Systemic Risk and Macroprudential Regulation

Gerald P. DwyerClemson University

University of Carlos III, Madrid

Acknowledgement

• John Devereux• James Lothian• Margarita Samartín

Systemic Risk

• The G10 Report on Consolidation in the Financial Sector (2001) suggested a working definition:

• "Systemic financial risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainly [sic] about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy."

Systemic Risk

• George G. Kaufman and Kenneth E. Scott (2003) define "systemic risk" in imprecise terms:

• "Systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by comovements (correlation) among most or all the parts."

Systemic Risk

• Darryll Hendricks (2009), who is a practitioner, suggests in a missive for the Pew Financial Trust, a more theoretical definition from the sciences:

• "A systemic risk is the risk of a phase transition from one equilibrium to another, much less optimal equilibrium, characterized by multiple self-reinforcing feedback mechanisms making it difficult to reverse."

Systemic Risk

• George G. Kaufman and Kenneth E. Scott (2003) define "systemic risk" in imprecise terms:

• "Systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by comovements (correlation) among most or all the parts."

Macroprudential Regulation

• “The objective of a macroprudential approach is to limit the risk of episodes of financial distress with significant losses in terms of the real output for the economy as a whole.” (Borio 2003)

Forecasting

• Usefulness depends on ability to forecast when crises will occur and when not

Types of Crises

• Banking crises• Sovereign-debt crises• Foreign exchange crises

Banking Crisis

• Losses at banks same order of magnitude as equity capital in banking system

Sovereign and FX Crises

• These are state-created problems!

Government Debt to GDP2000 to 2013

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 20130

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60

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120

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200UK France Italy GermanyGreece Portugal Spain USIreland

Source of Data: Eurostat

Definition of A Banking Crisis• Laeven and Valencia (2013)• Significant signs of financial distress in the banking system as indicated by

– significant bank runs– losses in the banking system– and/or bank liquidations

• Significant banking policy intervention measures in response to significant losses in the banking system. At least three out of following six – deposit freezes and/or bank holidays– significant bank nationalizations – bank restructuring gross costs at least 3 percent of GDP – extensive liquidity support (5 percent of deposits and liabilities to

nonresidents)– significant guarantees put in place– significant asset purchases (at least 5 percent of GDP).

Data

• Data on real GDP and banking crises for• 21 countries generally from 1870 to 2009• 2,950 annual observations• 91 banking crises

Another Set of Data

• Data on real GDP and banking crises for• 176 countries from 1970 to 2011• 7,392 annual observations• 150 banking crises

Real GDP per Capita and Banking Crises

Source: Dwyer, Devereux, Baier and Tamura (2013)

Definition of Recession• General discussion

– Bry and Boschan (NBER, 1971)• Algorithm to determine contractions in economic activity• Peak when increase followed by five monthly decreases• Cycle at least 15 months long

– Harding and Pagan (2002)• Peak when increase is followed by two quarters of decline in real GDP• Partly reflects requirement that a contraction be at least six months long

• Annual data– Peak when an increase followed by a decrease in real GDP

• Peak when an increase followed by a decrease of real Gross Domestic Product (GDP) per capita– Jordà, Schularick and Taylor (2012) and others in crisis literature

How To Measure Output Loss

• Laeven and Valencia (2013) measure output losses as the sum of the difference between actual and trend GDP over four periods (T to T+3)– Expressed as a percentage of GDP for the starting

year of the crisis• Compute trend GDP by applying an HP filter

Examples in which This Approach Produces Plausible Results

The approach is plausible for economies with an apparent or seeming underlying trend growth.

This is not the case for all economies.

Source: Devereux and Dwyer (2014)

GDP losses without a GDP Contraction

Country Start End Output loss Laeven

and Valencia

Lebanon 1990 1993 102

Israel 1977 1977 76

Spain 1977 1981 59

Colombia 1982 1982 47

Swaziland 1995 1999 46

Turkey 1982 1984 35

Guinea-Bissau 1995 1998 30

Laeven and Valencia (2013)

An exampleFigure Two

Lebanon 1990 (loss 102 percent)

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Banking Crisis

A second ExampleIsrael 1977 (77 percent of GDP)

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TrendCrisis

Isolated Cases?

• Very large output losses in Laeven and Valencia (2013) indicate this is empirically important

Largest Output Lossesin Laeven and Valencia (2013)

Banking Crisis

Country Start End

Output loss Laeven and Valencia

Kuwait 1982 1985 143.4 Congo, DR 1991 1994 129.5 Burundi 1994 1998 121.2 Thailand 1997 2000 109.3 Jordan 1989 1991 106.4 Ireland 2008

106.0

Largest Output LossFigure Four

Kuwait 1982 (144 percent of GDP)

Source: Devereux and Dwyer (2014)

Measurement of Output Losses

• A trend in potential output for many countries is uninformative because a stable trend growth of GDP does not exist for countries without modern economic growth

• An almost intractable problem since it holds true, almost by definition, for most of the low income economies

• A similar point can be made regarding Reinhart and Rogoff’s (2009) use of GDP per capita– Modern economic growth is relatively rare– Venezuela/Argentina where income per capita takes from

twenty or over forty years to recover after a banking crisis

Association Between Banking Crises and Contractions in Historical Data

Banking Crisis Start

Yes No

Contraction in real GDP per Capita in Same Year

Yes 43 643

No 48 1949

Source: Dwyer, Devereux, Baier and Tamura (2013)

Association Between Banking Crises and Contractions in Historical Data

Banking Crisis Start

Yes No

Contraction in real GDP per Capita in Same Year or Following Year

Yes 67 1038

No 24 1564

Source: Dwyer, Devereux, Baier and Tamura (2013)

Association Between Banking Crises and Contractions in Historical Data

Banking Crisis Start

Yes No

Contraction in real GDP per Capita in Same Year or Following Two Years

Yes 69 1318

No 22 1284

Source: Dwyer, Devereux, Baier and Tamura (2013)

Source: Dwyer, Devereux, Baier and Tamura (2013)

Densities of Mean Growth Rate of Real GDP per Capita Before and After Banking Crises

Source: Dwyer, Devereux, Baier and Tamura (2013)

Recessions After Banking Crisisin Post 1970 Data

Year of Beginning of Recession After Banking CrisisYear of Crisis Year After Crisis Two Years After

CrisisNo Recession even Two Years After Crisis

54 41 1 44

Source: Devereux and Dwyer (2014)

Real GDP Growth and Banking Crisesin Post 1970 Data

Source: Devereux and Dwyer (2014)

United States Banking Crises

Source: Dwyer and Lothian (2012)

Frequency of Recessionsafter Banking Crises

• Many banking crises are not associated with decreases in real GDP

Frequency of Recessionsafter Banking Crises

• Many banking crises are not associated with decreases in real GDP

• Why big differences?– Prior conditions and severity of problems– Policies before and after crisis

Macroprudential Regulation Itself

• “The objective of a macroprudential approach is to limit the risk of episodes of financial distress with significant losses in terms of the real output for the economy as a whole.” (Borio 2003)

Macroprudential Regulation Itself

• “The objective of a macroprudential approach is to limit the risk of episodes of financial distress with significant losses in terms of the real output for the economy as a whole.” (Borio 2003)

• Can we predict with reasonable confidence when these relatively infrequent events will occur?

Is Macroprudential RegulationLikely to Work?

• Different strategies– Discretionary regulation

• Prevent banking crises• Limit the cost if they occur

– Rule-based regulation• Higher capital requirements at banks

• Different strategies– Anticipation

• Prevent banking crises

– Resilience• Limit the cost

Is Macroprudential RegulationLikely to Work?

• Discretionary regulation– Down-payment requirements for houses

• Rule-based regulation– Higher capital requirements at banks

Housing and Financial Crisis

• Common theory: Rising housing prices created bubbles in various countries and that was a proximate cause of the recent banking crisis

• Implication for some: Limit rises in housing prices– Decreases probability of crisis– For example, change down payment requirements

when housing market is over-heated

Changing Down Payment Requirements

• Problem: This works by locking many people out of the housing market– Not obviously desirable– Not obviously feasible in a democratic country– Certainly will have consequences for the regulator

• General problem: Changing relative prices and creating identifiable winners and losers in the general population– This is quite different than most rationales for

standard macroeconomic policy

Changing Down Payment Requirements

• Problem: This works by locking many people out of the housing market– Not obviously desirable– Not obviously feasible in a democratic country– Certainly will have consequences for the regulator

• General problem: Changing relative prices and creating identifiable winners and losers in the general population– This is quite different than most rationales for standard

macroeconomic policy• Works quite differently in practice as well

Raising Capital Requirements

• Creates winners and losers of course– Likely to be fewer or at least smaller banks– Fewer financial services– Quite possibly, fewer financial services

counteracts the provision of too many financial services due to deposit insurance and too-big-to-fail

– Makes financial system more resilient to losses seen in past banking crises

Effective Anticipation

• What would it be good to have for anticipation to be effective?– Foresight into cause of next banking crisis– Given infrequency, some estimate of when more

or less likely– A firm foundation for connection between policies

and probability of a crisis

Effective Resilience

• What would it be good to have for resilience to be effective?– Foresight into likely factors that would lessen

effects as commonly seen– Some estimate of when more or less likely if a

state-contingent policy is to be adopted– Depending on the cost of resilience, a connection

between policies and severity of a crisis

Compare and Contrast Two Policies

• Anticipation – Head off a bubble in housing prices

• Resilience – Require banks to have more capital

Conclusion

• There is little doubt that events such as banking crises, sovereign-debt crises and possibly other “crises” are important

• Do we know enough to help avoid these events or lower their costs?

• Is macroprudential regulation, with its constant oversight, likely to be effective for banking crises which may not happen once in fifty years?

Conclusion

• Regulation is different than fiscal or monetary policy in operation– Public-interest and private-interest theories of

regulation– I think an independent central bank engaging in

macroprudential regulation is unlikely and undesirable in any case

A Quest for Stability

Source: http://img2.travelblog.org/Photos2/

One Way to Avoid Banking Crises