Considerable attention has been devoted to the annual Federal Reserve gathering at Jackson Hole this Labor Day weekend. For a good summary see Brad de Long's post I Am Not at the Jackson Lake Lodge This Labor Day Weekend, James Hamilton on The Taylor Rule and the housing boom, and Greg Ip's report Two Heavyweights Weigh in on Greenspan’s Legacy
But another recent central bank gathering is worth mentioning. The Reserve Bank of Australia held their annual research conference late August, concentrating this year on a very timely topic, the structure and resilience of the financial system. While some attention has been given to the paper by Fed Reserve Board's Karen Dynan and Donald Kohn, The Rise in U.S. Household Indebtedness: Causes and Consequences (PDF), I particularly enjoyed a paper by BIS official Claudio Borio: Change and Constancy in the Financial System: Implications for Financial Distress and Policy (PDF). Borio argues that a phase of "major structural change" in financial markets has "spawned an extraordinary variety of new instruments and markets" in recent decades, while the volume of transactions "has surged to unprecedented highs".
These profound changes have had implications for the potential dynamics of financial distress. Financial distress is more likely to involve the evaporation of market liquidity and to have far-reaching cross-border effects. New players are more likely to be at its origin and/or to amplify it. The dynamics of distress may have become more unpredictable. And the transfer of risk to the household sector may arguably have lengthened the time lag between the build-up of embedded risk in the financial system and its overt emergence.
But the sea-changes we have observed should not blind us to what has remained constant. For it is what has not changed that holds the key to the more durable aspects of financial instability. This paper has argued that the main form of financial instability with potentially serious macroeconomic costs has historically been, and continues to be, overextension in risk-taking and balance-sheets in good times, masked by the veneer of a vibrant economy, ie. the occasional build-up of financial imbalances that at some point unwind, inflicting damage on the economy.
What is behind this tendency for excessive risk-taking? The usual four horsemen of the (financial) apocalypse:
And behind this form of instability hide four enduring characteristics of financial activity and human behaviour, viz. deep-seated and pervasive (asymmetric) information problems in financial relationships; powerful positive feedback mechanisms within the financial system as well as between the financial system and the real economy; limitations in risk perceptions; and limitations in incentives. The sea-changes observed may affect the specific manifestation of these elements and their prominence, but should not be expected to alter them in a fundamental way.
What are the policy implications? Borio sees a the need to design and implement "effective speed limits" for financial markets:
..more could be done in designing policies that would seek to limit overextension in risk-taking and balance sheets (“speed limits”). Admittedly, very good work has been done in encouraging improvements in risk measurement and management and in risk disclosures. Even so, given limitations in risk perceptions and incentives, the effectiveness of these steps may not, in the end, fully match expectations.
Ideally, speed limits would become more binding as the risk of overextension increases. Three guidelines could inform their design. First, as with fiscal policy, on balance built-in stabilisers appear superior to discretionary measures. This could be achieved, for instance, by calibrating prudential instruments based on experience over whole business cycles or stress estimates. Second, discretionary measures could be deployed to complement built-in stabilisers if and when it was judged appropriate. This could help to tailor the measures to specific features of the overextension. Third, close cooperation between different authorities with responsibility for, or whose policies impinged on, financial stability would be needed. This would involve prudential and monetary authorities in the first instance, but also accounting standard setters and tax authorities.
...Despite the challenges, some progress in this direction has been made in recent years. Continuing to travel along this road holds out the prospect of edging closer to securing lasting financial stability.
BIS is often overlooked by the financial commentariat; much of their work is done quietly behind the scenes. But where BIS leads, central banks often follow. Watch this space.