Spring 2019 Dean's Circle Research Brief

RESEARCH BRIEF

D

SPRING 2019

D MIT Sloan’s Dean’s Circle donors share an important quality: they are driven to make an impact. In grateful recognition of your generosity, I am proud to share some of our latest faculty research that—like you—has the potential to make a significant impact in the world.

In the following pages, you will find Kristin Forbes’s January 2019 research paper, Macroprudential Policy: What We’ve Learned, Don’t Know and Need to Do, which is set to appear in the American Economic Review later this year. As you will read, Forbes argues that recent efforts to strengthen the global financial system may actually be paving the way for another financial crisis. Preceding the paper is a brief article which summarizes some of this research.

If you would like to learn more about the work MIT Sloan faculty and alumni are doing, be sure to attend the MIT Sloan Global Women’s Conference in NYC on October 3rd. This day-long event will be followed by an exclusive Dean’s Circle reception for you to further engage with the faculty speakers, Dean Schmittlein, and other dedicated Dean’s Circle donors.

I also encourage you to attend the Boston Dean’s Circle Reception on Friday, June 7th at 6:30 p.m. at the InterContinental Hotel in Boston. Held on Friday evening of Reunion Weekend, this is a highly-anticipated, annual event and is free for all Dean’s Circle donors, including non-reunion year donors. We hope you will join the celebration!

As these conferences and research publications illustrate, your Dean’s Circle dollars are integral to continuing the work we do here at MIT Sloan. I hope you enjoy experiencing this ‘Dean’s Circle difference’ firsthand through this research brief, and I look forward to seeing you at a Dean’s Circle gathering in the future.

Until then,

Wendy Connors Senior Director of Development

KRISTIN FORBES Kristin Forbes is the Jerome and Dorothy Lemelson Professor of Management and Global Economics at MIT’s Sloan School of Management. She has regularly rotated between academia and senior policy positions. From 2014-2017 she was an External Member of the Monetary Policy Committee for the Bank of England. From 2003 to 2005 Forbes served as a Member of the White House’s Council of Economic Advisers and from 2001-2002 she was a Deputy Assistant Secretary of Quantitative Policy Analysis, Latin American and Caribbean Nations in the U.S. Treasury Department. She also was a Member of the Governor’s Council of Economic Advisers for the State of Massachusetts from 2009-2014.

Forbes was honored as one of the top 25 economists under the age of 45 who are “shaping how we think about the global economy” (by Finance & Development, 2014). She was also named as a “Young Global Leader” as part of the World Economic Forum at Davos. She is currently a research associate at the NBER and CEPR and a member of the Bellagio Group and Council on Foreign Relations.

Forbes’ academic research addresses policy-related questions in international macroeconomics. Recent projects include work on exchange rate pass-through, capital flows, macroprudential regulation, financial crises, contagion, current account imbalances, capital controls, inflation dynamics, foreign investment, and tax holidays. Forbes has chaired research projects on the Global Financial Crisis, Global Linkages and International Financial Contagion. She has won numerous teaching awards and teaches one of the most popular classes at MIT’s Sloan School. Before joining MIT, Forbes worked at the World Bank and Morgan Stanley. She received her PhD in Economics from MIT and graduated summa cum laude with highest honors from Williams College.

In her free time, Forbes enjoys traveling, hiking, and scaling tall peaks (including Mt. Blanc and the Grand Teton). She ran the Boston Marathon in 2014 and the London Marathon in 2016.

Global Economics and Management The Global Economics and Management group (GEM) is an explicitly interdisciplinary group that includes faculty with backgrounds in economics, political science, sociology, finance, strategy, management and energy. The group’s research and teaching focuses on the global business environment through a range of disciplines and aims to increase understanding of the international economy and influence global economic policy for the better.

ARE WE PREPARED FOR THE NEXT FINANCIAL SHOCK?

by TRACY MAYOR

Changes to the global financial system aimed at building resilience may actually be sowing the seeds of the next crisis.

Measures taken to strengthen the global financial system after the 2008 financial crisis have been effective, but they may be opening up new vulnerabilities, research from MIT Sloan shows.

“We’ve made substantial progress in devising tools and regulations to build up capital cushions, support the credit supply, and boost liquidity,” says MIT Sloan professor of management Kristin Forbes in a paper to be published in the American Economic Review. “But many risks remain.”

Forbes cautions, “It’s not yet clear that these tools can live up to their promise of reducing systemic financial weaknesses and preventing a future shock — from wherever it emerges — from becoming another costly crisis.”

Our successes are likely not nearly enough to avoid another financial crisis.

Kristin Forbes | Professor

One of the causes of the 2008 crisis was an insufficient understanding of macroprudential risks — that is, vulnerabilities in the wider financial system by which shocks can spread and become amplified. Before the crisis, most countries relied on central banks for price stability and microprudential regulators for the security of individual banks. The subsequent collapse of the financial system underscored the inherent problems with that approach, Forbes writes.

In the aftermath of the meltdown, most countries established some type of macroprudential authority and adopted new policies and tools, including regulations designed to fortify bank balance sheets and support financial institutions. “These rules have made banks safer, but risks are still there — in some cases they’ve just migrated to other sectors,” says Forbes.

The non-bank institutions that make up the “shadow” financial system — including hedge funds, pension funds, insurance companies, securitization vehicles, money market funds, and mortgage funds — are typically outside the regulatory perimeter or subject to oversight by less-powerful bodies, which means they could wind up being a source of broader financial vulnerabilities, she writes.

1

Calibration matters Another issue, says Forbes, is how financial authorities calibrate new regulations. Very tight regulations often significantly reduce risks, but they could also harm economic growth. “Tighter regulations usually entail immediate costs — such as reducing a person’s access to credit to buy a home or start a company. Meanwhile, the benefits of tightening may not appear for years — or may be impossible to measure,” she says. “As a result, figuring out the right level of tightening is a politically tricky endeavor.”

More academic research is needed on macroprudential regulations, Forbes argues. In particular, the research ought to focus on better understanding how risks have shifted as investors and institutions find ways around the tighter regulations, as well as creative thinking about future risks.

“Macroprudential regulations today prioritize addressing the vulnerabilities behind the 2008 crisis. This makes sense, and there have been important steps forward,” she says. “But we simply don’t know whether changes in the global financial system — including those aimed at building bank resilience — are sowing the seeds of the next crisis.”

Article published online at http://mitsloan.mit.edu/ideas-made-to-matter/are-we-prepared-next-financial-shock.

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Formal invitation to follow. To register early, please email 2

Michele Emonds at memonds@mit.edu.

“Macroprudential Policy: What We Know, Don’t Know and Need to Do.” Forbes, Kristin J. American Economic Review: Papers and Proceedings. Forthcoming. (May 2019). Paper prepared for AEA Annual meetings held in Atlanta, GA in January 2019.

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Macroprudential Policy: What We’ve Learned, Don’t Know and Need to Do

BY Kristin J. Forbes* Forthcoming, American Economic Review, Papers and Proceedings, 2019 Abstract: Over the last decade, macroprudential policy has made important advances and become more widely used.

We have a better understanding of its goals and tools, and are accumulating evidence that it can be effective on its direct targets, albeit often with unintended leakages and spillovers. There has been less progress, however, in terms of understanding: the ramifications of these leakages and spillovers, the optimal calibration of various tools, and how to identify the next risks as the financial system evolves. A top priority is better understanding the new vulnerabilities developing as risks shift outside the perimeter of existing regulations. * MIT-Sloan School of Management, NBER and CEPR, MITSloan School, Room E62-416, 100 Main Street, Cambridge, MA 02142 (e-mail: kjforbes@mit.edu). Thanks to Thomas Philippon, Annette Vissing-Jorgensen and other participants at the ASSA annual meetings for helpful comments.

“best practice” macroeconomic framework now involves 3Ms: macroprudential policy, monetary

policy

and

microprudential

supervision. But is their sufficient progress?

During a discussion of the 2008 financial

Can macroprudential tools live up to their

crisis, the Queen of England asked, “Why did

promise of meaningfully reducing systemic

no one see it coming?” One recurring theme in

financial vulnerabilities? Can they prevent the

attempts to answer this question is an

next shock—from wherever it emerges—from

insufficient understanding of macroprudential

evolving into another costly crisis? If not, what

risks—of

more should be done?

vulnerabilities

in

the

broader

financial system and mechanisms by which

The

term

“macroprudential”

seems

shocks can spread and be amplified through the

straightforward (stability of the entire financial

system. The “best practice” macroeconomic

system), but quickly becomes complicated

framework in 2008, which relied on central

when constructing specific policies, applying

banks for price stability and microprudential

them, and assessing their effectiveness. It

regulators for the stability of individual

includes

institutions, was missing this crucial focus.

vulnerabilities. Even translating the goal of

Countries around the world have learned this lesson, however, and most have established

a

diverse

set

of

tools

and

financial stability to specific targets and policies is not straightforward.

some type of macroprudential authority and

As macroprudential policies have been

adopted an array of macroprudential tools. The

adopted more widely over the last decade,

1

however, we are beginning to accumulate evidence on their effectiveness, making this an opportune time to assess their successes and shortcomings. This paper explores what we have learned (Section I), what we don’t know (Section II), and what we need to do to make macroprudential policy more effective in the future (Section III).

I. What We’ve Learned The increased attention to macroprudential policy over the last decade has meaningfully improved our understanding of its goals, tools, effectiveness, and unintended consequences.

A. Goals and Tools 1

The discussion suggests that we have made

Unlike monetary policy—which can be

substantive progress in terms of understanding

succinctly summarized as focusing on one goal

the goals and developing a toolkit for

(such as 2% inflation) and accomplished

macroprudential policy. We are also beginning

through a small number of tools (such as

to accumulate evidence that many of these tools

adjusting an interest rate)—macroprudential

can successfully accomplish their specific

policy involves more amorphous goals and

goals, albeit often with unintended leakages

many more tools. It is even hard to assess if

and spillovers. There has been less progress,

macroprudential policy has been successful if

however, in terms of understanding: the

“success” is a crisis that never happened.

ramifications of these leakages and spillovers,

With these caveats, progress has been made

how to calibrate various tools, and how to

in defining three broad (and related) objectives

identify the next set of risks as the global

for macroprudential policy: (1) addressing

financial system evolves. In particular, there is

excessive credit expansion and building

more to do in terms of monitoring the new

resilience in the overall financial system; (2)

vulnerabilities that develop as individuals,

reducing key amplification mechanisms of

banks, and other firms adapt and shift risky

systemic risk; and (3) mitigating structural

exposures outside the regulatory perimeter.

vulnerabilities related to important institutions and markets. Macroprudential policy should improve the economy’s ability to withstand shocks and allow the financial system to function effectively under adverse conditions.

1

For progress on these goals and tools, see CGFS (2010), IMFFSB-BIS (2016), Cecchetti and Schoenholtz (2017) and Forbes (2018).

2

Progress has also been made developing a

attain the ultimate goals of building broader

macroprudential “toolkit” that includes: (1)

financial resilience and supporting economies

capital and reserve instruments; (2) liquidity

during downturns. This is more challenging,

instruments; (3) credit instruments; and (4)

and the initial evidence is mixed, but generally

structural institutions. Individual countries

supportive. 3

have adopted different combinations of these

regulations can support the supply of credit

tools, reflecting their history, institutions,

during downturns, crises, and/or recoveries.

political priorities, and vulnerabilities.

Martin and Philippon (2017) show how

B. Effectiveness As these macroprudential tools are being more widely used, a body of research is beginning to provide evidence on what does—

Several

macroprudential

papers

regulations

find

could

that

have

reduced unemployment during the 2008-12 recession in the Eurozone.

C. Unintended Consequences

and does not—work. 2 Although this literature

A final set of results emerging from this

is still in its infancy, and the observations and

literature is that macroprudential policies often

period for which to assess their impact is

have unintended leakages and spillovers. 4

limited, the evidence suggests that many

Leakages are shifts in lending or credit to other

macroprudential tools can influence their

institutions in the same country, while

immediate objective. For example, papers

spillovers are shifts to other countries. The

show that raising bank reserve requirements

evidence suggests these leakages and spillovers

reduces aggregate credit growth, and housing-

regularly occur and can be significant.

related policies restrain household credit

Two studies provide concrete examples.

growth. A smaller set of studies shows that

Aiyar et al. (2014) shows that increased capital

limits to foreign currency (FX) exposures

requirements on UK domestic banks causes

reduce bank borrowing and lending in FX.

foreign banks to increase their UK lending,

Several studies have a more ambitious goal,

with this “leakage” about one-third of the

of assessing whether macroprudential policies

contraction in lending by UK banks. Ahnert et

2 For evidence and cites, see Cerutti et al. (2015), Buch and Goldberg (2016), IMF-FSB-BIS (2016) and Forbes (2018).

3 Also see Cerutti et al. (2015), IMF-FSB-BIS (2016) and Forbes, Fratzscher and Straub (2015).

4 For evidence, see Avdjiev et al. (2016), Buch and Goldberg (2016), Agénor and da Silva (2017) and Forbes (2018).

3

al. (2018) shows that tighter regulations on FX

discussed

bank borrowing causes companies to increase

vulnerabilit

FX debt issuance, with this “leakage” about

Although

10% of the initial reduction on bank FX

magnitude

borrowing.

spillovers)

Studies

focusing

on

the

international

than the di

spillovers from macroprudential regulation

policies, it

also often find significant effects, but usually

context. Th

smaller in magnitude. For example, Buch and

meaningful

Goldberg (2016) finds that macroprudential

of the secto

tools can generate significant cross-border

consider A

bank credit spillovers, but the magnitudes are

tighter FX

usually moderate and sometimes insignificant.

leakage of

Forbes et al. (2017) finds larger spillovers in

increase in

global capital flows—but this may reflect its

to the reduc

focus on the UK, a major banking center.

equivalent,

II. What We Don’t Know Despite these advances in our understanding of macroprudential policy, there is still much that we do not know. I will focus on three areas crucial for these regulations to meaningfully bolster financial resilience: the new risks from the leakages and spillovers, appropriately calibrating the regulations, and targeting the next shock rather than focusing on the past.

A. Incorporating the Risks from Leakages and Spillovers An assessment of macroprudential policy should incorporate the leakages and spillovers

4

FX corpor

markets suc

meaningful

the purview

Even mo

correspond

broader fin

example ab

Are these e

their new c

solvent if th

If not, wi

systemic ris

FX risk u

critical sect

tions on FX to increase

discussed

above,

including

any

new

vulnerabilities introduced.

age� about

Although the evidence suggests that the

bank FX

magnitude of these leakages (and especially spillovers) tends to be meaningfully smaller

nternational

than the direct effects of the macroprudential

regulation

policies, it is important to put these results in

but usually

context. The unintended effects can still be

e, Buch and

meaningful when assessed relative to the size

oprudential

of the sector where the risks shift. For example,

ross-border

consider Ahnert et al. (2018), which shows

gnitudes are

tighter FX regulations on banks generate a

nsignificant.

leakage of “only� 10% (measured as the

pillovers in

increase in corporate FX debt issuance relative

y reflect its

to the reduction in bank FX borrowing). This is

center.

equivalent, however, to a 15%-20% increase in

w

derstanding

s still much

n three areas

eaningfully

w risks from

ppropriately

rgeting the

FX corporate debt issuance for emerging markets such as Brazil and Indonesia. This is a meaningful impact on a market that is not under the purview of macroprudential regulators.

Even more difficult to assess is what any corresponding shifting of risks implies for broader financial stability. Continuing with the example above, who holds this new FX debt?

Are these entities aware of the risks related to

the past.

their new currency exposure? Will they remain

m Leakages

If not, will their failure generate broader

ntial policy

d spillovers

solvent if there is a large currency movement? systemic risks? Although this reduction in bank FX risk undoubtedly builds resilience in a critical sector, this shifting of risks outside the

regulated sector may not only introduce new

tight these regulations should be to provide

vulnerabilities—but

less

sufficient protection during a downturn. Many

not monitored, and harder to

of these tools have only been widely used over

prepare for. If these new FX-related exposures

the past few years—a period of recovery—

are dispersed and diversified, there may be less

providing limited experience of how much

systemic

are

resilience they provide during a period of

financial

financial stress. Will the current levels of

interrelationships, they could amplify risks in

macroprudential regulations prove stringent

unexpected ways that are harder to address.

enough to provide the expected financial

understood,

risks

implications,

concentrated

and

but

feed

that

if into

are

they

B. Calibrating the Regulations A second issue about which we need to learn more is how to appropriately set and calibrate different regulations—especially given the inherent political challenges.

Macroprudential regulations have costs and benefits, and calibrating their levels to find the optimal balance is not straightforward. Very tight regulations on certain types of exposures would significantly reduce the risks related to those exposures, but could also significantly harm economic growth. If the economic slowdown was large enough, it could even increase the risks of financial instability in the future. Setting tighter regulations will also increase incentives for borrowers to shift outside the regulated sector, increasing the risks related to leakages and spillovers.

Aggravating this challenge of finding the optimal level at which to set macroprudential regulations is the limited experience of how

5

stability when the next downturn hits? Stress tests attempt to answer this question, but it is extremely difficult to model the various interactions. The only true test will come with the next downturn.

Moreover, even if we knew how to calibrate regulations optimally, there are challenging political hurdles. Tighter regulations usually entail immediate costs (such as reduced access to credit), while the benefits may not appear for years—or even be impossible to measure at all (i.e., a crisis avoided). Any macroprudential authority influenced by the political cycle would be tempted to adopt less stringent regulations.

Uncertainty

about

optimal

calibration only adds to this bias. Why would any politically sensitive authority adopt costly regulations if there is uncertainty about whether they are even necessary?

A clear example of how these challenges can bias macroprudential authorities to being “soft” is use of the counter-cyclical capital buffer

(CCyB). The CCyB is a macroprudential tool

(such as hedge funds, pension funds, insurance

that has widespread academic and policy

companies, securitization vehicles, money

support and a well-defined framework. It could

market funds, and mortgage funds). Most

cushion economies against “booms” as well as

macroprudential regulations focus on banks,

“busts”. Although many countries have a

leaving these “shadow” institutions outside the

framework in place to use the CCyB, as of 2017

regulatory perimeter or subject to oversight by

only about six countries have tightened it at all.

other bodies, which are usually less powerful,

None have tightened it or varied it as

adopt less stringent regulations, and are less

aggressively as suggested by basic calculations

focused on macroprudential risks. In fact, many

on its optimal use (i.e., Hanson et al., 2011).

of

C. The Source of the Next Shock A final concern about the current state of macroprudential policy is if it is sufficiently preparing for the next shock. Macroprudential regulations today prioritize addressing the vulnerabilities behind the 2008 crisis. This makes sense, and there has been meaningful progress, especially in requiring that the banks at the heart of the last crisis are better capitalized and less leveraged. But where will the next shock come from? Could changes in the global financial system—including those aimed at building bank resilience—be sowing the seeds of the next crisis?

One potential vulnerability is the “shadow” financial system—the range of non-bank institutions involved in financial transactions

5

See Forbes (2018) for evidence of this in Iceland. In 2016 pension funds in Iceland originated over half of new mortgages by value.

6

the

leakages

from

macroprudential

regulations are diverting financial flows to this shadow financial system.

Moreover, these “shadow” institutions could be a source of broader financial vulnerabilities.

For example, if tighter regulations on banks’ mortgage exposures cause consumers to shift to other sources of housing finance (such as pension funds)—then another key sector of the economy could become exposed to the housing market. 5 Or, as non-bank institutions take on the “leakage” of FX exposure that was previously held by banks, if these non-bank financers have bank loans and become insolvent after a large currency movement, the banks would still be negatively affected by FX movements.

As another example, consider recent shifts in cross-border capital flows, shifts that partly reflect tighter bank regulations. Gross cross-

border banking flows collapsed by over two-

importance

thirds between 2007 and 2017. Since cross-

combined with its more widespread use, has

border banking flows tend to be the most

undoubtedly helped improve the resilience of

volatile type of capital flow and played a key

financial systems.

role in the severity of the 2008 crisis, this has

of

macroprudential

policy,

These successes, however, are only a start,

of

and likely not nearly enough to avoid another

financial systems around the world to the types

financial crisis in the future. There are key

of shocks behind the 2008 crisis.

issues around macroprudential policy about

undoubtedly

increased

the

resilience

But what about the next set of shocks? As

which we do not have sufficient understanding,

international banking flows have declined,

such as on the new risks generated from the

portfolio debt flows now constitute a larger

leakages and spillovers, on how to calibrate the

share of gross global capital flows. Portfolio

different regulations (especially given political

debt flows can also be volatile, and along with

incentives), and on the potential risks to

cross-border debt flows, are key drivers of the

financial stability outside the mandates for

sudden “surges” and “stops” that correspond to

most macroprudential authorities.

periods of financial instability (Forbes and

On a more positive note, there are a number

Warnock, 2014). Portfolio debt flows could

of steps that economists and policymakers can

also be particularly vulnerable to the current

take to address these shortcomings.

Are

First, more academic research is needed on

macroprudential regulations nimble enough to

macroprudential regulations. This is not an

address these new types of vulnerabilities?

easy field to delve into. It requires learning a

changes

in

global

interest

rates.

substantial number of acronyms and technical

III. What We Need to Do

language—none of which is taught in graduate

This paper has highlighted a number of successes of macroprudential policy. There is a more coherent framing of its goals, a more developed toolkit of policies to target these goals, and an emerging body of evidence documenting that these tools can significantly affect their primary targets, albeit with unintended

7

consequences.

The

elevated

school. Nonetheless, it would be well worth the effort. Few academics have yet ventured into this area, and the rapid adoption of different regulations across countries over the last decade has provided a wealth of data and potential evidence. Careful research could have substantial impact on policy at the highest level and should be a priority for economists—

especially for a profession that was slow to see

especially those arising outside the purview of

the vulnerabilities that led to the 2008 crisis.

most regulators. Macroprudential regulations

A second area for progress is on designing

currently focus on where the last set of

institutions to support the optimal use of

vulnerabilities arose, especially in banks and

macroprudential

mortgage

policy.

Although

most

markets.

These

are

critically

countries have some type of committee or

important, but the next crisis could start in other

institution in charge of macroprudential

sectors. In fact, the success of existing

regulations, there is little consistency and “best

regulations in reducing the risks in banks could

practice” yet. 6 Tightening macroprudential

be

regulations can be politically challenging, as

vulnerabilities elsewhere, such as by shifting

the costs are immediate and apparent, while the

exposures to currency and liquidity risk to the

benefits are more amorphous and may not

corporate

appear for years. The CCyB example suggests

system—sectors about which regulators have

that regulations are not being sufficiently

less information and where entities may be less

tightened to provide the resilience that is hoped

prepared to handle surprises.

for. The optimal macroprudential authority

contributing

sector

to

the

and

build-up

shadow

of

financial

Macroprudential policy has made impressive

should be independent and somewhat insulated

progress

from the political cycle, while at the same time

probability of another crisis unfolding in the

maintaining a high degree of transparency and

banking

accountability, as macroprudential regulations

Macroprudential policy still has some way to

can affect consumers, firms, and the broader

go, however, to ensure that there is not another

economy.

show

crisis and economists are not asked again by a

Policy

future monarch: “Why did no one see it

Several

promise—such

as

frameworks the

Financial

Committee at the Bank of England—but careful analysis is needed of which frameworks are most effective and politically viable across the business cycle.

A final area where more progress is needed is creative thinking about future risks—and 6

See IMF-FSB-BIS (2016), Edge and Liang (2017), and Forbes (2018) for key issues.

8

coming?”

and

significantly

system

as

it

reduced did

in

the 2008.

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Macroprudential Policies: New Evidence.”

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