Tuesday, 4 September 2007

It's not just rates, stoopid

There were
some interesting remarks from James Hamilton at the FED Jackson Hole meeting. My favourite part is:

The instrument of monetary policy that we tend to think of first is the time path of short-term interest rates. It's natural to start there, because it's easy to quantify exactly what the Fed is doing.

But another instrument of monetary policy that I think needs to be discussed involves regulation and supervision of the financial system.

That certainly fits with the theme of this blog - that the rules of the game determine the dynamics you see, and you need to engineer the rule set carefully to get the right type of behaviour (and stop the wrong type, whatever right and wrong mean).

Naked Capitalism (where I picked up the report) talks about this in the context of the large complex financial institutions - the Bank of England's term for the largest most systemically important firms (of which it identifies 16).

This graph from the Bank's Financial Stability Review is quoted there:

What we see in the large is rising assets and (assuming asset quality remains roughly constant, which might well not be true) decreasing credit quality. Certainly leverage is increasing. Basel II is likely to make this worse if the results of the quantitative impact studies are to be believed, and the increasing prevalence of SIVs and conduits to get assets off balance sheet is not helping either. Stepping away from the details of risk sensitivity, the level playing field and so on, is the regulation of large complex financial institutions heading in the right direction if they are getting larger and their leverage is increasing?

The 16 LFCIs include Barclays, ABN AMRO and RBS, so if ABN is taken over by either of its two current suitors, the 16 will become 15. Are a smaller number of larger, more complex firms more or less systemically risky than a larger number of smaller, less well capitalised ones?

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