Wednesday, 24 June 2009

Micro and macro-prudential

Robert Peston has an interesting insight into the financial regulation debate today:
In other words, what's known as micro-prudential issues dovetail with macro-prudential issues. And if that's the case, it would make sense to put the central bank, the Bank of England, in charge of both. Or so the shadow chancellor believes.
Intriguing. Indeed, it's true that there is a direct causal link between micro and macro behaviour in the financial markets. There are two reasons for this. First, the trivial one that all macro outcomes are ultimately caused by individual decisions.

Second and more interestingly, one of the key influences on credit and asset markets is the appetite of individuals for risk. And a key factor in the stability of markets is whether these risk appetites are governed by rational preference theory and therefore have the ability to self-correct. In the long run everything (more or less) does correct itself, but an asset bubble and a financial crisis can easily erupt while we're waiting for the long run to come (I won't mention that old cliched Keynes quote - oops, I just did).

Both risk appetite and adherence to rational preferences are measurable at the individual level through techniques developed in behavioural economics. My proposal (here at VoxEU) is that the financial regulator designs an index to measure this, and samples it on a monthly basis as an input to macro-prudential decision making.

And this is where the substantive point arises in the current debate: whose job is it to do that? As Peston points out, micro regulation is currently the domain of the FSA - they are the ones dealing with banks' interactions with individual customers, and this is where the risk and rationality measurements would be made. But it is the macro-prudential regulator - the Bank of England, backed by the Treasury - who needs to make decisions based on the measurements.

Those decisions may have both macro consequences - interest rates or fiscal policy - and micro consequences - changes in how financial institutions communicate to their customers. The macro changes mainly affect risk appetite, while the micro changes can influence the customer's adherence to rational preferences. How do these regulators talk to each other and coordinate these changes? Who implements the decisions once they're made?

The Tories have one view of how this relationship should work; the FSA has another; Mervyn King a third; and the Treasury will be publishing its own version soon.

But the point is that a restructuring of the regulatory environment cannot work if it is just a shuffling of job titles. It must be accompanied by a new theoretical understanding of behavioural macroeconomics. Hints of this are emerging in the economics profession and in the regulation debate, but they are taking their time.

Update: For a different but very interesting view, look at comment #15 on Robert's article - written by David Chassels of Procession, it's a good summary from an auditor's point of view of how the financial crisis came about.

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