Is a less procyclical financial system an achievable goal?

Banking and finance are inherently procyclical, a condition exacerbated by the combination of Basel II and mark-to-market accounting, which is why countercyclical macroprudential policies must be implemented. This vulnerability was intensified by the reduction in bank liquidity (greater reliance on secondary funding) and the organizational shift from general partnerships to publicly traded corporations. Some commentators have viewed the application of direct restrictions on banking activity—such as the promotion of narrow banking¹ and limits on bank size—as a solution to this procyclicality. While there are arguments for strengthening regulation as systemic risk increases, direct restrictions are simplistic; more reasonable approaches involve adopting better-designed macroprudential regulation, perhaps including some form of bank self-insurance. However, much remains to be decided regarding the future of banking regulation. (Audio: Department of Economic Publications)