Dealing with asset bubbles

Another big theme in the current debate on changes in the regulatory framework is the need to prevent asset bubbles. While Greenspan & Co seemed to have successfully controlled inflation in the 2000s, they did not pay as much importance to the rising real estate prices. Identifying and preempting asset bubbles can go a long way in preventing shocks to the economy. Since the financial system plays a critical role in the formation of bubbles, appropriate regulation is needed.

Calomiris mentions that prudential regulations can succeed in reducing the supply of credit by tightening capital, liquidity, and provisioning requirements. This is the most direct and promising approach to attacking the problem of a building asset price bubble, assuming that one can be identified. Greenspan used to argue that it was difficult to identify asset bubbles. And the costs associated with tackling “imaginary” asset bubbles would be high. Calomiris accepts that there are economic costs associated with adopting macro prudential triggers to combat asset bubbles. Credit slowdowns and capital raising by banks may happen during periods identified as bubbles that are in fact not bubbles. These costs, however, are likely to be small. If a bank believes that its extraordinary growth is based on fundamentals rather than a bubble, then it can raise capital in support of continuing loan expansion. The cost to banks of raising a bit more capital during expansions is relatively small. Most importantly, macro prudential triggers would promote procyclical equity ratios for banks, which would mitigate the agency and moral-hazard problems that encourage banks to increase leverage during booms. During the subprime boom, commercial banks and investment banks substantially raised their leverage.

Indeed, we can learn from history in this context. There have been occasions in the past when banks behaved more prudently and wisely. During the boom era of the 1920s, New York city bank expanded their lending dramatically. Their loan-to-asset ratios also rose as the banks participated actively in promoting the growth in economic activity and stock prices during the 1920s. But recognizing the rising risk of their assets, the banks made adjustments accordingly and substantially raised their equity capital. New York banks went to the equity market frequently in the 1920s, and on average increased their market ratios of equity to assets from 14 percent in 1920 to 28 percent in 1928. Virtually no New York City banks failed during the Depression.