It’s quite easy to ignore the long-run costs of a policy in the short term (just ask anyone that’s been putting off their diet). Policymakers are also textbook hyperbolic discounters, especially with respect to financial regulation.
Thus, there is a natural hierarchy of financial policies and the institutions that implement them. Robert Macrae outlines the pecking order at VoxEU:
The most powerful domain is fiscal policy, so the ministry of finance sits on top. It may not interact with the other authorities regularly, but when it does so, it is usually without taking their concerns into account…
Below fiscal policy we have monetary policy, implemented by the central bank…In spite of its independence [which varies between countries], the central bank is still beholden to the ministry of finance, and perhaps increasingly so. Delegated power is only retained so long as the government is happy with it…
Microprudential policies (also known as ‘micropru’) focus on the stability and conduct of each financial institution in isolation, have less prestige, and are controlled more directly by the ministry of finance than monetary policy. Micropru may be housed in the central bank, a separate authority,or some hybrid between the two…
Macroprudential policies (‘macropru’) are concerned with financial stability and systemic risk, and have both ex-ante and ex-post functions: prevention and resolution. The macropru authority is usually housed within the central bank. Macropru has the disadvantage of being concerned with the distant future [Emphasis added].
This hierarchy is fairly intuitive during normal times (or “peacetimes,” as Macrae calls them). Governments will always need to take in and spend money, and the effects of monetary policy and regulations applied to specific firms are felt day-to-day, so it’s easy to let macroprudential policy, designed to prevent systemic risks down the line, take a back seat.
Worse, it’s easy for policymakers’ goals in the other three spaces to conflict with the goals of macroprudential regulators. For example, imagine an administration that wants to stimulate the economy through lower lending standards. This achieves short-run economic growth at the cost of greater systemic risk. Further research also confirms that there are political incentives to relax macroprudentail regulation before close elections.
This leads to a question of institutional design: how much independent authority should we give macroprudential regulators? “Splitting financial policy into four distinct domains is sensible” writes Macrae, “but can lead to suboptimal outcomes when the four domains overlap and compete. By contrast, housing them within the same institutions may reduce conflict and facilitate decision making but risks some areas being ignored.”
The tradeoffs are clear, and there doesn’t seem to be an obvious way to resolve the dilemma. One potential solution could be the implementation by statute of straightforward financial regulations (such as higher capital requirements or leverage taxes) that restrict some of the freedom of independent regulators, but that give them a clear mandate to act while protecting them from the contrary interests of other agencies.
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