Should Regulation Be Countercyclical?

McMegan has a nice post on reserve requirements and accounting rules for banks:

The problem with things like reserve ratios is that while in theory they should be countercyclical, in practice they aren't. A nice fat stack of reserves should enable you to better weather downturns. But of course, as long as they're required reserves, you can't actually touch them. If the government required you to carry $300 in your wallet at all times, you wouldn't have plenty of spending money; you'd have no spending money, unless you carried a lot more than $300.

A perfect regulator in an ideal market would relax capital requirements in bad times, and raise them in good times. The actual regulators we have, however, are terrified of spooking the markets if they do so--and more importantly, terrified of the all-out political war that would follow. So we lower capital requirements in good times, when all that capital seems like an untouched gold mine, and leave them stat, or raise them, when everything's going to hell.

Exactly right. The whole point of having reserves is to provide flexibility when times are bad. But if reserve requirements are fixed even in tough times then you don't get the positive benefit of having them. You do, however, still pay the cost of meeting the requirement.

The idea that policymakers should pursure countercyclical fiscal and monetary policies is uncontroversial, but when the source of the crisis is in the financial sector, it might make sense to tweak regulatory policies as well. In addition to giving damaged firms more flexibility in bad times, such a pattern might tamp down some "irrational exuberance" in good times.

Of course, countercyclical policies are often politically problematic: in good times, people and firms don't want the reins pulled in, and in bad times the tendency is to over-regulate in the areas causing the crisis. It is also too much to expect regulators to always make proper decisions, if given latitude (the recent flailing by the Fed and Treasury is proof enough of this). So it might make sense to set hard-and-fast rules in order to maintain stability.

Still, our current regulatory structure makes little sense. Improvements might be difficult, but regulation should make the system more stable, not less.