Afternoon Must-Read: Anil Kashyap et al.: Making Macroprudential Regulation Operational

Anil Kashyap et al.: Making macroprudential regulation operational: “Do the extant workhorse models used in policy analysis…

…support macroprudential and macrofinancial policies?… A new macroprudential model that stresses the special role played by banks…. Three theoretical channels through which intermediaries can improve welfare… extending credit to certain types of borrowers (e.g. Diamond 1984)… improving risk-sharing… creating liquid claims that are backed by illiquid assets (Diamond and Dybvig 1983)…. It is imperative to start with a general model where the financial system plays all three of these roles…. Regulation to fix potential runs, such as proposals for narrow banking (e.g. Cochrane 2014), also appears to be especially appealing. But if the fragility that creates the possibility of runs is not valuable on its own, of course, eliminating it would be desirable! The more challenging question is what happens if there is a fundamental underlying reason why maturity mismatches create value…. Intermediaries should operate in an environment where the savers who use them are forward looking, and the prices the intermediaries face adjust (endogenously) to the regulatory environment…. We are unaware of any existing models that satisfy these two principles. So, in Kashyap et al. (2014b), we have constructed one….

Savers can buy equity in a banking sector and save via deposits… banks choose to invest in safe assets or to fund entrepreneurs who have risky projects… banks and the entrepreneurs face limited liability… a probability of a run… governed by the banks’ leverage and mix of safe and risky assets…. The banks in this world not only offer liquidity insurance with their deposits, but they offer savers a better alternative to making direct loans to entrepreneurs…. This model is that it can be used to explore how capital regulation, liquidity regulation, deposit insurance, loan to value limits, and dividend taxes alter allocations and change the degree of run-risk and total risk-taking…. It is not correct to conclude that combining any two tools is necessarily enough to correct the two externalities in the model… interactions among the regulations are sufficiently subtle that it would be hard to guess which combinations prove to be optimal…. Finally, coming up with regulations that simultaneously eliminate runs and shrink total lending (and risk-taking) is hard… the usual interventions that make runs less likely either create opportunities for banks to raise more funds or take more risk, or so severely restrict the savers, banks or borrowers that one of them is made much worse-off. We hope that these ideas will lead others to move away from small perturbations of existing DSGE models and instead consider much more fundamental changes…