The Gradual Transformation?The Incremental Dynamics of Macroprudential Regulation
Financial and economic crises, have, throughout history, resulted in ‘great transformations’ in regulatory orders, reconstituting permitted market activityand reconfiguring state society relations (Blyth, 2002, Polanyi, 1944, Gamble, 2009). Changes to dominant overarching economic ideas about how markets and the economy function, have been identified ascrucial drivers of such transformations (Blyth, 2002, Widmaier, Blyth and Seabrooke, 2007). What has often been neglected in accounts of such transformations is the question of time and temporal dynamics (Helleiner, 2010), as well hownew ideas that rise to prominence in crisis situations, interact with existing institutional environments (Bell, 2011). This article focuses on the transformatory potential of macroprudential ideas following the financial crash of 2008,examining how they are being mediated by existing institutional contexts andhow and why the task of building a new body of technical macroprudential knowledge is proceeding slowly. Macroprudential regulation (MPR)is a system wide top down approach to regulation and financial stability that seeks to ‘curb the credit cycle’ through countercyclical regulatory interventions, by directing and sometimes directly constraining the commercial activities of private institutions, in an effort to restrain extreme movements in asset prices.The macroprudential turn is therefore potentially transformatory in that it could signal a reversal of the primary regulatory trajectory in the financial sector over the last three decades, of allowing market actors more freedoms to price their own risk. However, the movement towards a form of macroprudential regulation has a distinctly uneven and incremental dynamic that means any macroprudential transformation will be a gradual processthat is likely to span a decade or more[1].
In their framing piece, the editors of this special sectionhave urged contributors to address and explain the issue of variability in financial regulatory change after the global financial crisis of 2008 (Moschella and Tsingou, 2013, this issue). But how should we conceive of and conceptualise ‘variability?’ This contribution argues that it is useful tothink along two dimensions and in terms of three orders of policy change. First, along a trajectoral or substantive dimension is the question of the substantive content of regulation - its objectives, the intellectual concepts and assumptions on which it is based, the instruments used to attain those objectives, and whether those changes constitute a dramatic transformational trajectory change in regulatory direction, imposing more constraints on market actors, or giving them greater freedoms. Second,along a temporal dimension, there isthe question of the length of time it takes for regulatory change to unfold, - whether it is quick and speedy, or whether it is a protracted lengthy process? This article argues that the emergence of macroprudential regulation, illustrates how regulatory change can simultaneously be dramatic and transformational, and gradual and incremental, along both dimensions at the same time, but to appreciate how this is so, we need to distinguish between types of regulatory change and pay close attention to the all important question of sequencing. It is suggested that a useful way of doing this is to use the three orders of policy change identified by Peter Hall. This enables us to distinguish between: the ideas and assumptions that inform and set the overarching objectives of policy in a given area (third order change), which in the past has signalled the start ofa process of great transformation in regulatory orders and state society relations, similar to those referred to by Blyth and Polanyi (Hall, 1993, Blyth, 2002,);the institutional arrangements and instruments used to achieve those objectives (second order change); and the precise settings of those instruments in quantitative or numerical terms (first order change) (Hall, 1993)[2].Applying this framework of temporal and substantive dimensions in terms of three orders of policy change enables us to illuminate the complex ways in which the macroprudential regulatory (MPR) turn that has materialised since 2008 is bothdramatic or (potentially) transformational and gradual and incremental at the same time. The article argues that a relatively radical and rapid intellectual change has given way to an incremental process of building macroprudential regulation in substantive terms.
The argument proceeds in four steps. First, it is argued that the movement in the direction of macroprudential thinking, which displaced the dominant efficient markets thesis in international regulatory networks from 2009 onwards as the dominant ‘interpretative frame’ for determining and driving regulatory practice, is an example of what Hall referred to as third order change, or a ‘gestalt flip’. A third order change, occurs when there is a radical change in the overarching terms of policy discourse, in the hierarchy of goals behind policy and in causal assumptions or accounts of how the world facing policy makers actually works. The movement from efficient market to macroprudential thinking represents an example of third order change according to these three criteria and in this sense it was intellectually radical (and potentially transformative) along the substantive dimension.
A second step, examines the time period and the sequencing this third order macroprudential ideational shift has entailed. This section argues thatthe rise of macroprudential ideas has constituted a form of dramatic third order change, without prior first and second order change, that took place in a time frame of a little over six months. This third order change was rapid and dramatic along the temporal dimension.
In a third step, it is argued, that we have now entered a phase of first and second order policy experimentation in the development of macroprudential policy, partly through a process of practical trial and error, but also as macroprudential technical knowledge evolves in relation to appropriate and workable first and second order policy changes. The example of the Basel III agreement is used to illustrate how various change agents and veto players are contesting macroprudential policydevelopment in ways, which are producing a series of compromises and diluting substantive content.
In a fourth step, the obstacles to developing MPR along the temporal dimension are briefly outlined. Developing countercyclical policies, a principal aim of MPR, is politically treacherous. The countercyclical objectives of macroprudential policy mean that many macroprudential policies are time dependent and will not become evident until a period of financial asset growth. Consequently, for the time being the true positions and powers of change agents and veto players in relation to first order policies and second order institutional arrangementsare partially concealed as the nature of contestation over macroprudential regulation continues to evolve in accordance with the rhythms of economic and credit cycles. This argument is illustrated with examples from the ongoing struggles between change agents and veto players over MPR in the United Kingdom (UK), which is resulting in slow paced gradual change along the temporal dimension.
Macroprudential as radical (transformative?) third order change: The substantive/ trajectoral dimension
Peter Hall used the notion ofthird order change to denote radical change in the overarching terms of policy discourse, in the hierarchy of goals behind policy (Hall, 1993, p.279) and in causal assumptions or accounts of how the world facing policy makers actually works (Hall, 1993, p.280). Hall associated this kind of change with a Kuhnian ‘paradigm shift’ (Kuhn, 1996). Thomas Kuhn famously compared scientific paradigms to a Gestalt or aninterpretative framework of terminology and assumptions, which are influential precisely because so much of them aretaken for granted and resistant to scrutiny. From time to time, the policy and regulatory process Hall argued, is characterized by a shift from one policy frame to another, - third order change. Kuhn referred to this process of moving from one paradigm to another as a Gestalt flip, when underlying assumptions about aspects of the world are reversed and overturned and replaced with a different, or diametrically opposed set of assumptions about how things are actually constituted. Due to Hall’s seminal writings therefore, third order change has become associated with the very definition of radical public policy change, associated with a disjunctive process, involving periodic discontinuities that in turn change or transform regulatory orders (Hall, 1993, p.279).
Prior to the financial crash of 2008, a specific Gestalt or interpretative frame based on the efficient markets hypothesis (EMH)had come to dominate the world of financial regulation, evident in both international agreements such as Basel II and in national regulatory practice (Turner, 2011). Regulatory practice was informed by Eugene Fama’s efficient markets position that liquid financial markets were characterized by the efficient processing of all available information, which in turn would make the actual price of a security a good estimation of its intrinsic value (Fama, 1970). Simplified versions of the efficient markets position came to dominate in leading central banks, regulatory agencies and in the risk management departments of large banks, to such an extent this position became part of a wider ‘institutional DNA’ (Turner, 2011, p.29). This simplified version of efficient markets and equilibrium theory saw market completion as the cure to most problems and mathematical sophistication as the key to effective risk management.
The risk management departments of large banks and their investment strategies were driven by Value at Risk’ (VaR) models and techniques. VaR techniques assume that one can infer the probability distribution of future potential movements of market prices from the observations of movements over the recent past. Market prices were assumed to be driven by the rational interaction of multiple independent agents and market risk was therefore mathematically modelable. Greater transparency, more disclosure and more effective risk management by financial firms based on market prices became the cornerstones for theregulation of ‘efficient markets’. The Basel II agreement for example established a reliance on internal risk management systems based on the state of the art VaRmodels of big banks. Supervisors engaged in assessments of these models, effectively asking institutions and their managers what they did, resulting in a focus on process or IT capacity, rather than results or risk capacity (Tsingou, 2008, Warwick Commission, 2009). VaR risk management models operated through daily price sensitive risk limits that required banks to reduce exposure when the probability of losses increased as a result of falling prices. The efficient markets position thus placed so much confidence in market processes and prices, it put those prices at the very centre of regulatory practice, reflecting a basic norm of optimization (Eatwell, 2009, Simon, 2010).
Macroprudential concepts however, refute not only the efficient markets position, but also according to one macroprudential pioneer,‘the rational expectations foundations of both new classical and new Keynesian perspectives’(White, 2009, pp.16-17). Four constituent concepts provide the intellectual underpinning for MPR. In this regard, macroprudential thinking draws on the notion of ‘fallacy of composition’ (with its Keynesian origins) – recognizing that individual incentives and the courses of action that flow from these do not necessarily result in desirable aggregate or systemic outcomes (Borio, 2011, Crockett, 2000). Similarly, reflecting Minskian roots, macroprudential thinking recognizes that prices in financial markets can be driven to extremes by a combination of: procyclicality, when the calculation of risk follows prices, so that the supply of credit fuelling investment is most plentiful when least needed (when asset prices are rising) and least plentiful when most needed (when asset prices are falling), driving asset values to extremes in both directions (Borio, Furfine and Lowe, 2001, Borio and White, 2004, White, 2006[3], BIS 2006, Minsky, 1977); and herding (reflecting a link to Keynes), where individuals adopt behaviours close to the overall mean, deferring to the judgements of others, behaving in a non rational, or short term fashion, due to the chemistry of the human brain and the propensities of the limbic system (Haldane, 2010, 2011). A final macroprudential concept focuses attention on network externalities and complex systems, when small events can generate all kinds of systemic dislocations due to the complex and unintended interactions that ensue in complex systems (Haldane, 2010a, Haldane and May, 2011).Analysis of this kind provides a powerful rationale to move the perimeter of regulation to cover shadow banking, but also to modularise or separate financial activities, through Glass-Stegall type legislation, to tax and even prohibit certain financial activities and transactions, because their social costs in terms of lost output can exceed any economic value they generate (Haldane, 2010, Turner, 2011, Tucker, 2010.)
As will be explained in the next section of this contribution, a very broad macroprudential third order consensus came to dominate in regulatory policy making circles in a relatively short period of time following the peak of the financial crisis in 2008, and the desirability and the need for some variant of a macroprudential approach to regulation has barely been contested. In substantive terms, or along the trajectoral dimension, the acceptance and embrace of macroprudential thinking is about as clear an example of third order change as one could hope to find. For Paul Tucker, Deputy Governor for financial stability at the Bank of England, the move from “a default assumption that core markets are more or less efficient most of the time,” (- the efficient markets position), to, “thinking of markets as inefficient, riddled with preferred habitats, imperfect arbitrage, herding and inhabited by agents with less than idealized rationality,” (the macroprudential position,) constitutes a ‘gestalt flip’ (Tucker, 2011, pp.3-4).The dominant assumption informing financial regulation is no longer that financial markets are efficient most of the time, but that they are characterised by myopia, procyclical patterns and herd behaviour, representing a diametrically opposed set of assumptions about how the financial world actually operates. At the same time, the movement from a microprudential focus solely on the safety and soundness of individual institutions, to viewing risk as a systemic, interconnected and endogenous property that requires a macroprudential regulatory top down focus, represents a substantial change in the hierarchy of policy goals. In Hall’s own terms therefore, the movement from an efficient markets consensus to a macroprudential consensus can be viewed as an example of third order change, precisely because there is a new macroprudential policy discourse and lexicon (a new gestalt), a change in the hierarchy of goals behind policy (from micro to macro) (Hall, 1993, p.279) and a change in causal assumptions or accounts of how the world facing policy makers actually works (Hall, 1993, p.280).
As a consequence of the macroprudential ideational shift policy makers’ cognitive filter has switched to a different setting. Policy makers are now using various combinations of the four key constituent concepts of fallacy of composition,procyclicality, herding, and complex externalities to inform and guide regulatory initiatives and practice. Consequently, a whole range of policy proposals can now be placed on the table and seriously discussed, that were previously out of reach. These include: countercyclical capital requirements; dynamic loan loss provisioning; countercyclical liquidity requirements; administrative caps on aggregate lending; reserve requirements; limits on leverage in asset purchases; loan to value ratios for mortgages; loan to income ratios; minimum margins on secured lending; transaction taxes; constraints on currency mismatches; capital controls; and host country regulation (Elliot, 2011).The third order macroprudential shift, therefore represents a potential trajectory change in financial regulation. After three decades of entrusting more and more autonomy to private actors to price and mange their own risk, that trajectory,is potentially, at least, reversed. Macroprudential conceptspotentially empower regulatorsby providing them with the intellectual equipment to set limits to market activities, reducing the scale and restricting the scope of financial transacting (Turner, 2011). Political contests played out over time will determine if this results in a reformulation of the powers, strategies and hierarchies of the regulatory state, extending beyond audit and surveillance (Moran, 2003,) towards much more interventionist forms of command regulation and system wide countercyclical management, constituting a great regulatory transformation, driven third order ideational change[4]. Third order change in a macroprudential direction is intellectually radical, at least in relation to what has gone before, as the four key macroprudential concepts provide a multifaceted challenge to the key claims of the efficient markets perspective.Fallacy of composition challenges the notion that the rational incentives of individual actors are sufficient to generate financial stability. Procyclicality raises the prospect that financial market prices are prone to extreme swings rather than usually being correct. Herding challenges the notion that individuals have the capacity and inclination to rationally evaluate all information, while complex systems analysis indicates that complex innovative financial systems can be a cause of systemic instability and fragility rather than enhancing durability, as per the market completion hypothesis.
Macroprudential as sudden and dramatic third order change: The temporal dimension
Applying Hall’s three orders of change framework, (originally developed on the basis of a case study of British macroeconomic policy in the 1970s), to financial regulation,does help to illuminate some of the dynamics at work in efforts to develop macroprudential regulation. The events of 2007-08 were dramatic as asset values collapsed, liquidity dried up, credit markets froze, interbank lending markets ground to a halt, several financial institutions became insolvent and many others required public financial support of various descriptions to continue trading. Rather than the progressive accumulation of anomalies as in the case of the Keynesian paradigm in Hall’s original case, a much more dramatic financial explosion resulted in the rapid collapse of the efficient markets perspective.For example, an early centre piece international policy document responding to signs of distress in securities and derivatives markets, - a report by the Financial Stability Forum (FSF 2008), re-iterated ‘the familiar trilogy’ (Eatwell, 2009), of‘greater transparency, more disclosure and more effective risk management’ by banks and investment funds (FSF, 2008). However, exactly one year later the Horsham G20 communiqué was openly advocating counter cyclical capital buffers and policies designed to ‘mitigate the procyclicality’ of the financial system (G20, 2009). Macroprudential thinking critiqued the prior efficient markets orthodox and its overreliance on VaR models, asserting that such an approach was a cause of the crisis, that had further ‘hard wired’ procyclicality into the financial system (FSA, 2009).In a little over six months, macroprudential ideas moved from relative obscurity in certain enclaves of the Bank for International Settlements (BIS), to the centre of the policy agenda, dominating and driving the post crisis financial reform debate, in the international community of central bankers, displacing the previous efficient markets orthodoxyand acting as the foundational premises shaping many of the key proposals emerging from the Basel Committee on Banking Supervision (BCBS), the Financial Stability Board (FSB) and national central banks (Borio, 2011, Haldane, 2009, Tucker, 2011, Bernanke, 2011, Constancio, 2011, FSB/IMF/BIS, 2011, Baker 2012). As Claudio Borio of the BIS has pointed out,‘a decade ago the term macroprudential was barely used and there was little appetite amongst policy makers and regulators to even engage with the concept, let alone strengthen macroprudential regulation’ (Borio, 2009, p.32). “This swell of support [for macroprudential regulation] could not have been anticipated even as recently as a couple of years ago. The current financial crisis has been instrumental in underpinning it” (Borio, 2009, p.2)[5].It is possible to argue that macroprudentialists are overstating the extent and significance of the macroprudential ideational shift, in an effort to enhance their own policy role and to facilitate ‘technocratic control and mastery of financial markets’ (Erturk et al, 2011). However, this remains an open empirical question that depends on the development of macroprudential policy instruments over time. At the same time, conceptually and intellectually, macroprudential thinking is a radical break with the recent efficient markets past, and that this shift has also been surprisingly rapid.