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Rethinking regulation for financial
system stability and growth
Presentation at the Central Bank of Nigeria‘s
50th Anniversary International Conference on
"Central banking, financial system stability and growth“,
Abuja, 4-9 May 2009
Robert N McCauley*, Senior Adviser
Monetary and Economic Department
* Views expressed are those of the author and not necessarily those of the BIS
Where do we want to go?
 “We will amend our regulatory systems to ensure
authorities are able to identify and take account
of macro-prudential risks across the financial
system”
-- G20 declaration on strengthening the
financial system, 2 April 2009
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Agenda
 Macroprudential regulation—what is it?
 Macroprudential perspective on the current
financial crisis.
 Macroprudential policy: what has been done?
What is under discussion?
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I. Macroprudential regulation
Where are we coming from?
 Macroprudential regulation
– Term used at the BIS since late 1970s more precisely
since early 2000
– Distinguish macro- and microprudential
 Two distinguishing features of macroprudential
– Focus on the financial system as a whole with the
objective to contain likelihood and cost of financial
system distress and thus to limit costs to the economy
– Treat aggregate risk as endogenous: manias and
leverage increase financial fragility
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Table 1*
The macro- and microprudential perspectives compared
Macroprudential
Microprudential
Proximate objective
Limit financial system-wide
distress
Limit distress of individual
institutions
Ultimate objective
Avoid output (GDP) costs
linked to financial instability
Consumer (investor/depositor)
protection
Endogenous
Exogenous
Important
Irrelevant
Characterisation of risk
Correlations and
common exposures
across institutions
Calibration of
prudential controls
Likelihood of failure of
individual institutions
Contribution to system-wide
risk;
top-down
Maybe different
Risks of individual institution;
bottom-up
Same
* Based on Borio (2009). The two perspectives are intentionally stylised. They are intended to
highlight two orientations that inevitably coexist in current prudential frameworks.
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Why do we need a macroprudential approach?
 Could a microprudential approach be sufficient?
– Yes - if bank failures were independent and if welfare losses
exhausted by losses to equity holders and depositors
 But:
– Banks play crucial role in the intermediation from saving to
investment
→ Real costs of financial crises can be substantial
– Bank failures are correlated
• Common exposures and direct and indirect interlinkages
– Endogenous risk is crucial to financial instability
• Endogenous feedback effects during crises
• Procyclicality of the financial system
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Procyclicality: The key mechanisms-1
 Limitations in measuring risk (and values)
– expectations are not well grounded
• bouts of optimism/pessimism; hard to tell cycle/trend
– measures of risk are highly procyclical
• Up markets tend to have low volatility, suggesting
low risk, while down markets tend to have high
volatility, suggesting high risk.
• Thus measured risk spikes when risk “materialises”
but may be quite low as risk/vulnerabilities build up
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Procyclicality: The key mechanisms-2
 Limitations in incentives
– how imperfect information/conflicts of interest are
addressed in financial contracts
• eg credit availability depends on value of collateral
which waxes and wanes over cycle
• Compensation arrangements
– leaves wedge between individually rational and socially
desirable actions (private/public interest)
• “coordination failures”, “prisoner’s dilemma”,
herding
– eg lending booms, self-defeating retrenchment
 Importance of short horizons
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II. Macroprudential perspective on the current financial crisis
 What is new: System-wide threats arising from pseudo-
dissemination of risk and in fact concentrations of risk in big banks.
 What is not new:
– Crisis as turn in an outsized credit cycle
• overextension in balance sheets in good times masked by
strong economy
• build-up of “financial imbalances” that at some point reverse
– Evidence
• unusually low volatility and risk premia
• unusually rapid growth in credit and asset prices
– BIS leading indicators help in real time
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Credit and asset price behaviour around banking crises1
Credit to GDP gap2
Property price gap3, 4
Equity price gap4
1
Distribution for the relevant variable is taken at the specific quarter across all crisis countries. 2 In percentage points as deviations from trend.
3
Weighted average of residential and commercial property prices with weights corresponding to estimates of their share in overall property wealth.
4
In per cent relative to trend.
Sources: Borio and Drehmann (2009)
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III. Macroprudential policy: What has been done?
What is under discussion
The policy problem in the upswing
 Asset inflation amid rapid growth of credit
 Inflation may be well-behaved
 What is to be done?
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Possible policy interventions
 Force disclosure of exposure to inflated assets
 Regulate the terms of credit
 Selectively increase capital requirement
 Impose reserves against (ie tax) credit or excess
credit
 Generally increase capital ratios.
 …but do not expect such policies to be popular!
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Force disclosure of exposure to inflated assets
 “Sunshine is the best disinfectant”
 Disclose credit (or equity) concentrations—sounds easy!
 But “common exposure” may need to be invented.
 For example, US regulatory authorities had defined “Highly
leveraged transactions” by 1988, well before collapse of the
leveraged buyout mania in late 1989
– Could be in tobacco, utilities or airlines
– Cut across supervisory categories
 No equivalent move in 2000s:
– Define and publicise exposure to off-balance sheet
structures like “structured investment vehicles” (SIVs)17
Regulate the terms of credit-1
 Limit credit in relation to a “stock”
– Minimum margin on equity purchase
– Security “haircuts” in repo funding.
– Maximum loan-to-value ratios in real estate.
– Minimum down payment in purchases of
consumer durables
 Restrict debt service in relation to income (flow
policy)
– Mortgage payments in relation to income.
– Credit card monthly payments (Bank of Thailand)
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Regulate the terms of credit-2
 Effective?
 Natural tendency of market is to raise loan to value
ratio as asset prices rise, sometimes to over 100%,
as next year’s price serves as collateral value
 So merely holding the line would be an achievement
 Hong Kong authorities reduced loan-to-value ratios
through February 1997; apartment prices peaked in
September 1997; subsequent 50% fall did not lead to
banking crisis.
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Ratcheting down the loan-to-value ratio in HK
Index , 1989=100
Loan-to-value
ratio lowered to
60% for luxury
residences
500
400
300
Loan-to-value
ratio lowered
to 70%
200
100
R es idenc es
1989:1
1990:1
1991:1
1992:1
Loan-to-value ratio
lowered to 60% for
luxury residences
100+ m² r es idenc es
1993:1
1994:1
1995:1
H ang Seng index
1996:1
1997:1
1998:1
Year and quar ter
Sources: Hong Kong Monthly Digest of Statistics, Hong Kong Monetary Authority
Note: Luxury properties are defined as those costing over HK$ 5million (US$0.6 million) in 1993
and over HK$12 million (US$1.5 million) in 1997. Banks appear to have loosened their lending
standards between 1994 and 1997.
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Selectively increase capital requirement
 Attach higher risk weight to class of loans/assets associated
with/subject to asset inflation
 Examples:
– Proposal to attach 200% weight to highly leverage
transactions in late 1980s.
– US proposal to deduct venture capital investments of banks
from own capital in late 1980s (=2,500% weight).
– Reserve Bank of India’s higher capital weight on claims on
households, given rapid growth of lending to same several
years ago (Borio and Shim (2007)).
 Could have put on high LTV or low documentation mortgages.
 Effect is to raise overall capital ratio.
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Impose reserve requirements on credit growth
 On credit growth above a threshold (Finland in late
1980s-30%)
 In effect a tax if required reserves remunerated at
yields below those in the market.
 Problem of uneven incidence: firms with access to
securities markets or foreign bank loans can avoid
paying
 Uneven incidence may not be a problem if selects
non-traded goods, e.g. real estate borrowing
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Raise overall capital requirements
 Subject of active research.
 Building on Basel II, apply multiplicative or additive factor based
on some measure of the aggregate risk in the economy
– eg Goodhart and Persaud (2008)
 Any rule has two components:
– Measure of risk
– How increase/decrease in required capital depends on this
measure
 The rub: Measure of aggregate risk in the economy can be
problematic
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Graph 1
Possible conditioning variables and non-performing loans in the US
Real GDP growth
Real credit growth
Corporate bond spreads1
Credit and asset price gaps
Non-performing loans are in billion USD.
1)
BBB rated corporate bond spread (source Moody’s )
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Raise overall capital requirements—does it work?
 Question effectiveness: Adoption of Basel 1 rules in late 1980s
did not prevent Japanese asset prices and Japanese bank
lending from rising into 1990.
 But Japanese banks holdings of equities linked their market-
value capital to bubble in equity and real estate.
 Thus no general conclusion is justified that raising capital
requirements is ineffective
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Credit policies are not popular
 Rapid credit growth and asset inflation generate “economic”
justifications endogenously—eg professors at Tokyo University
in the late 1980s rationalised the bubble with Q theory.
 In Ibsen’s play, Enemy of the People, a doctor reveals that the
water source on which a spa town’s prosperity based is tainted
by poison: town rejects doctor.
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Rules or discretion?
 Rely as far as possible on rules rather than discretion…
– can margin of error
• measuring aggregate risk in real time with sufficient lead and
confidence to take remedial action is very hard
– rules act as pre-commitment devices
•  pressure on supervisors not to take action during boom
even if see risks building up
– fear of going against view of markets
 …But do not rule discretion out!
– fool-proof rules may be hard to design
– can be better tailored to features of financial institutions
– need to discipline discretion (transparency and accountability)
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Credit policies require stronger institutional set-up
 Need to strengthen institutional setting for implementation
– align objectives-instruments-know how
 How?
– strengthen cooperation between central banks and
supervisory authorities
– strengthen accountability
• clarity of mandate, independence, transparency
– monetary policy as a model?
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Macroprudential policies, tried & proposed: recap
Sectoral
Disclosure
Credit
General
Reserve requirements (tax)
vs credit growth
Loan-to-value ratio, etc
Superweights, selective
Build equity over cycle
Equity
req’s
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Conclusions
 Macroprudential regulation is on the agenda.
 Current financial crisis combined asset inflation and
excessive credit in source countries.
 Central banks and authorities have tried sectoral credit
policies to an extent not widely appreciated, and in some
cases used sectoral bank capital policies as well.
 Much work ongoing on rules that would build banks’
equity buffers during booms so that they can be run down
in bad times.
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References
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Crockett, A (2000): “Marrying the micro- and macroprudential dimensions of financial
stability”, BIS Speeches, 21 September.
Borio C (2003): “Towards a macroprudential framework for financial supervision and
regulation?”, CESifo Economic Studies, vol 49, no 2/2003, pp 181–216. Also available
as BIS Working Papers, no 128, February.
Borio, C and M Drehmann (2008): “Towards an operational framework for financial
stability: 'fuzzy' measurement and its consequences”, 12th Annual Conference of the
Banco Central de Chile, Financial stability, monetary policy and central banking,
Santiago, 6–7 November. http://www.bcentral.cl/eng/conferences-seminars/annualconferences/2008/program.htm.
Borio, C and M Drehmann (2009): “Assessing the risk of banking crises – revisited”,
BIS Quarterly Review, March, pp. 29-46.
Borio and I Shim (2007): “What can (macro-)prudential policy do to support monetary
policy?” BIS Working Papers no 242
Goodhart, C and A Persaud (2008): “A party pooper’s guide to financial stability”
Financial Times, 4 June.
McCauley, R, J Ruud and F Iacono (1999): Dodging Bullets: Changing US Corporate
Capital Structures in the 1980s (Cambridge: MIT Press), chapter 10, “Policy and
asset inflation”.
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