax.

• This means that most modest-inflation fiscal jurisdictions have apro-debt, anti-equity bias. Lower inflation exacerbates this.

• A pro-debt bias in taxation encourages leverage. Isn’t this an avoidable error that the tax authorities should rectify?

Fiscal macropru: 2 suggestions, contd

• As Knoll et al (AER 2017) show, OECD house prices have generally outpaced inflation for overhalf a century. Miles and Sefton (CEPR 12103, 2017) set up a Ramsey-type model with landinputs, where they tend to outpace incomes too. But one influence may result from a secondfiscal distortion. Save (partly) for Germany, the explicit yield from a tenant’s rent is taxed;save in Switzerland, the imputed rent of the owner occupant (OO) goes typically untaxed. In aworld where labour and capital are far more mobile than buildings or land, this contravenesRamsey efficiency. In addition, it distorts the allocation of housing towards (mainly well off)occupants and away from both housing for tenants, and other forms of capital. The fiscalprivilege for OO, often compounded by favourable CGT treatment, is capitalized in the formof needlessly high house prices. And collateral-hungry, risk-averse banks think mortgageloans are “as safe as houses”, rather than lending, say, to small businesses.

• Removing pro-debt and pro-OO tax biases should help tenants, curb undue risk taking, trim house prices, raise revenue, assist young mortgage applicants, help to reduce inequality within and across generations…..and, it appears, assist in reducing the risk of crises, so long as that is done very gradually.

Ending Remarks: ME

• Earlier we sketched an “9 Is Theory of Finance”. But now is the time toswitch from the nominative to the accusative of the first personsingular pronoun. That is ME.

• But for us, ME does not connote egocentricity. It is an acronym. Itstands for a unifying theme in much of this paper: MORE EQUITY.

• More equity (meaning common stocks) would soften the pro-gamblingkink inherent in debt contracts and banking with limited liability. Itwould result from removing pro-debt bias in taxation. It would providea different, market-related, forward looking method of valuing banks’capital. It would reinforce the disputed yet promising advantages ofCoCos. With a different meaning of equity, it might also help to makethe financial system less unfair.

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MACROPRUDENTIAL POLICY CHALLENGES: HOW BEST TO … Stability/FinStab_Research... · independent actions by people unable to coordinate could lead to a tragedy of the commons. And