It does not hurt at all

Tim Harford has a good piece on why Central banks need real-time decision makers. It is an idea worth discussing.

Tracy Alloway’s piece on central banks trying to exert pressure on big banks not to help dodgy credits raise money is a bit confusing. I could not understand the rationale behind her argument that central banks are wrong to focus on banks because the big corporate debt holdings are with the funds. Hasn’t that always been the case?

Don’t investment banks have a responsibility to price risk correctly? What is quite wrong with regulators leaning on banks against bringing assets with poor return-risk trade-off to the market? Isn’t that not what they did securities backed by sub-prime mortgages?

A Bloomberg story on this same topic had this to say:

For the first time, more than half of the junk-rated loans made in the U.S. during the fourth quarter and so far this year lacked standard protections for lenders such as limits on debt relative to cash flow, Bloomberg data show. Such so-called covenant-light loans amounted to a record $84 billion in the fourth quarter. That was followed by another $57 billion since December.

The exclusion of “meaningful maintenance covenants” is a sign that “prudent underwriting practices have deteriorated,” the Fed, OCC and Federal Deposit Insurance Corp. said in a March 21 statement accompanying the release of their underwriting guidelines. [Link]

I do not see anything unreasonable or fruitless in regulators leaning on banks to tighten the norms for underwriting and for bringing debt issues to the market. The said statement was released nearly a year ago!

In fact, Tracy Alloway’s piece on the first day of the New Year was a powerful reason for regulators to intervene. It had excellent charts on overheating and irrational exuberance in credit markets.

Of course, it should not come as a surprise that the Federal Reserve sees nothing and hears nothing:

Murphy: “The reason I ask is would you be willing and open to pushing for policies to prevent another catastrophe, if it means the slowing or deflating an asset Bubble? And to sort of follow-up to that, are you seeing any Bubbles out there now or anything you’re concerned about?”

Yellen: “Nothing is more important than avoiding another financial crisis like the one that we just lived through. So, it’s an immensely high priority for the Federal Reserve to do what we can to identify threats to financial stability. One approach that we’re putting in place in part through our Dodd-Frank rulemakings is simply to build a financial system that is much more resilient to shocks. The amount of capital in the largest banking organizations is doubled. We do have a safer and sounder system, and that’s important. But detecting threats to financial stability, we are looking for those threats. I’d say my general assessment at this point is that I can’t see threats to financial stability that have built to the point of flashing orange or red… We don’t see a broad-based buildup, for example, in leverage or very rapid Credit growth. Asset prices generally do not appear to be out of line with traditional metrics. But this is something we’re looking at very, very carefully.” [Link]

It is only fair to leave the last word to some one who said something sensible on this:

“Jawboning rarely works if there’s money to be made,” said Mark Calabria, director of financial regulation studies at the Washington-based Cato Institute, a research group that espouses limited government. “History doesn’t repeat itself but sometimes it rhymes — I certainly have those concerns.”

Tarullo, in his speech last month, said central bankers must preserve the option of using interest rates to lean against dangerous financial bubbles. They may have to do that, said Cato’s Calabria.

“It’s all well and good for the regulators to say ‘You need to be aware of this risk,’” he said. “You also have to be aware that interest-rate environments create such strong incentives to do some things.”

“I’m a believer you have to do this monetary wise.” [Link]

He is spot-on. Macro-prudential measures fool no one when monetary policy is sending a different signal for risk-taking. Policy-makers would only be fooling themselves. But, not using regulatory tools too would take us to the third best world.

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