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CommentAugust 26 2014

Welcome to the great macroprudential experiment

Until a countercyclical buffer has been deployed through an entire cycle, we have no idea how effective it will be. 
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Since the financial crisis, the UK has acquired a taste for being the world’s regulatory trailblazer, introducing the terms living wills and ring-fencing to the financial lexicon. The Bank of England’s newest bright idea is a time-varying leverage ratio. The leverage capital ratio would be increased during a boom to force banks to store up capital and ease off lending, and decreased during a downturn to minimise the impact of deleveraging.

The countercyclical capital buffer has been discussed ever since 2008, but the Bank of England is the first regulator to take the plunge and propose a method for its implementation. Until a countercyclical buffer has been deployed through an entire cycle, the reality is that we have no idea how effective it will be. One former senior executive from the UK prudential regulator believes a variable leverage ratio may constrain the size of a financial bubble on the upside, but do little to cushion the economy on the downside. The tendency for a flight to quality in wholesale markets during a downturn would discourage banks from running down their leverage ratio, even if regulators permitted it.

The thorniest problem is being able to analyse a credit cycle with enough accuracy to pull the policy levers at the right time. Fearing an overheating housing market, the Bank of Israel introduced countercyclical restrictions on mortgage borrowing from 2010 onward. In one of his final interviews as Bank of Israel governor last year, Stanley Fischer told The Banker that the Israeli regulator should probably have introduced these measures earlier and more vigorously.

Consequently, macroprudential buffers and levers may do little to convince the sceptics – seemingly led by the Bank of England’s chief economist, Andrew Haldane, and the US Federal Reserve’s regulatory supremo, Daniel Tarullo – who fear post-crisis regulation is just too complicated to be manageable for banks or regulators. They argue that higher and simpler capital requirements throughout the cycle are a better guarantee against systemic risk. As US academic Charles Calomiris succinctly suggests, it may be more use to prevent your friend from getting drunk in the first place than to offer them a strong cup of coffee when they are already unable to stay on their feet.

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Read more about:  Analysis & opinion , Comment , Western Europe , UK