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What Can Financial Stability Reports Tell Us About Macroprudential Supervision Jon Christensson, Kenneth Spong, and Jim Wilkinson Banking Research Department Federal Reserve Bank of Kansas City Presentation to the Research Conference on “Government intervention and moral hazard in the financial sector” Norges Bank September 2, 2010 The views presented here do not necessarily represent the views of the Federal Reserve Bank of Kansas City or the Board of Governors of the Federal Reserve System Federal Reserve Bank of Kansas City What Can Financial Stability Reports Tell Us About Macroprudential Supervision • The financial crisis is spurring many reform ideas. • One key idea is macroprudential supervision. • Most central banks already perform a similar role through their financial stability reports (FSRs). • Our paper looks at what FSRs can tell us about macroprudential supervision. Federal Reserve Bank of Kansas City Outline of our Paper • Overview of macroprudential supervision and FSRs • Summary of the financial crisis • Review of FSRs in five countries – UK, Sweden, the Netherlands, Spain, and Norway • Evaluation of FSRs and their implications for macroprudential supervision Federal Reserve Bank of Kansas City What is Macroprudential Supervision? • Its goal is to ensure stability of financial system in its entirety – Crockett (2000) and Borio (2003) • A systematic approach as opposed to an idiosyncratic one • More attention to largest institutions, counterparty risk, and imbalances and shocks to economy • New tool kit – indicators based on financial data, market prices, gaps, etc., and macro stress tests Federal Reserve Bank of Kansas City Policy Steps under Macroprudential Supervision • Countercyclical regulatory policy – build up more capital, reserves, and liquidity in prosperous times • Control of contagion risk – stronger supervision of systemic firms, significant counterparty exposures, and financial infrastructure • Discretionary policies – timely actions to address imbalances and large risk exposures developing in the financial system Federal Reserve Bank of Kansas City What are Financial Stability Reports? • Goal of FSRs is to promote financial stability by identifying risks, imbalances, and adverse trends that might threaten the financial system. • Ideally, FSRs provide timely information that allows public authorities, financial institutions, and market participants to understand and respond to such risks and imbalances. • In 2005, almost 50 central banks published FSRs (Čihák 2006). Federal Reserve Bank of Kansas City What are Financial Stability Reports? • Most FSRs look at three broad categories of risk: (1) macroeconomic conditions or sectoral imbalances, (2) financial sector risks, and (3) external or global risks. • Among the approaches or tools FSRs use are financial indicators or ratios, market-based indicators, qualitative indicators and analysis, and scenario and stress testing. Federal Reserve Bank of Kansas City Overview of the Financial Crisis • Long period of prosperity led to a substantial underestimation of the inherent risks in many financial activities. • Initial impetus was declining house prices in US and some other countries and collapse of subprime mortgage market. • These events cast doubt on the value of many financial instruments and the condition of financial institutions. Federal Reserve Bank of Kansas City Overview of the Financial Crisis • Through a variety of channels, the crisis spread globally, creating liquidity, capital, and public confidence problems and leading to breakdowns in financial markets and bailouts of large institutions. • The deterioration in financial markets further contributed to more general economic problems. Federal Reserve Bank of Kansas City Table 1A - Effect of the Financial Crisis Countries Effect on the Economy (OECD statistics) Effect on the Financial System United Kingdom 6 Quarters of GDP decline, Unemployment increased from 5% to nearly 8% Sweden 3 Quarters of GDP decline, Unemployment rose from about 6% to 9% Liquidity and longer-term funding issues, increase in bank loan losses Repo rate cut to .25%, state guarantee of bank liabilities, more treasury bills issued Netherlands 5 Quarters of GDP decline, Moderate rise in unemployment Losses on mortgage-related securities, collapse of Fortis Fortis takeover, bank debt guarantees and capital injections Spain 6 Quarters of GDP decline, Unemployment increased from 5% to 20%. Liquidity and real estate lending problems, two takeovers of savings banks Fiscal stimulus, deposit and debt guarantees, and bank capital injections Norway Several Quarters of mild GDP declines, Moderate increase in unemployment Funding problems for banks relying on foreign sources, declines in bank earnings Central bank policy rate lowered significantly and lending increased, capital injections, bond exchanges Policy Actions Significant losses at FIs, Takeover of some FIs, central funding concerns, collapse of bank rate lowered and lending several large FIs liberalized, fiscal stimulus Federal Reserve Bank of Kansas City Table 1 --What Risks Did the Countries Identify? Country United Kingdom Low interest rates/spreads Increasing Asset Prices Increasing Debt Levels Trade Imbalances “if risk premia Asset prices rose abruptly, asset high relative to prices would fall expected income sharply” streams Households strong in aggregate, but signs of stress “there is a risk of disorderly unwinding” Risk premiums Rapid increases historically low— in house prices risk of rapid price and debt cannot corrections continue Property companies’ borrowing is at a high rate July 2006 FSR Sweden Dec. 2006 FSR Netherlands Added to a greater risk appetite May 2006 FSR Norway Dec. 2006 FSR Persistent risk House prices Household debt tolerance reflected outpace inflation high when in low credit by 5% in early compared premiums 2006 internationally March 2007 FSR Spain Dec. 2006 FSR July 2006 FSR July 2006 FSR Sept. 2006 FSR March 2007 FSR Trend of house price growth still high Household debt levels are a concern, Risk premiums Growth in debt Household debt historically low – and asset prices and house prices increases vulnera- may be source at historically bility to shocks of instability high levels.” June 2006 FSR June 2006 FSR Other Risks U.S. sub-prime Large FI’s market not large expanding enough to be rapidly with systemic wholesale funds April 2007 FSR Pronounced Weakening of Baltic current economic US economy account deficits slowdown in expected to hurt substantial euro area growth Baltics, financial Dec. 2007 FSR June 2008 FSR infrastructure Oil prices, Disorderly corLiquidity rection of global squeeze linked complex credit products, imbalances not to subprime spillovers from implausible crisis March 2007 FSR Sept. 2007 FSR U.S. and others U.S. negative Slowing real Use of wholesavings rate and estate activity in sale funding to trade deficit the U.S. replace deposits Commercial Global trade and US housing property, lower capital flow market is a capital under imbalances are source of Basel II, avian increasing. uncertainty. June 2006 FSR Dec. 2006 FSR flu Federal Reserve Bank of Kansas City Dec. 2006 FSR Risks from the U.S. Table 2 -- What Did the Countries Use to Evaluate Risk? Countries Financial Indicators and Ratios Market Based Indicators Qualitative Indicators, Surveys, and Specialized Data Data on large FI Ratio and trend analysis of Extensive use of a range counterparty exposures, United Kingdom global, corporate, household, of market based data market and systemic and financial sectors risk surveys Sweden Ratio and trend analysis of banks and their customers -companies, households, and foreign borrowers Netherlands Charts and tables of selected economic and financial data (More are on Bank’s website) Spain Trend and ratio analysis of financial and regulatory data Norway Ratio and trend analysis of companies, households, and banks Other Tests Projected market values of mortgage-backed securities, modeling household distress, etc. Household finance data, Price data on equities, Major counterparty KMV expected default bonds, real estate, CDS, failure, household debt frequencies, risk survey etc. servicing ability of market participants Selected charts on equity prices, CDS, credit ratings, etc. Bank lending survey Housing correction, vulnerable households, avian flu, macro model of liquidity stress Used to a lesser extent Comparisons with U.S. Data on all loans over mortgage markets, €6,000 made in Spain quality of Spanish MBS Equity and real estate prices Bank lending and liquidity surveys, counterparty exposure survey Federal Reserve Bank of Kansas City Gap indicator analysis, bank failure probabilities, house price estimates Table 3 - What Stress Tests Were Used? Country Type of Model United Kingdom Macro forecasting model – models added for household, corporate, and banking sectors Financial Institutions Included Losses equal to 15% to 30% of Tier 1 capital (Used more qualitative approach after 2007) Varies by FSR – severe test included 2-year drop in GDP of 6.3% and home prices of 30%, unemployment at 9.7% At large banks, Tier 1 capital fell by 4% points but remained well above minimum standards All depository institutions 4 consecutive declines in GDP similar to 1993 levels. 2 years before previous growth rate resumes. Considerable increase in credit risk, but “would not jeopardize the strength of Spanish institutions.” Five or six largest banks Varies by FSR -- most severe test similar to last crisis and assumed sharp fall in exports, oil prices, and foreign funding Banks have a capital shortage under most severe test, but adequate capital in other tests Major UK banks Loan portfolio model Four largest banks Netherlands Macro forecasting model -- individual banks also run stress tests Banks, insurance companies, and pension funds Credit risk model Norway Macro model -- models added for household, enterprise, and financial sectors General Results 2006 severe scenario: 1.5% decline in UK GDP 25% drop in house prices 35% drop for com. prop. 2009:1 Test – 2 years of annual loan losses of: 1.3% on loans in Sweden 10 % on loans in Baltics 30% on loans in Ukraine Sweden Spain Assumptions Used in Stress Tests Federal Reserve Bank of Kansas City All 4 banks still meet Tier 1 capital standard, but several have large capital declines Evaluation of FSRs and the Implications for Macroprudential Supervision • The FSRs for our five countries provide a systematic approach to tracking key economic and financial risks and are an important step in efforts to mitigate or respond to crises – which is the role we want macroprudential supervision to play. • These FSRs did succeed in identifying many of the risks and unsustainable trends behind the financial crisis. Federal Reserve Bank of Kansas City Evaluation of FSRs and the Implications for Macroprudential Supervision • But some of these risks were regarded as low probability events and several identified risks did not play a direct role in the crisis. • Identifying the timing and magnitude of these risks and their effects on the financial system proved to be a greater, if not impossible, challenge. Federal Reserve Bank of Kansas City Evaluation of FSRs and the Implications for Macroprudential Supervision • Several of the stress tests and other tests in the FSRs succeeded in capturing the capital needs of banks and the ensuing economic downturns. • However, banks and public authorities may not have heeded these warnings because some were described as low probability tail events. • A key benefit of the FSRs is that they may have given the central banks a better picture of financial markets and the type of assistance needed during the crisis. Federal Reserve Bank of Kansas City Evaluation of FSRs and the Implications for Macroprudential Supervision “It is difficult to estimate the probability and price the risk of all possible outcomes in financial markets. This particularly applies to events that occur rarely and have not occurred for a long time…In the long term, public authorities have an important role to play in maintaining a collective memory of previous crises.” – Norges Bank’s May 2009 FSR Federal Reserve Bank of Kansas City Evaluation of FSRs and the Implications for Macroprudential Supervision • This experience with FSRs carries a number of implications for macroprudential supervision. • First, it is unrealistic to expect macroprudential supervision to be the missing piece in our ability to prevent the next financial crisis – a role many politicians are now giving to it. • There are dangers both from underestimating the treat of a crisis and from overestimating and overreacting to such threats. Federal Reserve Bank of Kansas City Evaluation of FSRs and the Implications for Macroprudential Supervision • Macroprudential supervisors will need strong evidence to overcome political, public, and industry pressures when attempting to curtail credit booms and asset bubbles. • There must be a close linkage between those analyzing the macro risks and those supervising. • It may be even more important to have macroprudential supervision focus on creating a financial system that is more resilient and less crisis-prone in the first place. Federal Reserve Bank of Kansas City Concluding Comments • Macroprudential supervision is of much interest now with such recent steps as the European Systemic Risk Board and the Financial Stability Oversight Council in the US. • FSRs are a worthwhile exercise in identifying and monitoring important financial trends and emerging risks and understanding financial markets – which will also be essential elements in macroprudential supervision. Federal Reserve Bank of Kansas City