A thread summarizing my @WSJopinion argument for the Fed to increase the countercyclical capital buffer, requiring banks to hold more capital in good times. Is a powerful new tool that has not been used yet but should be. wsj.com/articles/the-f…
My conclusion: “Asking banks to lay more capital aside while the sun is still shining would strengthen their ability to withstand the next rainy day. It would lessen the risk of future bailouts. And... reduce the chances of another crisis in the first place.”
Background: the Fed effectively has three goals (maximum employment, price stability, and financial stability). And it mostly operates by varying one instrument with economic conditions (the interest rate). Hard to hit three goals with one instrument absent divine coincidence.
More background: bank regulators traditionally focused on safety and soundness of individual banks. But the way you regulate an individual bank also affects the macroeconomy and other banks, a spillover that was not taken into account.
Both of these are an argument for "macroprudential" regulation that takes the macroeconomic context/impact of regulation into account. aeaweb.org/articles?id=10…
Dodd-Frank says that the Fed should make banks hold extra capital in “times of economic expansion" & relax the requirement in the opposite case. 
Basel III also endorsed countercyclical capital buffers in Dec 2010. They have since been used by the UK, France, 8 other European countries, & other economies around the world. (As an aside, most of these have other macroprudential tools as well.) bis.org/bcbs/ccyb/
The US, however, has not acted and instead has kept the countercyclical capital buffer at zero. This contradicts a plain English reading of Dodd-Frank: we have had a lot of twitter debate about slack but I don’t think anyone would argue this is not a “time of economic expansion.”
The Fed instead defines the test for raising the countercyclical capital buffer more narrowly as “during periods of rising vulnerabilities in the financial system.” They rely in a wide set of indicators. federalreserve.gov/newsevents/pre…
Even the Fed’s narrower approach justifies an increase given valuations & other financial froth (a bigger concern than inflation right now). But am concerned that this narrower approach will miss most financial problems, as it has in the past. Better to rely on the macro data.
I outline the benefits of this approach in the oped: (1) reduce financial froth now; (2) give us a tool to lower capital requirements in the next downturn; and (3) make this tool more predictable by establishing a more predictable cadence for altering capital buffers.
Personally I believe the cost-benefit justifies higher capital standards more generally but whatever your view about them generally could still support higher in good times and lower in bad times. federalreserve.gov/econres/feds/f…
As an aside, the biggest downside of higher capital requirements in general—or even temporarily higher ones in booms—is shifting more financial activity to the less regulated shadow banking sector. Ideally would toughen regulation/supervision there as well.
This debate has not gotten much attention but several contributions including Brainard and Rosengren on the pro side, Liang on the not yet side, and Cochrane on the no side. federalreserve.gov/newsevents/spe… bostonfed.org/news-and-event… brookings.edu/wp-content/upl… wsj.com/articles/the-d…
The Fed will be deciding this fall. They act in a technocratic expert manner in monetary policy (which doesn’t mean they are always right) but can be overly influenced by the banking industry on the regulatory side. So a broader public debate on this issue would be welcome.
Beyond the immediate decision about whether to raise the countercyclical buffer, it would be good to have broader thinking on when to use macroprudential tools and how to give the Fed even more tools to deal with the financial sector. END THREAD
