As the financial system changes shape, it seems plausible to think that further change could be necessary. If so, that change would benefit from further research on the costs and benefits of the extended regulatory and central bank safety net. (f) The Macroprudential Policy Framework: As a still-fledgling framework, there are a wide range of questions still surrounding the macroprudential framework. There is no settled, practical approach to defining the breadth of objectives of a macroprudential regime. Should the potential for aggregate demand externalities associated with a debt overhang in the household sector, for instance, fall under the purview of a macroprudential authority? Nor, in the main, is there any settled approach to defining the appropriate set of macroprudential instruments, whether for banks or especially for non-banks, or the optimal strategy for their use to address emerging vulnerabilities. If household debt externalities are within scope, is it better to deal with this risk by restricting mortgage lending directly via loan to income or loan to value limits, or by adding a macroprudential overlay to risk weights on mortgages (Turner (2017))? This lack of a settled approach has some benefits, in making for a diverse range of cross-country experiences. This is giving rise to a period of “learning by doing” among regulators. It does, however, come at some cost. A regime without especially well-defined objectives is likely to suffer greater problems of time-inconsistency. It may also increase uncertainty among outside participants about the likely regulatory policy reaction function.
The range of published estimates in the LEI study reflected different assumptions about the persistence of the effects of crises on GDP, an area of particular empirical uncertainty in the academic literature. A contemporaneous study by Miles et al (2013) concluded that optimal capital requirements were likely to be higher – perhaps around 20% - if account was taken of the offsetting risk and cost of capital effects of higher solvency standards (the Modigliani-Miller offset). It is useful to revisit the calibration in the LEI study in the light of subsequent research. A little notation may be useful to organise this evidence. Suppose the aim of policy is to keep output in the economy, y, as close 11  These figures are expressed in terms of current definitions of capital and risk-weighted assets. The mapping from the estimates reported in the LEI report and those above are due to Brooke et al (2015). 9  All speeches are available online at www.bankofengland.co.uk/speeches  9  as possible to its trend growth path, y̅. The objective for the authorities is then to minimise a loss function, which can be written as: L = (yt − y̅t )2 Let’s simplify further and assume two factors can cause output to deviate from its trend: first, higher capital requirements, k, which act to reduce output each period by δ; and second, the occurrence of a financial crisis which, with probability γ, leads to a discrete drop in output of ∆.