Time Consistency in Bank Regulation
By Arnold Kling
By definition, the next period of financial excess will appear to have recent history on its side. Asset prices will have been rising, and whatever new financial instrument that comes along will look as if it is safe. “When things are going well,” Paul A. Volcker, the former Fed chairman, says, “it’s very hard to conduct a disciplined regulation, because everyone’s against you.” Sure enough, both Bernanke and Geithner, along with dozens of other regulators, overlooked many signs of excess over the past decade.
The essence of Leonhardt’s article is a sympathetic portrayal of Treasury Secretary Geithner.
He warned that periods of calm often led to unanticipated crises and that once confidence started to slip, it could quickly vanish. Intellectually, he understood how things could go wrong.
What he missed, however, was the fact that things were going wrong in some of the very institutions he was overseeing. “Financial innovation has improved the capacity to measure and manage risk,” Geithner said in a speech at a Fed conference in Georgia in May 2007. Large firms, he added, “are generally stronger in terms of capital relative to risk.” Bernanke, who may have years as Fed chairman ahead of him, made statements that look even worse in retrospect.
The basic message of the article is that human nature makes regulation procyclical, meaning that regulators naturally loosen up in good times and tighten up after a crash. The challenge is to come up with a time-consistent regulatory regime.
One time-consistency problem is making credible commitments not to bail out failed banks. You promise not to bail them out, but when the crunch comes the incentive of policy makers is to bail them out. It is exactly like paying ransom to a kidnapper. To discourage kidnapping, you want to have a policy of never paying ransom. But when the kidnapping occurs, your incentive is to pay the ransom “this time,” because you cannot tolerate the consequences if you do not.
The other time-consistency problem, which Leonhardt’s article brings into focus, is that you need to make credible commitments to keep rules in place when times are good. So now, when we’ve just had a crash and nobody is in a mood to take risks, it may be relatively easy to enact regulations that limit risk-taking. But as time moves forward and banks become willing to extend credit more readily and undertake innovative financing methods, the commitment to today’s regulatory regime is going to break down.