A New Regulatory Tool for Financial Stability

Economists tend to be pretty good at pointing out what is currently going wrong with the economy. But we tend to be rather hamstrung at offering solutions. In the current crisis, public policy needs to achieve three things: 1) help troubled homeowners and declining communities, 2) maintain liquidity and stability in the credit market, and 3) prevent another financial crisis of this magnitude from happening again. Lawyers, community activists, consumer advocates, sociologists, among others, have offered a wide array of proposals to address the first two problems. Little has been suggested in ways of addressing the chance of a repeat crisis in the future. Economists in particular are reluctant to go beyond simple proposals that call for more market transparency. A changed regulatory, environment, though, may help to reduce the chance of future financial crises. Specifically, a few economists have proposed a new regulatory tool called asset-based reserve requirements for more than three decades. This tool would allow the regulatory agency, often assumed to be the Fed, to force financial institutions to bear the cost of their investment decisions and not to unload them onto society.

Under a system of asset-based reserve requirements, the Federal Reserve would require that financial institutions hold a fixed percentage of each financial investment - mortgages, car loans, credit card debt -- with the Federal Reserve as low-interest or interest-free reserves. The percentage held as reserves would be larger for riskier investments, thus forcing lenders to face the costs of their risky lending decisions. Also, the Federal Reserve could change the reserve requirement for each investment category over time. For instance, if lenders became more reluctant to lend in the mortgage market, the Federal Reserve could lower the reserve requirement on standard mortgages, thus giving a banks an incentive to extend more mortgages relative to other forms of credit. At the same time that asset-based requirements are introduced, the current system of liability-based reserves on deposits would be eliminated.

A number of factors speak for the introduction of asset-based reserve requirements. The existing system of reserve requirements leveraged on deposits has become increasingly blunt since an ever smaller share of the financial system runs through deposit-taking institutions. By replacing liability-based reserve requirements with asset-based reserve requirements, the Federal Reserve could get a regulatory tool that may be better suited to achieve financial stability. Also, in the wake of the financial crises of the 1990s, the global financial system has started to adopt new measures for the risks included on the balance sheets of financial institutions. The introduction of asset-based reserve requirements could just piggy-back on this new risk measurement system.

The idea of this regulatory tool has been around for quite some time. Originally, members of the Federal Reserve's Board of Governors, in particular Andrew Brimmer and Sherman Maisel, suggested the use of asset-based reserve requirements in the early 1970s as a way of steering loans to underserved communities. MIT economics professor Lester Thurow introduced the idea into the academic debate in the early 1970s. In the early 1990s, University of Massachusetts economics professor Robert Pollin picked up on the idea and expanded its use as a potential economic stabilization tool. Economist Jane D'Arista with the Financial Markets Center in Philomont, VA, proposed to apply asset-based reserve requirements to banks after the Asian financial crisis in the late 1990s. Also, starting in the late 1990s, economist Thomas Palley formalized the regulatory mechanism of asset-based reserve requirements and expanded it to all asset classes, including corporate stocks. In a paper that I co-authored with Boston College law student Kate Sabatini and published at the Center for American Progress, we showed how asset-based reserve requirements would have worked to help reduce the chance of the mortgage bubble in the first place and how this regulatory tool could have helped to mitigate the crisis afterwards.