Managing Financial Risks as Markets Move

Report argues that asset-based reserve requirements for all lenders would protect the U.S. economy from volatile swings in asset prices.

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Revised October 2007

What a ride! Housing and mortgages went from binge to withdrawal in just 12 months. Importantly, the housing boom contributed to a mortgage boom, especially in new exotic loan products such as adjustable-rate mortgages, interest-only mortgages, and payment-options mortgages, all of which helped to fuel economic growth. With the housing boom at an end, economic growth and job growth have both slowed, ultimately leaving more and more families unable to make their debt payments. Foreclosures have grown, resulting in tighter credit standards and contributing to further economic slowdown as borrowers, once awash in easy credit, find it harder to finance a new home, their education, or a business venture, among other things.

To address boom-and-bust financial cycles, which hold a serious threat to our economic health, we recommend a regulatory tool, considered but never adopted by policymakers, known as asset-based reserve requiremets. ABRRs were first proposed in the 1970s by proponents of allocating credit to underserved borrowers, and the proposal was revived in the early 1990s to encourage access to credit for a wider set of socially desirable ends. More recently, ABRRs have been proposed as a way of diminishing speculative bubbles (see “Genesis of Asset-based Reserve Requirements,” page 9). We explore how this regulatory policy tool might have affected the recent mortgage boom and mitigated some of the adverse consequences of recent events. The tool may seem radical to some but deserves, in our view, serious consideration against the backdrop of apparently increasing systemic financial market risks. Specifically, ABRRs would require all lending institutions that originate new loans to place with the Federal Reserve a specified percentage of loans as low- or no-interest-bearing reserves. The share of loans to be held with the Federal Reserve would be larger for riskier loans and could be adjusted according to economic needs. For instance, when the economy slows down, regulators could reduce the share of a loan required to be held in reserves to increase the amount of credit available.

The use of ABRRs, if they had been in place, would have allowed the Federal Reserve to better manage economic fluctuations. It may have been able to slow the sudden proliferation of risky mortgages and thus protected the economy from the fallout of rapidly rising economic distress and the threat of severe credit tightening, which could hurt economic growth and job creation. Alternatively, ABRRs would also allow the Fed to react swiftly to a financial bust by lowering reserves to counter tightening lending standards.

Several aspects of today’s financial markets and concomitant regulatory regimes support the introduction of ABRRs. Specifically:

The Federal Reserve needs new tools to fulfill its regulatory and monetary duties. Some of the existing tools, such as reserve requirements on deposits, have become blunt since they apply to an ever-shrinking share of the financial system. Hence, we recommend replacing existing deposit reserve requirements for depository institutions with ABRRs for all lending institutions. This would level the playing field among lenders. In addition, it would give the Federal Reserve a tool to directly influence financial market cycles without relying solely on interest rates.

ABRRs would complement existing capital requirements. Under the aegis of the Bank for International Settlements’ so-called Basel I and Basel II accords, the world’s financial institutions are required to maintain adequate capital on their own books
depending on their assets’ riskiness.
Capital requirements help to grow the
credit supply when times are good and tighten it when times are bad, in line with fluctuations in the risk of a bank’s underlying assets. As a complement to capital requirements, ABRRs would therefore give the Fed the ability to regulate the money supply in a countercyclical fashion by, for example, setting lower reserve requirements when times are tough and hence allowing lenders to expand credit more than otherwise would be the case.

There are established procedures to assess risk. The implementation of capital reserve requirements has necessitated procedures to measure risk at the world’s major financial institutions. If the same mechanisms to evaluate risk for the purposes of calculating capital requirements are used to value risk for the basis of assessing ABRRs, banks would have to implement only one valuation method and the Federal Reserve’s regulatory work would be facilitated.

The Federal Reserve can process reserve requirements in a complex, fast-paced world. The Fed has established mechanisms for deposit reserve requirements in a world characterized by increasing complexity and speed. For the calculation of deposit reserve requirements, for instance, deposits are averaged over several weeks as the basis for reserves so that reserves do not have to be calculated daily. Put differently, as long as lenders lend some money during a specified period, say two weeks, they will be required to hold ABRRs at the Fed.

Policymakers need to consider complementary policies to equalize credit access. There needs to be a balance between restricting risky lending to stabilize financial markets and the economy and granting underserved borrowers sufficient access to credit. Specifically, if financial institutions respond to the incentives embedded in ABRRs, then access to some costly and risky forms of credit could decline. The hope would be that at least for some borrowers access to lower-cost and lower-risk credit may increase under this proposal. Policy-makers, though, may have to consider additional measures to increase access to stable, low-risk, and low-cost forms of credit for borrowers, who may see their access to credit decline if ABRRs were enacted. This is of critical importance to those borrowers who typically have less access than their counter-parts to affordable and stable credit, such as minorities, low-income families, and small businesses.

Given the sweep of financial liberalization in the United States over the past three decades—and the accompanying rise in volatility across a number of asset marketplaces—the time for ABRRs may have arrived, although the proposal has been around some time (see box, page 9). We raise the issue once again because we want to give this proposal more visibility and spark a discussion over whether the country needs new regulatory tools to handle more complex and larger financial markets—and, if so, what those new tools should look like, using ABRRs as a possible example.

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