But this suggests that it might be better for central bankers to examine the efficacy of other instruments in their toolbox, rather than simply ignoring the development of asset bubbles. 3. If existing tools are judged inadequate, then central banks should work on developing additional policy instruments. Let’s take the housing bubble as an example. Housing prices rose far faster than income. As a result, underwriting standards deteriorated. If regulators had forced mortgage originators to tighten up their standards or had forced the originators and securities issuers to keep “skin in the game”, I think the housing bubble might not have been so big. I think that this crisis has demonstrated that the cost of waiting to clean up asset bubbles after they burst can be very high. That suggests we should explore how to respond earlier. Harkening back to my earlier themes, I think we can respond in a number of ways: •  First, we can do a better job understanding interconnectedness. This means changing how we oversee and supervise financial intermediaries. •  Second, we can change the system so that it is more self-dampening. •  Third, we can improve incentives. •  Fourth, we can increase transparency. •  Fifth, we can develop additional policy instruments. For example, we might give a systemic risk regulator the authority to establish overall leverage limits or collateral and collateral haircut requirements across the system.
The high degree of interconnectedness across the financial system has a number of implications. First, supervision must not just be vertical – firm by firm, or region by region, but also horizontal – looking broadly across banks, securities firms, markets and geographies. Second, this means that supervisory practices need to be revamped. They need to be coordinated and multi-disciplinary. I think the U.S. Treasury is right in proposing a systemic risk regulator as part of their regulatory reform plan. But, we shouldn’t kid ourselves about how difficult this will be to execute. You will need a flexible and dynamic governance process to be able to identify the important elements of systemic risk, to elevate those concerns to the appropriate level and then to act on those concerns in a timely manner. It will take the right people, with the right skill sets, operating in a system with the right culture and legal framework. I don’t believe creating this oversight process will be an easy task. Consider, for example, subprime lending. There were obvious excesses in terms of underwriting standards, product design and risk management. But addressing those issues during the boom would have required the supervisor to absorb attacks that reining in some of these practices would make it more difficult for some low- and moderate-income households to become homeowners for the first time. System dynamics In thinking about interconnectedness, we also need to focus on system dynamics. By system dynamics, I mean how the different parts of the system interact.