Charles A.E. Goodhart
Charles A.E. Goodhart
Anil K. Kashyap, Richard Berner and Charles A.E. Goodhart
Most treatments of financial regulation worry about threats to the banking system and the economy from defaults or credit crunches. This paper argues that the recent crisis points to fire sales through capital markets as another source of financial and economic instability. Accounting for fire sales implies several changes to the standard approach. First, if there are three channels of instability, then three regulatory tools are needed to deliver stability. Second, if only a single capital tool and a single liquidity tool are available, then there is a risk that using them pushes activity into the shadow banking system. Third, liquidity requirements on the asset side of bank balance sheets are conceptually different from liquidity requirements on the liability side. The paper starts with a review of the recent theoretical work on fire sales that form the building blocks for a next generation of models of the financial system. A summary of some evidence suggesting that fire sales were present in the crisis is offered. Next, the paper outlines a general equilibrium framework that can be used to think about a financial system in which default, credit crunches, and fire sales are all possible. The paper concludes with a discussion of the regulatory options and some speculation on how such a framework could be extended.
Charles A.E. Goodhart and Dimitrios P. Tsomocos
International monetary relationships have been under strain in recent years. This is largely because adjustment mechanisms are asymmetric; the IMF has no means of putting pressure on countries with large current account surpluses to adjust. But such countries’ accompanying capital account outflows have often had disappointing returns. So, we propose a method to impose symmetric constraints on the net capital flows both of deficit and surplus countries.
Charles A.E. Goodhart, Anil K. Kashyap, Dimitrios P. Tsomocos and Alexandros P. Vardoulakis
This paper explores how different types of financial regulation could combat many of the phenomena that were observed in the financial crisis of 2007 to 2009. The primary contribution is the introduction of a model that includes both a banking system and a “shadow banking system” that each help households finance their expenditures. Households sometimes choose to default on their loans, and when they do this triggers forced selling by the shadow banks. Because the forced selling comes when net worth of potential buyers is low, the ensuing price dynamics can be described as a fire sale. The proposed framework can assess five different policy options that officials have advocated for combating defaults, credit crunches and fire sales, namely: limits on loan to value ratios, capital requirements for banks, liquidity coverage ratios for banks, dynamic loan loss provisioning for banks, and margin requirements on repurchase agreements used by shadow banks. The paper aims to develop some general intuition about the interactions between the tools and to determine whether they act as complements and substitutes.
Charles A.E. Goodhart, Anil K. Kashyap and Alexandros P. Vardoulakis
In this companion paper to Goodhart et al. (2012), we explore the interactions of various types of financial regulation. We find that regulations that control fire-sale risk are critical for delivering financial stability and improving the welfare of savers and borrowers. We describe the combinations of capital regulations, margin requirements, liquidity regulation, and dynamic provisioning that are most effective in this respect. A policy featuring margin requirements together with countercyclical capital requirements delivers equal or better outcomes for the economy than does an unregulated financial system. But it is easy to produce combinations of regulation that look sensible but, when combined, have adverse effects on the economy
Sudipto Bhattacharya, Charles A.E. Goodhart, Dimitrios P. Tsomocos and Alexandros P. Vardoulakis
The worst and longest depressions have tended to occur after periods of prolonged, and reasonably stable, prosperity. This results in part from agents rationally updating their expectations during good times and hence becoming more optimistic about future economic prospects. Investors then increase their leverage and shift their portfolios toward projects that would previously have been considered too risky. So, when a downturn does eventually occur, the financial crisis and the extent of default become more severe. Whereas a general appreciation of this syndrome dates back to Minsky (1992) and even beyond, to Irving Fisher (1933), we model it formally. In addition, endogenous default introduces a pecuniary externality since investors do not factor in the impact of their decision to take risk and default on the borrowing cost. We explore the relative advantages of alternative regulations in reducing financial fragility and suggest a novel criterion for improvement of aggregate welfare.
Charles A.E. Goodhart, M. Udara Peiris and Dimitrios P. Tsomocos
We study a monetary economy with two large open economies displaying net real and financial flows. If default on cross-border loans is possible, taxing financial flows can reduce its negative consequences. In doing so it can improve welfare unilaterally, in some cases in a Pareto sense, via altering the terms of trade and reducing the costs of such default.