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Course on Financial Instability at the Estonian Central Bank,
9-11 December 2009 – Lecture 6
E Philip Davis
NIESR and Brunel University
West London
• Talk based on background paper co-authored by Dilruba
Karim, forthcoming in NIER
• Macroprudential defined (Borio 2009) as:
– policy focused on financial system as a whole;
– treats aggregate risk as endogenous with regard to collective
behaviour of institutions;
– aims to limit system wide distress so as to avoid output costs
associated with financial instability.
• We assess the need for a macroprudential policy pillar and
the degree to which progress has been made in instituting
one, viewed in light of lessons learnt in field of financial
stability over past decade from research, experience and
policy development
Why we need macroprudential regulation developments in the understanding of the process
of financial instability
Progress with the macroprudential pillar - the
development of macroprudential oversight
Policy issues – making macroprudential
regulation operational
2 Why macroprudential regulation developments in understanding
financial instability
(a) A generic approach
• Seen as most appropriate – key common
features of crises
• Exogenous and endogenous aspects…..
• …..which may be diverse or common in
generic terms
• While key additional generic aspect is high cost
in fiscal and GDP terms
Example ofof
Phase of crisis
Propagation build-up of
Deregulation, monetary or fiscal easing,
invention, change in market sentiment
Common – main
subject of
New entry to financial markets, Debt
accumulation, Asset price booms, Innovation in
financial markets, Underpricing of risk, risk
concentration and lower capital adequacy for
banks, Unsustainable macro policy
Monetary, fiscal or regulatory tightening,
asymmetric trade shock
Failure of institution or market leading to failure
of others via direct links or uncertainty in
presence of asymmetric information – or
generalised failure due to common shock
Deposit insurance, lender of last resort, general
monetary easing
(adverse) shock
Propagation crisis
Policy action
Common – main
subject of crisis
Common – scope
depends on
severity and
policy action
Credit rationing and wider uncertainty leading to
fall in GDP, notably investment
(b) Types of crises
• Traditional banking crisis, bank failures
following loan losses, but given securitisation
• Extreme market volatility after shift in
• Protracted collapse of debt or derivatives
market liquidity and issuance, including
interbank market
• Subprime crisis typifies the third type, as did
(c) Lessons from theory
• “Financial fragility” view of credit/asset price
cycle from Kindleberger and Minsky repeatedly
• Heightened “uncertainty” over innovations not
tested in a downturn
• “Disaster myopia”, short memories of instability
and role of incentives (including bonuses) in
underpricing of risk
• Recent models can add to understanding (Lectures
1 and 4)
3 Progress with the macroprudential
pillar - the development of
macroprudential oversight
(a) Definition
• Early realisation of need for early warnings on
crises for policy and markets
• ‘Macroprudential surveillance’ – monitoring of
conjunctural and structural trends in financial
markets so as to give warning of the approach
of financial instability – become a core activity
for many central banks
• Necessary but not sufficient for a policy pillar
(b) Methods of surveillance
• Production of financial stability reviews by over 50
central banks
• Data needs:
– macroeconomic and financial data for assessing
conjunctural conditions
– non-financial sector debt, leverage and asset prices for
considering vulnerability of borrowers
– bank balance sheets and income and expenditure for
considering robustness of banks
– risk measures derived from financial prices to complement
leverage and income indicators
– stress tests and forecasts of indicators and derived stability
indicators such as defaults and bankruptcies, including
risks to the central projection
Detail on data needs
• Whole economy
– Macroeconomic forecasts and related simulations,
including fiscal debts and deficit projections
– Prediction of crisis from logit model using current
outturns and macro forecasts
– Prediction of crisis from signal extraction indicators
using current outturns and macro forecasts
– Prediction of crisis from binomial recursive tree model
using current outturns and macro forecasts
– CDS spreads
– Conditional volatility of industrial production, retail
sales and inflation
• Banking sector
Non performing loans as a share of total loans
Banks’ return on assets
Banks’ return on equity
Banks’ unadjusted capital adequacy
Banks’ risk adjusted capital adequacy
Net interest income to total gross income
Non interest expenses to total gross income
Liquid assets to total assets
Foreign borrowing by banking sector
Interbank spreads
• Household sector:
– Sectoral debt to personal income ratios
– Currency composition of household sector debt
– House prices
• Corporate sector:
Debt to equity ratio
Corporate profitability
Altman index and its components
Corporate bankruptcy rate
Currency composition of corporate sector debt
• Market indicators:
Standard deviation and correlation of equity prices
Equity risk premium and correlations
Nominal and real interest rate volatility
Exchange rate risk premia
Conditional volatility and covariance of equity prices
Conditional volatility and covariance of exchange rates
Key macro determinants of equity and exchange rate
• Key background features
Trade relations matrix
Exchange rate regime and its sustainability
Size and foreign ownership of banking system
Size of equity market
• Key lessons
– Need for economy in number of variables
– Derivation of data needs from theory and
– Qualitative and quantitative aspects (regulation,
competition, innovation)
– Benchmarks and norms for economy, also
allowing for changes (liberalisation, yields)
– Cross border and domestic aspects
– New players and instruments (hedge funds,
• Observation of overall patterns in light of
theory, experience, generic view
• Judgemental approach in drawing
• Concept of implicit corridor (ECB), then
focus on vulnerabilities, risk scenarios,
causes of scenarios, likelihood of them
arising, costs of them
(c) Tools for macroprudential surveillance
• Distance to default measuring credit risk by
expressing net worth as proportion of asset
price volatility – mainly institution level
• Value at risk – flawed due to assumptions
such as normality, correlations
• Stress tests at institution, banking system
and economy wide level
• Bubble detection
• Early warning systems
– Multinomial logit using macro, structural and
financial variables for binary variable of
banking crisis – samples generally dominated
by EMEs
– Signal extraction EWS using relation of
individual time series to banking crises – can
use country specific data
– Binary recursive tree - “which non-linear
variable interactions make an economy more
vulnerable to crisis than others?” liquidity,
credit and market risks potentially non-linear –
seeks key discriminator between crisis and non
(d) Limits of macroprudential oversight
– subprime crisis
• Davis and Karim – leading producers of
MPS failed to predict subprime crisis
Multiplier effect of subprime losses via CDOs
Conduits and SIVs
Collapse of interbank market
Links to real economy
• But equally early warning systems showed
– Too much focus on EMEs
– Usefulness of generic feature checklist
4 Policy issues – making
macroprudential regulation operational
(a) The broad issue
• Whereas MPS may help to detect incipient
crises, and encourage firms to stress test, what
policy to pursue when warnings received?
• Options include moral suasion, speeches and
intensified supervision – how effective?
• Monetary policy up to now resist use in MP
field – focus on consumer prices only
• Variation in prudential parameters?
• Rationale of macroprudential regulation is that
individual bank supervision insufficient
• Basel 1 had a number of adverse incentive aspects….
• ….and procyclicality of financial system may be
worsened by Basel 2….
• ….while banks may act endogenously to worsen
financial system risk
• So design standards against financial fragility
– appropriate design of a countercyclical regulatory framework
(the time series dimension)
– increasing risk weights for risks that are common across
institutions rather than idiosyncratic (the cross section
(b) Countercyclical regulation
• Ongoing global regulation
– Improvements to Basel 2 to make it less
– Also tougher liquidity standards following
– Albeit partly offset by mark-to-market effects
• National regulation against procyclicality
– Some ad hoc responses to recent boom
– Dynamic provisioning in Spain – tax and
accounting problems
• Measures under consideration
– Leverage ratio (FSA)
– Capital surcharge based on MPS judgements (Bank
of England)
– Time varying capital requirements linked to lending
growth, and catastrophe capital insurance
– Relate capital requirements to asset price growth
– Limit bank asset growth to level consistent inflation
• Rules or discretion?
• Wider range of policies affecting procyclicality
(c) Cross section regulation
• Selection of systemically important institutions
– Closer supervision
– Higher capital? (regulatory vs economic capital)
• Higher capital charges on behaviour common
across institutions
– Controls on real estate lending, including lower
– Higher capital for higher wholesale funding?
• Tougher testing of financial innovations
– Higher capital charges till seen in recession
– A “drug testing” regime?
(d) Changes in the structure of regulation
• Dealing with the boundary problem as regulated
sector disintermediated
• A move back to structural regulation?
• A single regulatory structure across economic
units such as Euro Area (EU?)
• In home/host debate MP considerations favour
host regulation
• New institutions needed?…..
• ….or more care in dividing between central bank
and regulator?
• Recent focus of research on financial instability,
spurred by recurrent crises
• Development of macroprudential surveillance by
central banks….
• ….but sub prime crisis showed limitations…
• ….not only in accuracy but also absence of policy
tools for the “pillar”
• Need in particular for tools to limit ex ante the
scope of systemic risk, in time series and cross
sectional terms
• Davis E P and Karim D (2009),
"Macroprudential regulation - the missing
policy pillar" Keynote address at the
Euroframe Conference, London, June 2009,
forthcoming in National Institute Economic