Former Council of Economic Advisers Chair Jason Furman argues in the Wall Street Journal’s opinion page that the Federal Reserve should raise countercyclical capital-buffer rates during good times so our financial system is better prepared to weather a storm like the one experienced 10 years ago.
It’s high time for the Fed to raise countercyclical capital-buffer rates, which govern the amount of extra equity and cash banks are supposed to hold in good times. Increasing the capital buffer would reduce the risk of financial instability, set a precedent for sound macroeconomic management, and build up a bigger cushion for the next downturn.
Banking regulation naturally has a pro-cyclical bias. When times are good, there’s a de facto easing of standards, which exacerbates lending booms. Then when asset values crash and defaults proliferate, regulations become tougher to meet, which worsens credit crunches and recessions.
For those unfamiliar with the term, a countercyclical capital buffer functions in the same way as a traditional capital requirement, but can be adjusted based on the state of the economy. During good times, banks would be required to rely more on equity financing for their investments, preventing a sudden downturn from rendering insolvent an overly leveraged bank that can’t pay its debts.
During a recession, however, the capital requirements can be lowered. After the storm has passed, the risks of another crisis are reduced, and an easing of banks’ ability to borrow and invest would mitigate the effects of a downturn.
Since we’re in a booming economy now, it’s necessary to look ahead and prepare for another downturn.
An even stronger rationale for raising capital standards now is the macroeconomic situation. The unemployment rate is below 4%, and growth is well above 2%. Acting while the economy is robust would set a precedent, moving the Fed’s decision making on capital standards toward a more predictable approach, like the one for setting interest rates.
Instead of raising capital requirements when the Fed believes there is an impending crisis, potentially “spooking” the market and forcing regulators to rely on imperfect metrics, this strategy is elegantly targeted. It sends the message both that things are going well, but we should always be prepared for the next crisis before it’s too late.
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