MACROPRUDENTIAL REGULATION – THE

MISSING POLICY PILLAR 

E Philip Davis

NIESR and Brunel University

West London

e_philip_davis@msn.com

www.ephilipdavis.com

groups.yahoo.com/group/financial_stability

Course on Financial Instability at the Estonian Central Bank,9-11 December 2009 – Lecture 6

Introduction• 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

Outline

1 Introduction2 Why we need macroprudential regulation -

developments in the understanding of the process of financial instability

3 Progress with the macroprudential pillar - the development of macroprudential oversight

4 Policy issues – making macroprudential regulation operational

5 Conclusion

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

Generic features of instabilityPhase of crisis Nature Example of features Primary (favourable) shock

Diverse Deregulation, monetary or fiscal easing, invention, change in market sentiment

Propagation - build-up of vulnerability

Common – main subject of macroprudential surveillance

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

Secondary (adverse) shock

Diverse Monetary, fiscal or regulatory tightening, asymmetric trade shock

Propagation - crisis

Common 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

Policy action Common – main subject of crisis resolution

Deposit insurance, lender of last resort, general monetary easing

Economic consequences

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 also:

• Extreme market volatility after shift in expectations

• Protracted collapse of debt or derivatives market liquidity and issuance, including interbank market

• Subprime crisis typifies the third type, as did Russia-LTCM

(c) Lessons from theory

• “Financial fragility” view of credit/asset price cycle from Kindleberger and Minsky repeatedly vindicated

• 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

volatility

• 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

experience– 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,

CDOs, SIVs)

• Observation of overall patterns in light of theory, experience, generic view

• Judgemental approach in drawing conclusions

• 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 crisis

(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 limitations– 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 dimension)

(b) Countercyclical regulation

• Ongoing global regulation– Improvements to Basel 2 to make it less

procyclical– Also tougher liquidity standards following

crisis– 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 target

• 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

LTVs?– 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?

5 Conclusion

• 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

References

• 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 Review