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Keywords:

  • financial regulation;
  • incremental;
  • macroprudential;
  • paradigms;
  • regulatory change

Abstract

  1. Top of page
  2. Abstract
  3. Introduction
  4. Macroprudential as radical (transformative?) third order change: The substantive/trajectoral dimension
  5. Macroprudential as sudden and dramatic third order change: The temporal dimension
  6. Macroprudential first and second order policy development as an evolutionary, incremental process: The substantive/trajectoral dimension
  7. Macroprudential first and second order policy development as a slow, gradual, incremental process: The temporal dimension
  8. Conclusion
  9. Acknowledgments
  10. References

This article focuses on the transformatory potential of macroprudential ideas following the financial crash of 2008, examining how they are being mediated by existing institutional contexts and how and why the task of building a new body of technical macroprudential knowledge is proceeding slowly. It is argued that the movement toward a form of macroprudential regulation has a distinctly incremental dynamic that means any macroprudential transformation will be a gradual process that is likely to span a decade or more. Using Peter Hall's framework of three orders of policy change across substantive and temporal dimensions, the article argues that the macroprudential ideational shift can be compared to third order change. In this sense, it was intellectually radical and took place rapidly in a period of around six months. However, intellectual radicalism does not automatically translate into a radical change in regulatory practice, because of a variety of countervailing political, institutional, and informational variables. In this respect, the task of developing first and second order macroprudential policy is proving to be a much more politically contested process. Furthermore, macroprudential policy is being developed by cautious technocrats who rely on the gradual accumulation of data and evidence to justify policy. The result is a distinctly incremental dynamic to macroprudential policy development that displays many of the features of a process that historical institutionalists refer to as “layering.”

Introduction

  1. Top of page
  2. Abstract
  3. Introduction
  4. Macroprudential as radical (transformative?) third order change: The substantive/trajectoral dimension
  5. Macroprudential as sudden and dramatic third order change: The temporal dimension
  6. Macroprudential first and second order policy development as an evolutionary, incremental process: The substantive/trajectoral dimension
  7. Macroprudential first and second order policy development as a slow, gradual, incremental process: The temporal dimension
  8. Conclusion
  9. Acknowledgments
  10. References

Financial and economic crises have, throughout history, resulted in “great transformations” in regulatory orders, reconstituting permitted market activity, and reconfiguring state society relations (Polanyi 1944; Blyth 2002; Gamble 2009). Changes to dominant overarching economic ideas about how markets and the economy function have been identified as crucial drivers of such transformations (Blyth 2002; Widmaier et al. 2007). What has often been neglected in accounts of such transformations is the question of time and temporal dynamics (Helleiner 2010), as well how new ideas that rise to prominence in crisis situations interact with existing institutional environments (Bell 2011). This article focuses on the transformatory potential of macroprudential ideas following the financial crash of 2008, examining how they are being mediated by existing institutional contexts, and how and why the task of building a new body of technical macroprudential knowledge is proceeding slowly. Macroprudential regulation (MPR) is a system-wide top-down approach to regulation and financial stability that seeks to “curb the credit cycle” through countercyclical regulatory interventions by directing, and sometimes directly constraining, the commercial activities of private institutions in an effort to restrain extreme movements in asset prices. The macroprudential turn is, therefore, potentially transformatory in that it could signal a reversal of the primary regulatory trajectory in the financial sector over the last three decades, of allowing market actors more freedoms to price their own risk. However, the movement toward a form of macroprudential regulation has a distinctly uneven and incremental dynamic that means any macroprudential transformation will be a gradual process that is likely to span a decade or more.1

In their framing piece, the editors of this special section have urged contributors to address and explain the issue of variability in financial regulatory change after the global financial crisis of 2008 (Moschella & Tsingou 2013). But how should we conceive of and conceptualize “variability?” This contribution argues that it is useful to think along two dimensions, and in terms of three orders of policy change. First, along a trajectoral or substantive dimension is the question of the substantive content of regulation – its objectives, the intellectual concepts and assumptions on which it is based, the instruments used to attain those objectives, and whether those changes constitute a dramatic transformational trajectory change in regulatory direction, imposing more constraints on market actors or giving them greater freedoms. Second, along a temporal dimension, there is the question of the length of time it takes for regulatory change to unfold – whether it is quick and speedy, or whether it is a protracted lengthy process. This article argues that the emergence of macroprudential regulation illustrates how regulatory change can simultaneously be dramatic and transformational, and gradual and incremental, along both dimensions at the same time, but to appreciate how this is so we need to distinguish between types of regulatory change and pay close attention to the all-important question of sequencing. It is suggested that a useful way of doing this is to use the three orders of policy change identified by Peter Hall. This enables us to distinguish between: the ideas and assumptions that inform and set the overarching objectives of policy in a given area (third order change), which in the past has signaled the start of a process of great transformation in regulatory orders and state society relations, similar to those referred to by Blyth and Polanyi (Hall 1993; Blyth 2002); the institutional arrangements and instruments used to achieve those objectives (second order change); and the precise settings of those instruments in quantitative or numerical terms (first order change) (Hall 1993).2 Applying this framework of temporal and substantive dimensions in terms of three orders of policy change enables us to illuminate the complex ways in which the macroprudential regulatory turn that has materialized since 2008 is both dramatic or (potentially) transformational, and gradual and incremental at the same time. The article argues that a relatively radical and rapid intellectual change has given way to an incremental process of building macroprudential regulation in substantive terms.

The argument proceeds in four steps. First, it is argued that the movement in the direction of macroprudential thinking, which displaced the dominant efficient markets thesis in international regulatory networks from 2009 onwards as the dominant “interpretative frame” for determining and driving regulatory practice, is an example of what Hall referred to as third order change or a “gestalt flip.” A third order change occurs when there is a radical change in the overarching terms of policy discourse, in the hierarchy of goals behind policy, and in causal assumptions or accounts of how the world facing policymakers actually works. The movement from efficient market to macroprudential thinking represents an example of third order change according to these three criteria and in this sense it was intellectually radical (and potentially transformative) along the substantive dimension.

A second step examines the time period and the sequencing this third order macroprudential ideational shift has entailed. This section argues that the rise of macroprudential ideas has constituted a form of dramatic third order change, without prior first and second order change, that took place in a time frame of a little over six months. This third order change was rapid and dramatic along the temporal dimension.

In a third step, it is argued that we have now entered a phase of first and second order policy experimentation in the development of macroprudential policy, partly through a process of practical trial and error, but also as macroprudential technical knowledge evolves in relation to appropriate and workable first and second order policy changes. The example of the Basel III agreement is used to illustrate how various change agents and veto players are contesting macroprudential policy development in ways that are producing a series of compromises and diluting substantive content.

In a fourth step, the obstacles to developing MPR along the temporal dimension are briefly outlined. Developing countercyclical policies, a principal aim of MPR, is politically treacherous. The countercyclical objectives of macroprudential policy mean that many macroprudential policies are time dependent and will not become evident until a period of financial asset growth. Consequently, for the time being the true positions and powers of change agents and veto players in relation to first order policies and second order institutional arrangements are partially concealed as the nature of contestation over macroprudential regulation continues to evolve in accordance with the rhythms of economic and credit cycles. This argument is illustrated with examples from the ongoing struggles between change agents and veto players over MPR in the United Kingdom (UK), which is resulting in slow paced gradual change along the temporal dimension.

Macroprudential as radical (transformative?) third order change: The substantive/trajectoral dimension

  1. Top of page
  2. Abstract
  3. Introduction
  4. Macroprudential as radical (transformative?) third order change: The substantive/trajectoral dimension
  5. Macroprudential as sudden and dramatic third order change: The temporal dimension
  6. Macroprudential first and second order policy development as an evolutionary, incremental process: The substantive/trajectoral dimension
  7. Macroprudential first and second order policy development as a slow, gradual, incremental process: The temporal dimension
  8. Conclusion
  9. Acknowledgments
  10. References

Hall used the notion of third order change to denote radical change in the overarching terms of policy discourse, in the hierarchy of goals behind policy (Hall 1993, p. 279), and in causal assumptions or accounts of how the world facing policymakers actually works (Hall 1993, p. 280). Hall associated this kind of change with a Kuhnian “paradigm shift” (Kuhn 1996). Thomas Kuhn famously compared scientific paradigms to a gestalt or an interpretative framework of terminology and assumptions, which are influential precisely because so many of them are taken for granted and resistant to scrutiny. From time to time, the policy and regulatory process, Hall argued, is characterized by a shift from one policy frame to another – third order change. Kuhn referred to this process of moving from one paradigm to another as a gestalt flip, when underlying assumptions about aspects of the world are reversed and overturned and replaced with a different or diametrically opposed set of assumptions about how things are actually constituted. As a result of Hall's seminal writings, therefore, third order change has become associated with the very definition of radical public policy change, associated with a disjunctive process, involving periodic discontinuities that, in turn, change or transform regulatory orders (Hall 1993, p. 279).

Prior to the financial crash of 2008, a specific gestalt or interpretative frame based on the efficient markets hypothesis (EMH) had come to dominate the world of financial regulation, evident in both international agreements, such as Basel II, and in national regulatory practice (Turner 2011). Regulatory practice was informed by Eugene Fama's efficient markets position that liquid financial markets were characterized by the efficient processing of all available information, which, in turn, would make the actual price of a security a good estimation of its intrinsic value (Fama 1991). Simplified versions of the efficient markets position came to dominate in leading central banks, regulatory agencies, and in the risk management departments of large banks to such an extent this position became part of a wider “institutional DNA” (Turner 2011, p. 29). This simplified version of efficient markets and equilibrium theory saw market completion as the cure to most problems, and mathematical sophistication as the key to effective risk management.

The risk management departments of large banks and their investment strategies were driven by “Value at Risk” (VaR) models and techniques. VaR techniques assume that one can infer the probability distribution of future potential movements of market prices from the observations of movements over the recent past. Market prices were assumed to be driven by the rational interaction of multiple independent agents and market risk could therefore be mathematically modeled. Greater transparency, more disclosure, and more effective risk management by financial firms based on market prices became the cornerstones for the regulation of “efficient markets.” The Basel II agreement, for example, established a reliance on internal risk management systems based on the state-of-the-art VaR models of big banks. Supervisors engaged in assessments of these models, effectively asking institutions and their managers what they did, resulting in a focus on process or IT capacity, rather than results or risk capacity (Tsingou 2008; Warwick Commission 2009). VaR risk management models operated through daily price sensitive risk limits that required banks to reduce exposure when the probability of losses increased as a result of falling prices. The efficient markets position, thus, placed so much confidence in market processes and prices that it put those prices at the very centre of regulatory practice, reflecting a basic norm of optimization (Eatwell 2009; Simon 2010).

Macroprudential concepts, however, refute not only the efficient markets position, but also, according to one macroprudential pioneer, “the rational expectations foundations of both new classical and new Keynesian perspectives” (White 2009, pp. 16–17). Four constituent concepts provide the intellectual underpinning for MPR. In this regard, macroprudential thinking draws on the notion of “fallacy of composition” (with its Keynesian origins) – recognizing that individual incentives and the courses of action that flow from these do not necessarily result in desirable aggregate or systemic outcomes (Crockett 2000; Borio 2011). Similarly, reflecting Minskian roots, macroprudential thinking recognizes that prices in financial markets can be driven to extremes by a combination of: (i) procyclicality, when the calculation of risk follows prices, so that the supply of credit fueling investment is most plentiful when least needed (when asset prices are rising), and least plentiful when most needed (when asset prices are falling), driving asset values to extremes in both directions (Minsky 1977; Borio et al. 2001; Borio & White 2004; Bank for International Settlements 2006; White, 20063); and (ii) herding (reflecting a link to Keynes), where individuals adopt behaviors close to the overall mean, deferring to the judgments of others, behaving in a non-rational or short-term fashion, as a result of the chemistry of the human brain and the propensities of the limbic system (Haldane 2010a; Haldane & Davies 2011). A final macroprudential concept focuses attention on network externalities and complex systems, when small events can generate all kinds of systemic dislocations because of the complex and unintended interactions that ensue in complex systems (Haldane 2010b; Haldane & May 2011). Analysis of this kind provides a powerful rationale to move the perimeter of regulation to cover shadow banking, but also to modularize or separate financial activities through Glass–Stegall type legislation, to tax and even prohibit certain financial activities and transactions because their social costs in terms of lost output can exceed any economic value they generate (Haldane 2010a; Tucker 2010; Turner 2011).

As will be explained in the next section of this contribution, a very broad macroprudential third order consensus came to dominate in regulatory policymaking circles in a relatively short period of time following the peak of the financial crisis in 2008, and the desirability and the need for some variant of a macroprudential approach to regulation has barely been contested. In substantive terms, or along the trajectoral dimension, the acceptance and embrace of macroprudential thinking is about as clear an example of third order change as one could hope to find. For Paul Tucker, Deputy Governor for financial stability at the Bank of England, the move from “a default assumption that core markets are more or less efficient most of the time” (the efficient markets position) to, “thinking of markets as inefficient, riddled with preferred habitats, imperfect arbitrage, herding and inhabited by agents with less than idealized rationality” (the macroprudential position) constitutes a “gestalt flip” (Tucker 2011, pp. 3–4). The dominant assumption informing financial regulation is no longer that financial markets are efficient most of the time, but that they are characterized by myopia, procyclical patterns, and herd behavior, representing a diametrically opposed set of assumptions about how the financial world actually operates. At the same time, the movement from a microprudential focus solely on the safety and soundness of individual institutions, to viewing risk as a systemic, interconnected, and endogenous property that requires a macroprudential regulatory top-down focus, represents a substantial change in the hierarchy of policy goals. In Hall's own terms, therefore, the movement from an efficient markets consensus to a macroprudential consensus can be viewed as an example of third order change, precisely because there is a new macroprudential policy discourse and lexicon (a new gestalt), a change in the hierarchy of goals behind policy (from micro to macro) (Hall 1993, p. 279), and a change in causal assumptions or accounts of how the world facing policymakers actually works (Hall 1993, p. 280).

As a consequence of the macroprudential ideational shift, policymakers' cognitive filter has switched to a different setting. Policymakers are now using various combinations of the four key constituent concepts of fallacy of composition, procyclicality, herding, and complex externalities to inform and guide regulatory initiatives and practice. Consequently, a whole range of policy proposals can now be placed on the table and seriously discussed that were previously out of reach. These include: countercyclical capital requirements; dynamic loan loss provisioning; countercyclical liquidity requirements; administrative caps on aggregate lending; reserve requirements; limits on leverage in asset purchases; loan-to-value ratios for mortgages; loan-to-income ratios; minimum margins on secured lending; transaction taxes; constraints on currency mismatches; capital controls; and host country regulation (Elliot 2011). The third order macroprudential shift, therefore, represents a potential trajectory change in financial regulation. After three decades of entrusting more and more autonomy to private actors to price and mange their own, that trajectory is, potentially at least, reversed. Macroprudential concepts potentially empower regulators by providing them with the intellectual equipment to set limits to market activities, reducing the scale and restricting the scope of financial transacting (Turner 2011). Political contests played out over time will determine if this results in a reformulation of the powers, strategies, and hierarchies of the regulatory state, extending beyond audit and surveillance (Moran 2003), toward much more interventionist forms of command regulation and system-wide countercyclical management, constituting a great regulatory transformation driven by third order ideational change.4 Third order change in a macroprudential direction is intellectually radical, at least in relation to what has gone before, as the four key macroprudential concepts provide a multifaceted challenge to the key claims of the efficient markets perspective. Fallacy of composition challenges the notion that the rational incentives of individual actors are sufficient to generate financial stability. Procyclicality raises the prospect that financial market prices are prone to extreme swings, rather than usually being correct. Herding challenges the notion that individuals have the capacity and inclination to rationally evaluate all information, while complex systems analysis indicates that complex innovative financial systems can be a cause of systemic instability and fragility, rather than enhancing durability, as per the market completion hypothesis.

Macroprudential as sudden and dramatic third order change: The temporal dimension

  1. Top of page
  2. Abstract
  3. Introduction
  4. Macroprudential as radical (transformative?) third order change: The substantive/trajectoral dimension
  5. Macroprudential as sudden and dramatic third order change: The temporal dimension
  6. Macroprudential first and second order policy development as an evolutionary, incremental process: The substantive/trajectoral dimension
  7. Macroprudential first and second order policy development as a slow, gradual, incremental process: The temporal dimension
  8. Conclusion
  9. Acknowledgments
  10. References

Applying Hall's three orders of change framework (originally developed on the basis of a case study of British macroeconomic policy in the 1970s) to financial regulation does help to illuminate some of the dynamics at work in efforts to develop macroprudential regulation. The events of 2007–08 were dramatic as asset values collapsed, liquidity dried up, credit markets froze, interbank lending markets ground to a halt, several financial institutions became insolvent, and many others required public financial support of various descriptions to continue trading. Rather than the progressive accumulation of anomalies, as in the case of the Keynesian paradigm in Hall's original case, a much more dramatic financial explosion resulted in the rapid collapse of the efficient markets perspective. For example, an early centrepiece international policy document responding to signs of distress in securities and derivatives markets, a report by the Financial Stability Forum (2008), reiterated “the familiar trilogy” (Eatwell 2009), of “greater transparency, more disclosure and more effective risk management” by banks and investment funds (FSF 2008). However, exactly one year later, the Horsham G20 communiqué was openly advocating countercyclical capital buffers and policies designed to “mitigate the procyclicality” of the financial system (G20 2009). Macroprudential thinking critiqued the prior efficient markets orthodox and its over-reliance on VaR models, asserting that such an approach was a cause of the crisis that had further “hard wired” procyclicality into the financial system (FSA 2009). In a little over six months, macroprudential ideas moved from relative obscurity in certain enclaves of the Bank for International Settlements (BIS), to the center of the policy agenda, dominating and driving the post-crisis financial reform debate in the international community of central bankers, displacing the previous efficient markets orthodoxy, and acting as the foundational premises shaping many of the key proposals emerging from the Basel Committee on Banking Supervision (BCBS), the Financial Stability Board (FSB), and national central banks (Haldane 2009; Bernanke 2011; Borio 2011; Constancio 2011; FSB/IMF/BIS 2011; Tucker 2011; Baker 2013). As Claudio Borio of the BIS has pointed out, “a decade ago the term macroprudential was barely used and there was little appetite amongst policy makers and regulators to even engage with the concept, let alone strengthen macroprudential regulation” (Borio 2009, p. 32). “This swell of support [for macroprudential regulation] could not have been anticipated even as recently as a couple of years ago. The current financial crisis has been instrumental in underpinning it” (Borio 2009, p. 2).5 It is possible to argue that macroprudentialists are overstating the extent and significance of the macroprudential ideational shift, in an effort to enhance their own policy role and to facilitate “technocratic control and mastery of financial markets” (Erturk et al. 2011, p. 11). However, this remains an open empirical question that depends on the development of macroprudential policy instruments over time. At the same time, conceptually and intellectually, macroprudential thinking is a radical break with the recent efficient markets past, and this shift has also been surprisingly rapid.

Second, the sequencing evident in the rise to prominence of macroprudential ideas was highly unusual. In Hall's macroeconomic case, the sequence that prevailed was a 1 + 2 = 3 formulation (eventually), as a process of ad hoc experimentation with some policy prescriptions from outside of the prevailing Keynesian paradigm preceded a third order shift to stated monetarist objectives and assumptions. During the first half of the 2000s, while there were certainly critics warning about the dangers of VaR as an approach to risk management (Persaud 2000), and others pointing to the dangerous sets of conditions accumulating in financial markets and the inadequacy of the policy and regulatory response (Borio & White 2004), these problems were not perceived as significant anomalies by the majority of the international regulatory policy community. Consequently, there was no process of sustained prior policy experimentation with first and second order policy change from outside of the efficient markets perspective, with the exception of the odd isolated case.6 Rather than a sequence of 1 + 2 = 3, the macroprudential shift involved a move straight to 3, prior to first and second order policy experimentation, producing a 3 may = 2 + 1 shift. For a paradigm shift to occur, Hall is clear that there needs to be a simultaneous shift in all three types of policy, but because first and second order macroprudential policies are still in the process of being fully developed, the macroprudential shift represents an example of a contingent ideational shift, rather than a paradigm shift – the full implications of which will be determined by the subsequent process of first and second order policy development. This makes the macroprudential ideational shift an interesting test case for assessing whether a 3 = 2 + 1 sequence can be sustained without prior first and second order policy experimentation, or whether successful paradigm shifts always follow the 1 + 2 = 3 sequence first identified by Hall.7

Third, Hall writes that the process whereby one policy paradigm comes to replace another is likely to be “more sociological than scientific” and will involve a set of judgments more political in tone (Hall 1993, p. 280), as politicians will have to reach a judgment on which groups of experts to regard as authoritative. The macroprudential shift certainly had a sociological element. Macroprudential norm entrepreneurs' social status and professional standing rose following the financial crisis, meaning that macroprudential ideas had credible backers whose professional esteem was rising (Baker 2013). While in the words of Borio, macroprudential ideas had been “evolving quietly in the background, known only amongst a small but growing inner circle of cognoscenti” (Borio 2011, p. 1), these ideas had been cursorily rejected by leading central bankers, such as Alan Greenspan, during the first part of the decade (Balzli & Schiessl 2009). Following the financial crash of 2008 a number of key macroprudential norm entrepreneurs (Finnemore & Sikkink 1998), such as Borio, William White, Avinash Persaud, John Eatwell, Charles Goodhart, and Andrew Haldane, became much better placed to offer national policy advice in the UK, the EU, and Canada, and became integral in driving a number of key set piece reports that diagnosed the crisis and offered blueprints for reform (Blyth 2002). These included the Turner Review, the De Laroisière report, the G30, the UN Stiglitz Commission, and the G20's working group 1, as well as the work of the BIS (Baker 2013; Helleiner 2012). Many of the individuals mentioned were already recognized and well positioned within key policy networks, with a prior track record of advancing macroprudential ideas for nearly a decade. Consequently, the macroprudential ideational shift had the characteristics of “an insider's coup d'état,” instigated by existing technocratic elites (Baker 2013). In contrast, in Hall's case, third order change was promoted by politicians and societal actors, such as the media and think tanks (Hall 1993).

The very nature of the macroprudential shift, therefore, poses the question of whether technocratic elites can successfully instigate and crucially sustain third order change, or whether successful durable third order change has to emanate from wider societal and political actors. Crucially, the technocratic nature of financial regulation and its dependence on expert contributions meant that this particular instance of third order change could take a more immediate and rapid form, because it was less dependent on building consensus, support, and levels of understanding amongst wider societal and political actors, which macroeconomic policy's much higher political profile requires. Rather, politicians displayed a significant reliance on technocrats to provide them with an interpretative frame that offered a diagnosis of an uncertain situation and an institutional blueprint for reform (Blyth 2002) that drew heavily on macroprudential theory in a time span of little over six months. The macroprudential ideational shift was, therefore, relatively sudden and dramatic along the temporal dimension.

Macroprudential first and second order policy development as an evolutionary, incremental process: The substantive/trajectoral dimension

  1. Top of page
  2. Abstract
  3. Introduction
  4. Macroprudential as radical (transformative?) third order change: The substantive/trajectoral dimension
  5. Macroprudential as sudden and dramatic third order change: The temporal dimension
  6. Macroprudential first and second order policy development as an evolutionary, incremental process: The substantive/trajectoral dimension
  7. Macroprudential first and second order policy development as a slow, gradual, incremental process: The temporal dimension
  8. Conclusion
  9. Acknowledgments
  10. References

Macroprudential policy is a new ideology and a big idea. That befits what is, without question, a big crisis. There are a great many unanswered questions before this ideology can be put into practice. These questions will shape the intellectual and public policy debate over the next several decades, just as the great depression shaped the macroeconomic policy debate from the 1940s to the early 1970s. (Haldane 2009, p. 1)

When Borio quipped that, “we are all macroprudentialists now” (Borio 2009, p. 1), it was more than just a clever adjustment of Milton Freidman's famous idiom. It reflected the fact that within the regulatory networks centered around the Swiss city of Basel, the BIS, the Basel Committee on Banking Supervision (BCBS), and the revamped FSB, open opposition to the idea of developing a macroprudential policy regime has been scarce. The clear consensus is that macroprudential is a good idea. Open advocates of rational expectations, new classical thinking, and an efficient markets perspective have been hard to find in financial regulatory networks, since late 2008. Policymakers, Hall tells us, customarily work within a framework of ideas and standards that specify the very nature of the problems they are meant to be addressing. Like a gestalt, this framework is embedded in the very terminology through which policymakers communicate about their work (Hall 1993, p. 279; Finnemore & Sikkink 1998.) In the world of financial regulation, macroprudential is the new gestalt, and, as Borio has astutely observed of his regulatory peers, they are “all macroprudentialists now,” at least in terms of broad agreement on third order assumptions, objectives, and discourse.

However, as Andrew Haldane's quote at the start of this section indicates, much remains up for grabs. While there is broad agreement on the need for macroprudential policy, there has been much less agreement over what the detail and content of a macroprudential policy regime should look like, or how it might work in practice. In contrast to third order change, second order macroprudential instruments and institutional arrangements, and first order macroprudential policy settings are much more fiercely contested. The difficulty in developing macroprudential policy is compounded by the situation alluded to by voices at the Bank of England. “The state of macroprudential policy resembles the state of monetary policy just after the second world war, with patchy data, incomplete theory and negligible experience, meaning that MPR will be conducted by trial and error” (Aikman et al. 2011). Macroprudential authorities will not be able to draw on decades of research and experience. According to Haldane (of the Bank of England), “the authorities will be sailing largely in unchartered waters in a new boat, with a new crew” (Jones 2011, p. 2). New institutions, such as the European Systemic Risk Board (ESRB) in the EU, the Financial System Oversight Council (FSOC) in the US, and the Financial Policy Committee (FPC) in the UK, are to be given macroprudential responsibilities and are to be equipped with new policy instruments. In such circumstances, we might expect institutional and regulatory change to be dramatic, radical, and rapid, but there are two dynamics at play along the substantive dimension, which mean this is unlikely to be the case.

First, as the editors observe in their framing piece, when technical knowledge on specific regulatory issues is not well developed, or when organizational capacity to implement a specific regulatory decision is poor or absent, regulatory reform is likely to follow a slow or incremental process along the substantive or trajectoral dimension, precisely because time is needed to develop the relevant knowledge and organizational capacities (Moschella & Tsingou 2013). As the quotes from Bank of England officials above illustrate, this is precisely the situation that applies to the development of macroprudential policy. Macroprudential policy is so new, and experience with it is so limited, that we have entered a very fluid phase of experimentation. Regulators, both internationally and domestically, are devoting a great deal of energy and effort to addressing macroprudential policy questions. The most recent joint FSB, IMF, BIS report on macroprudential policy for the G20 contained references to 22 documents and reports with a macroprudential focus, published by those institutions alone, since 2010 (FSB, IMF, BIS 2011). An extraordinary amount of macroprudential analysis is underway in the regulatory policy community. The relative newness of macroprudential ideas and the novelty of macroprudential policy mean that a technical process of experimentation and refinement will very definitely give the development of the macroprudential ideational frame an incremental and evolutionary dynamic (Carstensen 2011). This is particularly so in the macroprudential case because, as the last section established, macroprudential has been an almost exclusively technocratic project to date, driven by technocrats whose aim is to achieve technocratic mastery of financial markets, by “rethinking” and “mapping” the financial network (Erturk et al. 2011).8 By their nature, technocrats like to proceed cautiously on the basis of data sets and empirical evidence, which take time to accumulate. Consequently, the task of filling macroprudential regulators' empty policy arsenal is proceeding gradually as evidence, data, and rationales are compiled and tested. For example, the latest FSB/IMF/BIS report to the G20 on macroprudential policy notes that “systemic risk identification is a nascent field, that requires fundamental applied research, so as to inform the collection of analysis and data, to fill data gaps and to lead to the development of better models (FSB, IMF, BIS 2011, p. 3).” Similarly, the private sector has been urging a slow, cautious approach to the development of macroprudential policy. The Institute of International Finance (IIF) has argued that “the science” in this area is at an early stage, while using capital as an instrument of macro stabilization was “unprecedented and untested,” requiring authorities to “exercise great caution” (IIF 2011, p. 22).

A second reason for the slow incremental pace of first and second order macroprudential policy development is political wrangling over detail. As the editors of this special section highlight in their framing piece, regulatory sectors with numerous veto players are more likely to follow slow dynamics of change, as “countries with many veto players will engage in only incremental policy changes” (Tsebelis 2000, p. 264; Moschella & Tsingou, 2013). Ultimately, because first order policy settings and second order policy instruments have implications for the day-to-day investment strategies and market operations of a variety of market actors, private sector actors are far more concerned with contesting appropriate first order policy settings and second order policy instruments, than they have been over third order questions of macroprudential philosophy and concepts (IIF 2011). Likewise, existing institutional actors – legislators, political parties, other agencies and bureaucracies – are taking a much closer interest in and developing stronger positions on second order macroprudential institutional questions, as they seek to protect their own turf and standing. The result is a far more contested, contingent, and even controversial sphere of first and second order macroprudential policy development, which is likely to lead to political compromises and is liable to dilute macroprudential policy content, in substantive terms.

Therefore, while Hall found that in the case of British macroeconomic policy, first and second order policy changes proved less politically contentious and were, therefore, guided and driven by technocrats, in the macroprudential case exactly the reverse applies. Third order macroprudential change was driven by technocrats and was relatively quick and uncontested.9 Second order and first order macroprudential policy choices, in contrast, are far more politically controversial and contested, because they have a more conspicuous impact on the daily activities, power, resources, and standing of both public and private actors, giving rise to a far more politically contested process that will likely slow macroprudential policy development and dilute it in substantive terms as various compromises are reached. A good example of this came in the Basel III agreement announced in September 2010.

Basel III

The Basel III agreement represents an example of what historical institutional scholars refer to as “layering.” Layering occurs when new rules are attached to existing ones, involving amendments, revisions, and additions to existing rules (Mahoney & Thelen 2010, p. 16). Layering typically involves change agents working within the existing system by adding new rules on top of or alongside existing ones. A process of layering also involves specific roles for change agents and veto players, which can be applied to the case of the Basel III agreement. Veto players in a situation of layering are able to preserve old rules, but are unable to prevent the addition of new rules. Change agents in a situation of “layering” perform the role of “subversives” working against the system from within it (termites in the basement), appearing supportive of existing arrangements, but promoting new rules on the edge of old ones, as new institutional arrangements are grafted onto old ones (Mahoney & Thelen 2010, p. 26). This clearly fits with the pattern of macroprudential norm entrepreneurs exercising an “insiders” coup de état, but it is even more evident in the patterns of politics surrounding the Basel III agreement. For example, microprudential risk management through VaR models revolving around price signals has not been jettisoned in Basel III, rather it is now overlain by macroprudential instruments, such as countercyclical capital buffers. Thus, in accordance with a pattern of “layering,” new rules have been added to existing ones. Basel III revises and adds to Basel II. Existing rules, such as the required ratio of equity capital to risk weighted assets, have been adjusted upwards from two percent to seven percent, fitting with the pattern of layering, but they also entail substantive (albeit minimal) changes in risk weights.

There are four reasons why this pattern of layering resulted in the case of Basel III. First, there is the issue of capacity. Change agents seeking to give Basel III a macroprudential quality, largely national regulators and officials at the BIS, were in no position to persuade the industry to abandon VaR risk modeling, even if they wanted to. A rewriting of the fundamental microprudential elements of Basel III was never really on the agenda, and some surveillance of the risk management strategies of banks will continue. Once third order macroprudential change had been instigated, however, industry and other potential opponents were also in no position to stop regulators from writing some countercyclical capital element into Basel III, at least on a point of principle (see Young 2013). The strategies and resources open to both change agents and veto players were, therefore, most likely to produce a form of layering. A second reason relates to the internal constitution of macroprudential ideas and how their internal component parts relate to microprudential ideas (Carstensen 2011). Microprudential supervision and regulation can be a constituent part of a macroprudential regime, but it is the adequacy of microprudential approaches that is disputed by the macroprudential perspective. Consequently, macroprudential approaches overlay, rather than replace, microprudential approaches in their entirety. A third reason is the lobbying capacity of large banks, stemming from first mover advantage and the personal connections leading personnel from the IIF have with members of the Basel Committee (Lall 2012). Initial empirical evidence reveals that industry lobbies, particularly the IIF, have been successful in watering down the provisions of Basel III, particularly during 2010 (Lall 2012), and direct participants in the Basel process have confirmed the role of industry lobbying in producing a much more minimal Basel III than originally envisaged (Turner 2011). Fourth, interjurisdictional conflict meant that while the US, UK, and Swiss representatives argued for a much higher equity capital ratio (Hanson et al. 2011), EU regulators wanted lower requirements, fearing this would disadvantage their ailing banks. An interstate, or interjurisdictional, contest, in which actors seek to gain competitive advantage for their own financial sectors, has, therefore, further diluted Basel III, and may, in turn, create further opportunities for market players to engage in regulatory arbitrage (Mugge & Stellinga 2010; Helleiner 2012).

One of the features of “subversives” as change agents identified by Mahoney and Thelen can also be observed in the case of macroprudential norm entrepreneurs. That is, that subversives often “bide their time,” disguising the true extent of their preferences, waiting for the moment at which they can actively advance their true preferences, contenting themselves with a short term strategy of minimal layering (Mahoney & Thelen 2010, pp. 26–27.) In the case of UK representatives (Turner 2011), the justification for a more expansive stance on capital ratios in Basel III drew on macroprudential arguments that capital requirements needed to be set far above any reasonable estimate of the losses likely to be incurred by an individual bank, because what mattered was the macro systemic stability of credit supply, not just the risk of individual failure (Miles et al. 2011; Turner 2011). From this perspective, Bank of England officials have argued that in an ideal world, Basel III capital ratios would be 15–20 percent of risk weighted assets (Miles et al. 2011; Turner 2011). This objective is, however, viewed as a long-term one, because while higher equity ratios would not, in the long run, carry an economic penalty, a starting point of suboptimally high leverage means that higher equity ratios could slow recovery from a crisis induced recession (Turner 2011). This argument was accepted by more ambitious macroprudentialists, such as Adair Turner and the BIS macroeconomic assessment group, whose analysis informed Basel III design. The position of macroprudential change agents, therefore, is that Basel III is a step in the right direction, but that the system remains more vulnerable to instability than is ideal, and that long term, the answer must be to move toward the 15–20 percent level (Miles et al. 2011; Turner 2011). For many macroprudentialists, therefore, Basel III remains unfinished business to be revisited. While the private sector was not in a position to veto an increase in equity ratios (Young 2013), they did play a de facto veto role, minimizing and diluting requirements through the implicit threat that it would lead to a shrinking of balance sheets, causing a new credit crunch (Hanson et al. 2011, p. 24). Consequently, Basel III is to have a slow phase-in with many new requirements not becoming effective until January 2019. The veto powers of private actors, while not enough to prevent a rule change, did dilute Basel III, producing only a minimal layering effect relative to Basel II. From a macroprudential perspective, Basel III is an imperfect, unfinished, and only temporary best fit solution that will require revising in the future. These layering dynamics mean that the construction of MPR is proceeding in an incremental and gradual fashion.

The language surrounding the major macroprudential component of Basel III – a country-by-country countercyclical capital buffer of between 0 and 2.5 percent – is also deliberately ambiguous. The relevant passage reads: “For any given country, this (countercyclical capital) buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk” (BCBS 2010, pp. 57–58). In other words, a failure to deploy a countercyclical capital buffer can be justified if system-wide credit growth is deemed not to be excessive. The capacity to implement countercyclical capital buffers will, therefore, depend on the capacity and capability of domestic regulators to exercise their discretionary judgment, which will be determined by national institutional arrangements. In substantive terms, therefore, political wrangling has resulted in a Basel III agreement that seems weak on implementation.10

Macroprudential first and second order policy development as a slow, gradual, incremental process: The temporal dimension

  1. Top of page
  2. Abstract
  3. Introduction
  4. Macroprudential as radical (transformative?) third order change: The substantive/trajectoral dimension
  5. Macroprudential as sudden and dramatic third order change: The temporal dimension
  6. Macroprudential first and second order policy development as an evolutionary, incremental process: The substantive/trajectoral dimension
  7. Macroprudential first and second order policy development as a slow, gradual, incremental process: The temporal dimension
  8. Conclusion
  9. Acknowledgments
  10. References

The specific countercyclical objectives of macroprudential regulation, as time variable policies that are only conspicuous at certain parts of the economic cycle, intensify the time sensitive nature of developing macroprudential policy. Notably, countercyclicality is politically treacherous. In an economic downturn immediately following a crisis, when the political will for more regulation is precisely at its greatest, the macroprudential perspective advocates a more generous approach to regulatory and capital requirements, but then favors tightening these requirements during a growth phase – precisely when the political appetite for such requirements may have dissipated, as the memory of the crisis fades. This leaves macroprudential regulators with a tricky political conundrum to solve: the question of how to arm themselves with sufficient institutional autonomy, policy capability, and discretion to neutralize procyclical political pressures. It is important, therefore, for macroprudential authorities to have some institutional insulation to enable them to implement countercyclical policies, but this immediately brings them into potential conflict with legislative bodies, who seek to call them to account.

Creating new institutions, such as the Financial Policy Committee at the Bank of England in the UK, is potentially controversial and raises all kinds of accountability issues. Moreover, macroprudential authorities have to be empowered by legislation. Legislative processes and ratification can be notoriously protracted as a result of the time consuming nature of parliamentary scrutiny, which can give rise to further rounds of negotiation regarding the precise content of legislation, and the exact powers and remit to be assigned to new bodies. Existing institutions are likely to jealously guard their turf from newcomers, while also seeking to maximize their own role and importance in the process. Such a process has been evident in the UK, as the parliamentary Treasury Select Committee has sought to restrain the powers of the Bank of England's FPC and to restrict the discretion it enjoys in making macroprudential policy calls and judgments. The Treasury Select Committee has, for example, argued that the FPC should include a majority of external members, including industry practitioners (Masters & Giles 2011). In this instance, Parliament in the UK is acting as a veto player seeking to restrain the FPC, by pushing for a more industry favorable composition, which, in turn, may result in the vetoing of future countercyclical policy. Time variable political opposition to macroprudential action might, therefore, restrict macroprudential implementation in temporal terms over the economic cycle, while institutional contests over turf slow the process of developing a workable macroprudential institutional framework.

Conclusion

  1. Top of page
  2. Abstract
  3. Introduction
  4. Macroprudential as radical (transformative?) third order change: The substantive/trajectoral dimension
  5. Macroprudential as sudden and dramatic third order change: The temporal dimension
  6. Macroprudential first and second order policy development as an evolutionary, incremental process: The substantive/trajectoral dimension
  7. Macroprudential first and second order policy development as a slow, gradual, incremental process: The temporal dimension
  8. Conclusion
  9. Acknowledgments
  10. References

This article began by arguing that the movement from efficient market thinking to a new macroprudential policy discourse about a set of new macro or systemic policy objectives, as well as an entirely different set of assumptions about the financial world, is comparable to Peter Hall's notion of third order change. In this sense, the macroprudential ideational shift is intellectually radical and potentially transformatory. The second section of the paper identified that this intellectual shift was not only radical in intellectual terms, but its rise to prominence was also surprisingly dramatic and rapid, taking place in a time frame of little over six months, and did not involve a prior process of first and second order policy experimentation. Third order change proved relatively uncontroversial and was driven by technocrats, in a reversal of the pattern that applied in Hall's case study of macroeconomic policy. The article then went on to argue that if the macroprudential ideational turn is to be transformatory in regulatory terms, and result in a much more interventionist state trammeling, restricting, and, occasionally, directing and orchestrating private agents' investment strategies, this transformation will almost certainly be a gradual one, involving small cautious incremental steps in the direction of an activist functioning macroprudential regulatory regime. In this sense, intellectual radicalism does not automatically translate into a radical change in regulatory practice, because of a variety of countervailing political, institutional, and informational variables (Bell 2011). Because it has been led and engineered by technocrats, the macroprudential regulatory project will proceed on the basis of the compilation of empirical evidence and data sets that take time to assemble. Similarly, the task of development of first and second order macroprudential policy is proving to be much more politically contested than third order change, as a wider range of political actors have taken a much keener interest in the development of quantitative policy settings and institutional arrangements. These choices and decisions have a more obvious and conspicuous impact on their daily activities, routines, and capabilities. The continued privileged institutional positions of industry lobbies has meant they have been successful in diluting the macroprudential policy content of Basel III – a pattern that is likely to be repeated in national contexts. Interstate conflict, institutional turf wars, and the effects of the economic cycle are further diluting the content and slowing the pace of reform in a macroprudential direction. The task of building macroprudential regulation has, therefore, displayed many of the features that historical institutionalists refer to as “layering,” when new rules are gradually grafted onto old ones (Mahoney & Thelen 2010). Change agents associated with patterns of “layering” – “insider subversives” – typically bide their time, pursing long-term objectives. The macroprudential regulatory turn will consequently be a long haul, with distinctive incremental dynamics. Moreover, any transformation in the regulatory order arising from this is likely to be gradual.

Acknowledgments

  1. Top of page
  2. Abstract
  3. Introduction
  4. Macroprudential as radical (transformative?) third order change: The substantive/trajectoral dimension
  5. Macroprudential as sudden and dramatic third order change: The temporal dimension
  6. Macroprudential first and second order policy development as an evolutionary, incremental process: The substantive/trajectoral dimension
  7. Macroprudential first and second order policy development as a slow, gradual, incremental process: The temporal dimension
  8. Conclusion
  9. Acknowledgments
  10. References

Earlier versions of this paper were presented at the European Consortium of Political Research, Research Sessions, European University Institute, Florence, and a workshop hosted by the Department of Business and Politics, Copenhagen Business School. For comments on earlier drafts I would like to thank David Levi-Faur, Manuella Moschella, Eleni Tsingou, Kevin Young, Andre Broome, Stephen Bell, Stefano Pagliari, Thomas Rixen, Sebastian Botzem, Lucia Quaglia, Martin Carstensen, Jens Mortensen, Sven Steinmo, all others at those events, and three anonymous reviewers for Regulation & Governance. Remaining errors are my responsibility alone.

Notes
  1. 1

    “Incremental” refers to the individual steps in regulatory change. “Gradual” refers to the trajectory and pace of cumulative change as a result of those individual steps. Thanks to David Levi-Faur for forcing me to clarify this.

  2. 2

    Hall's original framework was devised on the basis of a case study of macroeconomic policy, which raises the question of whether it is suited to applications to financial regulatory policy. While macroeconomic policy clearly has different dynamics, the precise nature of macroprudential change can be illuminated by the application of the Hall framework, which also illuminates some of the differences between the two areas. I thank one of the reviewers for Regulation & Governance for drawing out this observation.

  3. 3

    White has been influenced by Austrian business cycle theory.

  4. 4

    It should be noted that figures, such as Haldane, Turner, White, and Borio, who are cited here as pioneers in developing macroprudential thinking and have promoted it in policy debates, are also technocratic regulators. Potentially, they stand to gain from the adoption of macroprudential concepts and policy instruments, through an expansion of their own policy role and bureaucratic turf. While these individuals may have genuine “ideational commitment” (Finnemore & Sikkink 1998) to macroprudential ideas, they are, therefore, not entirely neutral bystanders in macroprudential debates and do have institutional and professional incentives. I thank one of the reviewers for Regulation & Governance for encouraging me to draw out this observation.

  5. 5

    It is not my intention to explain this ideational shift in this paper, but, rather, to explore the regulatory and reform dynamics it has set in train. Some work has already outlined the scope and conditions that shaped the nature and form of the macroprudential ideational shift (Baker 2013).

  6. 6

    What is marked about the pre-crisis period is how few cases of operational macroprudential policy, such as the system of countercyclical capital buffers or “dynamic provisioning” in Spain and India, and leverage limits in Canada, there were. These cases were outliers and subsequently held up as functioning examples of macroprudential policy.

  7. 7

    The author is unaware of any other instance of a dramatic third order change without prior first and second order policy experimentation, such as the one outlined here. First and second order change often results in paradigm evolution and maintenance (Oliver & Pemberton 2004).

  8. 8

    This is not to say that macroprudential policy does not have normative implications, but these have not always been explicitly acknowledged by technocrats.

  9. 9

    The partisan distributional implications of targeting certain macroeconomic objectives often appear clear, making macroeconomic third order choices politically contentious. In contrast, the decision to target macro financial stability through some combination of countercyclical policies represents a wider common good that potentially limits financial and macroeconomic disruptions and shocks to output, serving a clearer, wider public interest.

  10. 10

    It should be noted that procyclicality is a concept that has found much less favor in the US than in Europe. As such, US officials appear to be much more circumspect about the countercyclical elements of macroprudential policy, and the ambiguity of Basel III on this point may owe much to this. (Confidential correspondence between the author and a BIS official.)

References

  1. Top of page
  2. Abstract
  3. Introduction
  4. Macroprudential as radical (transformative?) third order change: The substantive/trajectoral dimension
  5. Macroprudential as sudden and dramatic third order change: The temporal dimension
  6. Macroprudential first and second order policy development as an evolutionary, incremental process: The substantive/trajectoral dimension
  7. Macroprudential first and second order policy development as a slow, gradual, incremental process: The temporal dimension
  8. Conclusion
  9. Acknowledgments
  10. References
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