In a new policy brief, Jan Kregel looks at a lesser-known, early period of Minsky’s work on financial reform. In the ’60s, Minsky was a consultant to a number of government agencies, including the Federal Reserve, on issues related to financial regulation. In this context, he came up with a new approach to bank examination, which he called “cash-flow based.” The new approach evaluated bank liquidity, not as an innate feature of a particular class of assets, but as a function of the balance sheet of the institutions under examination, the markets for those assets, the state of the macroeconomy and the financial system as a whole, and much else. In fact, as Kregel explains, what Minsky was after here was related to an early form of what we now call “macroprudential regulation.”

The evolution of Minsky’s thought on this approach to bank examination is interesting enough in itself, but it’s also a reflection of Minsky’s broader thinking about financial regulation and reform. Minsky developed his regulatory proposals in the ’60s and ’70s with an eye to what was to become his well-known “financial instability hypothesis,” which is to say, his proposals were informed by a theory of endogenous financial instability: a theory in which financial crises are not only possible, but are to be expected; generated as a result of the “normal” functioning of the financial system. Without such a theory, as Kregel points out, it’s hard to formulate effective regulation:

As Minsky was fond of pointing out, the bedrock of mainstream theory is a system of self-adjusting equilibrium that provides little scope for the discussion of a systemic crisis, since, in this theory, one could not occur. It was thus extremely difficult to formulate prudential regulations to respond to a financial crisis if one could only occur as the result of random, external shocks, or what Alan Greenspan would consider idiosyncratic, nonrational (fraudulent) behavior. The only basis for regulation would be to concentrate on the eradication of the disruptive behavior of bad actors or mismanaged financial institutions. From this initial presumption, the formulation of regulations and supervisory procedures required the assessment of the activities of individual banks—without any reference to their relations with other institutions or the overall environment in which they functioned.

One consequence of being informed by a proper theory of financial instability, Minsky maintained, is that regulation has to be responsive to innovations in the financial system; innovations that are often reactions to new regulatory frameworks. What this calls for, then, is not just the right set of rules, whether your preferred model is Glass-Steagall or something else, but also an adaptive, “dynamic” framework that’s attuned to the evolution of the financial system. This is from the preface:

the challenge for reform is not just the proper formulation and implementation of specific rules, but the development of an approach that is sensitive to the potential of actors in the financial system to adapt and innovate, creating new practices that threaten the stability of the system in ways that may not become apparent until the next crisis hits. Financial regulation and examination procedures need to be constantly reassessed in order to avoid becoming obsolete. And in that sense, as Minsky recognized, “the quest to get money and finance right may be a never ending struggle.”

There’s a lot more here, including Kregel’s take on the ongoing debates about imposing specific capital and liquidity ratios on financial institutions:

While the imposition of minimum liquidity and capital ratios is an improvement over the prior risk-based approach, such target ratios are not macroprudential regulations in Minsky’s sense. Similarly, stress tests of banks’ capital positions are applied to banks individually, rather than in a systemic interaction. Neither approach to macroprudential regulation takes into account the dynamic macro factors that impact the bank’s position-making assets and liabilities and the secondary markets in which they trade, or the ongoing institutional and policy changes that are a natural part of the economic system.

Download it here: “Minsky and Dynamic Macroprudential Regulation“