For release on delivery
8:30 a.m. EDT
September 27, 2019
Law and Macroeconomics: The Global Evolution of Macroprudential Regulation
Remarks by
Randal K. Quarles
Vice Chair
Board of Governors of the Federal Reserve System
at
"Law and Macroeconomics," a conference at
Georgetown University Law Center
Washington, D.C.
September 27, 2019
Good morning. I would like to thank Georgetown University Law Center and the
conference organizers, Anna Gelpern and Adam Levitin, for the opportunity to speak to
you.
I was particularly delighted to be asked to speak at today's conference because the
topic is law and macroeconomics, a field that my experience has persuaded me is of the
first importance, but ill understood, and surprisingly understudied. Now, this may at first
blush sound like a beloved former president, venturing into a grocery store-"Golly, can
you believe these scanners!?"-because the field of law and economics was already
sturdily established when I was in law school back in the Coolidge Administration, and is
now well over half a century old. It has been the source of some of the most innovative
and influential legal scholarship over the lifetimes of everyone here, and in many ways
the insights of the law and economics movement have become the default framework that
policy makers and practitioners alike use when we think about the law conceptually, and
often even at the level of granular application.
Yet, while we have called this law and economics, it would be more precise to
call it law and microeconomics. Both law and microeconomics are centrally concerned
with incentives-how are they constructed, how do they operate, how do legal or
economic actors respond to them-and the interplay between these different ways to
think about incentives has been a natural and fruitful focus of investigation in a broad
range of legal studies: tort law, property law, criminal law, contract law, corporate law.
But both law and economics are also centrally concerned with systems, the
performance and relationships of broad aggregates of laws or economic activity. Not
merely how do individual actors react to changes in incentives, but how do large-scale
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combinations of actors respond to changes in systems: how are legal or economic
systems constructed, how do they operate, how do those systems constrain wide areas of
human activity. The interplay between those two ways of thinking about systems would
seem to be as natural and fruitful a focus of investigation as is law and microeconomics,
but it is only just beginning to be thought of as a field in itself.
For a concrete example, think about the often observed fact that corporate profit
margins have been increasing steadily over the last few decades. Law is likely to have
been a significant element in this evolution, but not any individual law. Rather an entire
system of laws-laws relating to corporate governance, corporate combinations, taxation,
litigation, labor-have evolved over an extended period of time. And, under this theory,
one outcome of this system-higher corporate profit margins-would likely give firms
greater scope to increase wages without increasing prices, thus offering a potential
explanation for the flattening of the Phillips curve, the traditional macroeconomic
relationship between the unemployment rate and inflation. For a policymaker who
accepted this theory, his comfort in maintaining a very low rate of unemployment could
depend significantly on his understanding of that underlying legal system and his
estimation of how its evolution would likely proceed in the future.
Thus, the formal union of law and macroeconomics should seek to examine the
interplay between a legal system and macroeconomic outcomes, above and beyond the
connections a particular law may have with its impact on human behavior. Scholars and
policymakers have spent our time primarily thinking about the impact of single laws, but
it is appropriate to focus more broadly, especially since we have in fact repeatedly sought
over the past century to revamp our system of laws to improve macroeconomic outcomes.
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Consider the roaring debate in the half-dozen years after the 1929 market crash
that led to the establishment of the foundations of federal financial regulation in the
United States. Laws creating the Federal Deposit Insurance Corporation and a federal
deposit insurance and receivership framework, establishing the Securities and Exchange
Commission, and greatly expanding the responsibilities and capabilities of the Federal
Reserve System were very purposefully intended to help restore confidence in the U.S.
financial system as a necessary condition to foster a recovery from the devastation of the
Great Depression. In essence, we designed and implemented a new system of financial
regulatory laws to alter macroeconomic outcomes, not only to affect individual behavior.
The debate around those laws, in the 1930s, was not an academic one, because the pain
and suffering of that era was evident-at the time Congress was debating the Banking
Act of 1935, which established the modern framework for the federal bank regulation and
supervision, the unemployment rate in the United States was still 20 percent.1
I will leave to others the question of whether every detail of the laws passed in
this period was equally effective, in the short or long term, in promoting macroeconomic
stability. But we should recognize that rules to promote financial stability and a healthy
economy have deep roots in the American legal tradition.
The Post-Crisis International Consensus
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Building upon that strong tradition, I would like to focus this morning's remarks
on the role that law and macroeconomics has played since the financial crisis in
promoting a more stable economy. I am, of course, referring to macroprudential financial
regulation.
Let's rewind the tape. After many decades of remarkable financial stability in the
United States since the 1930s, the focus of financial oversight had moved away from
systemic risks. Prior to the financial crisis, the better part of our regulatory framework
was microprudential in nature-individual laws geared toward mitigating the fallout from
idiosyncratic shocks to firms. This framework was designed to protect investors and
depositors, viewed negative shocks as not originating from the financial system, and did
not take into account risks that might be shared by financial firms.2 This is not to say that
regulators did not understand the consequences of an interconnected system and the
potential of contagion. For instance, the U.S. government, under the able leadership of
Treasury Secretary Nicholas Brady, recognized and responded to the financial stability
risks of the Latin American debt crisis of the 1980s. The United States had interests in
stabilizing allies in Latin America, but a central part of the motivation was to contain
potential risks to the U.S. economy.
The events of 2008-09 redefined our mission by more explicitly connecting
macroeconomic and financial stability, as in the 1930s. Congress and the executive
branch embraced a sweeping response, designing a system of laws to reflect a recognition
that the cumulative, interconnected behavior of financial institutions had implications for
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financial stability and that even the behavior of a single large and complex institution
could have implications for financial stability. This new system was also adopted at the
international level. Starting with the G20 summit in Washington, D.C., in November
2008, the global community established the runway for a structural change. The
subsequent G20 summit in London led to the establishment of the Financial Stability
Board (FSB), with a strengthened mandate as a successor to the Financial Stability
Forum. Subsequently, including at the following summit in Pittsburgh, world leaders
agreed that the supervision of individual financial institutions had to account for the
financial system as a whole, and it was recognized that shocks could originate from
within the system and could spread to institutions with common exposures. In other
words, the supervisory framework had to be macroprudential-focusing on mitigating
systemic risk and accounting for macroeconomic consequences.3 This reorientation was
a defining part of the 2010 Dodd-Frank Act, and internationally, in the Basel III Accord.
Section 165 of the Dodd-Frank Act, in particular, requires the Board to implement
heightened capital and liquidity standards, concentration limits, and stress testing-all to
further the macroprudential purpose of preventing or mitigating risks to the financial
stability of the United States. As I will discuss later, the Board has followed through with
rules such as the G-SIB surcharge, the liquidity coverage ratio, and single-counterparty
credit limits, just to name a few; and, importantly, we have used macroeconomic
considerations in calibrating some of these rules.
An Evolving Regulatory Perspective
3
See Busch and van Rijin (2018), supra.
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Now, let's fast forward to the present. Over a decade has passed since the
migration began toward a renewed focus on macroprudential regulation. Our evolution
did not stop with the Pittsburgh G20 summit in 2009. Indeed, global financial standard-
setters have continued to adapt and learn as they implemented and updated regulations in
line with the global consensus that was reflected in Basel III. I would like to highlight
three important regulatory paradigm shifts that follow from this renewed focus on
macroprudential regulation.
Taking Stock of the Entire Banking Sector
First, in line with the pivot away from microprudential regulation, we have a
renewed focus not only on the health of individual financial firms but on the amount of
capital in the entire banking sector. Note that the idea of improving the stability of the
financial system by regulating individual bank capital has been around for decades.
Global policymakers began construction of the modern risk-based, bank capital
framework in the 1980s, when the aforementioned Latin American debt crisis increased
concerns that the capital held by large international banks was deteriorating. Since then,
regulators, such as the Board, have continued to have one eye focused on the capital held
at individual firms. Now, over a decade after the crisis, exercises such as stress testing
have caused us to have the other eye focused on and assessing the amount of capital in
the entire banking system.
Considering Macroeconomic Outcomes in Calibrations and Impact Analyses
The second paradigm shift is that regulators have improved their methods of
conducting quantitative analysis of regulations. Such analysis, including conventional -
cost-benefit analysis, traditionally did not take macroeconomic variables like gross
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domestic product (GDP) growth or the unemployment rate. That is no longer the case.
Since regulators are given the task of maintaining the stability of the system as a whole,
they must concern themselves with externalities and spillover effects to the broader
economy. At the Federal Reserve, several regulatory initiatives have exemplified this
change in quantitative analysis.
At the height of the financial crisis, the Federal Reserve created the first stress
test, the Supervisory Capital Assessment Program (SCAP), to estimate potential losses at
those banks, if economic and financial conditions worsened. Building on SCAP, the
Federal Reserve moved to the current stress testing assessment-the Comprehensive
Capital Analysis and Review (CCAR)-to evaluate whether the largest firms have
sufficient capital to absorb potential losses and continue to lend under stressful
conditions. In the CCAR process, the Federal Reserve simulates macroeconomic
scenarios like a recession in which GDP falls and the unemployment rate rises
significantly. In the 2019 stress test cycle, for example, we tested banks against a
hypothetical global recession in which the unemployment rate in the United States rose to
10 percent.4 The stressed banks were required to show that they could continue to meet
minimum capital requirements in the face of those hypothetical macroeconomic shocks.
Aside from CCAR, the FSB compiles an annual list of global systemically
important banks (G-SIBs), which are subject to stricter capital requirements in the form
of a capital surcharge. These banks must meet this higher capital standard based on the
judgement that their potential failure would have a larger, systemwide impact on the
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economy. The goal, therefore, is to reduce a G-SIB's probability of failure so that its
expected impact on the economy would be the same as that of a non-G-SIB.
Similarly, to reduce the risks of interconnectedness and contagion, the United
States and other jurisdictions have implemented rules that limit the exposure that one
bank may have to a single counterparty.
Finally, research on optimal bank capital levels by staff at regulatory and
supervisory bodies around the world have factored in macroeconomic costs and benefits.
Specifically, these models assume that higher capital requirements would reduce the
probability of a financial crisis occurring but would increase the cost of bank lending,
thereby lowering GDP growth. Not surprisingly, these models have produced a wide
range of capital estimates given the wide range of underlying assumptions.
Combating Pro-cyclicality
The third paradigm shift at the Fed is combatting pro-cyclicality. To be sure,
none of the regulatory developments that I have discussed so far screams
macroeconomics quite as loudly as a time-varying, discretionary regulatory regime the
express goal of which is to fight pro-cyclicality. Cyclicality-in this case, fluctuations in
the economy based on the business cycle-is a concept that is near and dear to every
macroeconomist's heart. In fact, theoretical studies of economic cycles go back to the
early 1800s, and the National Bureau of Economic Research's tracker of the U.S.
business cycle dates economic contractions and expansions back to the 1850s. Quite
impressive. There's also more than just a handful of volumes of articles and book
chapters written on the business cycle and countercyclical fiscal policy.
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In the context of macroprudential regulation, pro-cyclicality represents a problem
because banks tend to build up excessive credit during an economic expansion. Limiting
pro-cyclicality means limiting both the highs and lows of a credit cycle.
Along with many other jurisdictions, the United States adopted a countercyclical
capital buffer (CCyB) to address the issue. The U.S. CCyB is a capital buffer that ranges
from zero percent to 2.5 percent of covered institutions' risk-weighted assets. Domestic
regulators have discretion to switch the CCyB on or off anywhere within that range in
order to prevent or mitigate the overheating of credit markets under their jurisdiction. In
setting the buffer, the Federal Reserve takes into account, among other things, leverage in
the financial sector, leverage in the nonfinancial sector, maturity and liquidity
transformation in the financial sector, and asset valuation pressures. Notably, the CCyB
is not calibrated bank-by-bank and is not calibrated asset-class-by-asset-class. Rather,
regulators set the buffer based on their perception of the aggregate domestic credit cycle,
whether it's too hot, too cold, or just right. Under the Board's current policy, we would
activate the CCyB based on "when systemic vulnerabilities are meaningfully above
normal."
Based on this policy, the CCyB is currently set at zero percent in the United States
but has been turned on in France, Hong Kong, Sweden, the United Kingdom, and
Norway. It is worth noting that, in the United Kingdom, the CCyB is set equal to a
positive level-1 percent-in normal times. As a result, their buffer can be adjusted
upward or downward based on the perceived risks of the time-varying credit cycle. As I
have recently said, I see real merit in exploring the U.K. approach as a tool to promote
financial stability.
Conclusion
Let me conclude by offering a few thoughts on three research topics that fall
squarely in the intersection of law and macroeconomics.
Central Bank Mandates
First, while international agreements such as Basel III demonstrate that the
international regulatory community has agreed on the high-level systematic changes and
developed similar perspectives following the crisis, national governments gave different
regulatory powers-in both degree and scope-to their central banks in pursuit of the
new post-crisis consensus.5 In the United States, Congress did not change the Federal
Reserve's dual mandate but did provide new responsibilities to promote financial
stability. There was no change to the European Central Bank's monetary policy mandate,
but it received direct supervisory authority over some of the Eurozone's largest banks
through the Single Supervisory Mechanism and also continues to monitor financial sector
risks. The Bank of Japan does not control Japan's macroprudential toolkit but does play
an active role in monitoring systemic risk. The Bank of England, on the other hand, was
explicitly tasked with a new financial stability mandate, and it oversees macroprudential
regulation.
In line with the debates over central bank independence and macroeconomic
outcomes, legal scholars who engage in cutting-edge research on institutional design may
have thoughts on which model leads to the best outcomes for financial stability.
Financial Stability Monitoring
Second, in addition to giving varying degrees of power to their central banks,
national governments also created new bodies that promote financial stability, such as the
FSB and the Financial Stability Oversight Council (FSOC), to monitor systemic risk and
identify systemically important institutions and activities. For example, the main issues
on the FSB agenda for this year were developments in financial technology, nonbank
financial intermediation, and evaluation of too-big-to-fail reforms.6 In the same vein, the
FSOC produces annual reports that highlight such threats and vulnerabilities, including
news ones such as cybersecurity.7
Given today's audience, I very much look forward to hearing your thoughts on
these issues, particularly suggestions on ways in which our legal framework can be used
to mitigate these risks and the extent to which additional macroeconomic tools should be
developed to monitor or address evolving risks.
Due Process
Third and finally, since I have spent a good part of this speech talking about
issues that are near and dear to every economist, I feel like it is only fair for me to wrap
up by discussing an issue of equal, if not greater, emotional import to lawyers: due
process. Specifically, I'd like to close by talking about the due process considerations
associated with the aforementioned macroprudential policies. There is nothing improper
about mitigating negative externalities through regulation, and that is an important
purpose of much post-crisis financial regulation. However, it is also well-accepted that
due process requires the fair, evenhanded application of laws so that individuals are not at
the mercy of the arbitrary exercise of government power.8 As I have alluded to
throughout my remarks, we are currently placing a much greater regulatory burden on a
select group of banks-the largest and most complex firms-because we believe their
failures would bring down the entire financial system.
Some might argue that, during the financial crisis, we dispensed with due process
considerations while conducting version 1.0 of the stress tests. This is why
I have strongly pushed for the recent shift toward greater transparency around the
structure of the stress tests and the models themselves. It affords greater due process to
the affected participants.
In the same vein, I would welcome greater legal scholarship on the due process
considerations associated with bank supervision as a process distinct from bank
regulation. By bank supervision, I refer to the processes and activities identified with
examining banks, including checking compliance with laws and regulations, assessing
bank capital and liquidity levels, assigning supervisory ratings to banks, and taking
formal and informal enforcement actions. While it is important for bank supervision to
be up to the task of assessing the world's largest banks, especially in light of the financial
stability risks that I have been describing today, an equally important task is making sure
that supervisors are acting fairly. Although questions of fairness are routine in law and
economics, there is ample room to explore these issues as they relate to bank supervision.
While transparency and fairness are pillars of due process, I appreciate that there
are other approaches worth considering on this matter. With this growing field of law
and macroeconomics, I hope to see and implement many interdisciplinary solutions on
the path forward.