The Macroprudential Toolkit
Chicago Booth Initiative on Global Markets Working Paper No. 60
21 Pages Posted: 9 Jan 2011 Last revised: 4 Apr 2013
Date Written: January 5, 2011
Most treatments of financial regulation worry about threats to the banking system and the economy from defaults or credit crunches. This paper argues that the recent crisis points to fire sales through capital markets as another source of financial and economic instability. Accounting for fire sales implies several changes to the standard approach. First, if there are three channels of instability, then three regulatory tools are needed to deliver stability. Second, if only a single capital tool and a single liquidity tool are available, then there is a risk that using them pushes activity into the shadow banking system. Third, liquidity requirements on the asset side of bank balance sheets are conceptually different from liquidity requirements on the liability side.
The paper starts with a review of the recent theoretical work on fire sales that form the building blocks for a next generation of models of the financial system. A summary of some evidence suggesting that fire sales were present in the crisis is offered. Next a general equilibrium framework is introduced to describe a financial system in which default, credit crunches and fire sales are all possible. The paper concludes with a discussion of the regulatory options and some speculation on how this framework could be extended.
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