After the Mortgage Boom and Bust, aWay to Stabilize Financial Markets

Abstract

Between 2001 and 2007, the US economy experienced a mortgage boom and bust that spilled over into the real economy. The mortgage boom was fuelled in part by new, less regulated products and institutions. To improve the stability of US financial markets, federal regulators could use asset-based reserve requirements (ABRRs). ABRRs have several features that may have helped to smooth the large financial market swings after 2001. For one, ABRRs increase the tools at the Federal Reserve’s disposal to conduct monetary policy. Second, ABRRs directly influence lenders’ asset allocation decisions and thus could provide strong incentives to engage in less risky lending strategies. In this regard, they may prove superior to the existing system of reserve requirements on deposits, which they could possibly replace. Third, ABRRs would impact a much larger share of the credit market than reserve requirements on deposits, not just loans by deposit-taking institutions that fall under the Federal Reserve’s regulatory regime. Fourth, ABRRs could offset the procyclical bias of new capital adequacy standards and thus help to stave off too much credit tightening in an economic downturn.