Transcript Financial cycle

Macroprudential policy – a framework
Jan Frait
Executive Director
Financial Stability Department
„ … in tracking systemic risk … we should avoid a false
sense of precision … it is better to be approximately
right than precisely wrong“
Claudio Borio, BIS (2010)
2
I.
Concept of Macroprudential Policy
3
The birth of macroprudential“ policy
• Following the global financial crisis, additional pillar for coping with
systemic risk and maintaining financial stability – macroprudential policy
framework – was put high on the agenda.
• Until the crisis, the concept of macroprudential policy was discussed
primarily within the central banking community under the leadership of
the Bank for International Settlements (BIS).
• After the crisis, the term “macroprudential” has become a buzzword
(Clement, 2010).
• The term “macroprudential” as applied now is too embracive and often
used outside of the scope of its original meaning.
4
The birth of macroprudential policy
• Establishment of effective macroprudential policy framework was one
of the prime objectives of the G20 (Financial Stability Board), IMF and
other global structures.
• In the EU, the European Systemic Risk Board as the EU-wide
authority of macroprudential supervision was created
• Number of iniciatives focusing on defining the EU-wide framework for
macroprudential regulation appeared.
• The EU-wide framework for macroprudential regulation including the
toolkit was created over 2012 and 2013.
• National competent or designated authorities in terms of
macroprudential policy were constituted.
• The CNB is the only institution responsible for macroprudential policy in
the Czech Republic.
• There are different models in the EU (CB only, FSA only, multi-agency
committees, more institutions, minister of finance).
5
Cyclical (time, conjuncural) component of macroprudential policy?
• The CNB is formally in charge of macroprudential policy from 2013.
• The CNB looks at the concept of macroprudential policy primarily from
relatively narrow perspective of the original BIS approach (e.g. Borio,
2003, Borio and White, 2004).
• The objective of a macroprudential approach in the BIS tradition falls
within the macroeconomic concept and implicitly involves monetary and
fiscal policies (Borio and Shim, 2007, and White, 2009).
• In the BIS tradition, the phenomena financial/credit cycle and financial
market procyclicality (mainly the procyclical behaviour in credit provision)
stands centrally (Borio and Lowe, 2001, or Borio, Furnine and Lowe,
2001).
• The CNB‘s analyses have also been focused mainly on the time
dimension of systemic risk (risks associated with procyclical behaviour in
credit cycle).
6
Two credit booms and one bust thus far in the CR
• Credit boom in early 1990s followed by sharp increase in credit losses and
major financial crisis.
• Credit “boom” of 2005-2008 had benign consequences.
• What made the difference?
Credit cycle in the Czech Republic
(1993-2015 H2), v %)
GDP growth and credit risk in the Czech Republic
(1993-2015 (H2), in %)
30
65
25
60
20
55
15
10
50
5
45
35
8
30
6
4
25
2
20
0
15
-2
0
40
-5
-10
-15
I/93
I/96
I/99
I/02
credit growth (MA)
I/05
I/08
I/11
10
35
5
30
0
I/14
credit-to-GDP (rhs)
Source: CNB
Note: Credit growth is year-over-year increase in total bank credit.
% NPL is the share of nonperforming loans on total bank credit.
Data from the beginning of 1990s are based on authors' estimates.
-4
-6
-8
I/93
I/96
I/99
I/02
%NPL
I/05
I/08
I/11
I/14
GDP growth (rhs)
Source: CNB
Note: % NPL is the share of non-performing loans on total bank credit.
Data from the beginning of 1990s are based on authors' estimates.
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Financial cycle
• The US example …
8
Financial cycle
• Swedish example (see Stremmel, Hanno (2015), "Capturing the Financial
Cycle in Europe", European Central Bank - Working Paper Series, No.
1811).…
9
Structural component of macroprudential policy
• Financial market structures surely matter as well.
• The other stream of macroprudential thinking is less macro-oriented and
focusing on individual institutions and their mutual interactions.
• In this stream systemic risk arises primarily through interlinkages and
common exposures to risk factors across institutions, i.e canonical models
of financial instability like Diamond and Dybvig (1983).
• Sources of structural or cross-sector dimension of systemic risk (common
exposures among institutions, network risks, infrastructure risks, contagion
...) have been intensively studied by both academia, international
institutions, and national supervisory or macroprudential authorities.
• In small economies structural dimension can materialize through contagion
from external environment.
• The ESRB analytical work puts more emphasis on structural issues
than conjunctural ones.
• It started to operate during financial crisis characterized by number of
contagion risk channels.
• The CNB as a member institution follows the ESRB recommendations to
reasonable extent also in the area of structural risks.
10
The CNB’s historical interpretation of financial stability
•
•
•
Consensus in the central bank community - the financial stability objective is to achieve
continuously a level of stability in the provision of financial services which will support the
economy in attaining maximum sustainable economic growth.
The CNB adopted a definition consistent with this way of thinking about the financial
stability objective back in 2004.
• It has defined financial stability as a situation where the financial system operates
with no serious failures or undesirable impacts on the present and future
development of the economy as a whole, while showing a high degree of resilience
to shocks.
Financial stability analysis as the study of potential sources of systemic risk arising from
the links between vulnerabilities in the financial system and potential shocks coming
from various sectors of the economy, the financial markets and macroeconomic
developments.
• The sources of systemic risks can be viewed as externalities associated with
behaviour of financial institutions (for details of such approach see Nicolò et al.,
2012), and financial markets and their participants (short-termism, myopia, risk
ignorance, herding).
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The CNB’s historical interpretation of financial stability
Sound financial system
Yes: resilience
No
Financial
stability
Yes
Financial
volatility
Shocks
• The CNB’s approach to financial
stability has historically been strongly
macroprudential.
• Its objective is to ensure that the
financial system does not become so
vulnerable in the course of cycle that
unexpected shocks ultimately cause
financial instability in the form of a
crisis.
No: vulnerability
Financial
vulnerability
Financial
instability
(crisis)
12
The CNB’s current interpretation of financial stability
• Robustness is the key to avoiding vulnerability.
• For a bank-based system, robustness can be achieved via high loss
absorbency, strong liquidity, barriers to credit boom and plenty of luck.
• BIS: increase the resilience of the financial system and constrain financial
booms: protecting the banks from the financial cycle and protecting the
financial cycle from the banks (or taming the financial cycle).
• Loss-absorbency:
• expected losses – sufficient provisions (Frait and Komárková, 2009),
• unexpected losses – capital cushions,
• microprudential (Basel II) component,
• countercyclical component (Frait, Geršl and Seidler, 2011; Geršl and Seidler,
2011),
• cross-section SIFI component (Komárková, Hausenblas and Frait, 2012).
• Strong liquidity (buffers and stable funding) is essential way for limiting
fragility of liabilites (Komárková, Geršl and Komárek, 2011).
• Some macroprudential tools for creating barriers to credit booms,
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excessive leverage are needed too.
Financial stability vs. macroprudential policy
•
The CNB considers macroprudential policy to be an element of financial stability
policy (Frait and Komárková, 2011).
• the other part is microprudential oversight (regulation and supervision),
• differences are more in conceptual approach (philosophy) than in toolkit.
•
•
The main distinguishing feature of macroprudential policy is that unlike traditional
microprudential regulation and supervision (focused on the resilience of individual
financial institutions to mostly exogenous events):
• it focuses on the stability of the system as a whole;
• it primarily monitors endogenous processes in which financial institutions that
may seem individually sound can get into a situation of systemic instability
through common behaviour and mutual interaction,
• the objective of financial stability analysts is therefore avoid the risk of the fallacy
of composition – wrong assumption that the state of the whole is the sum of the
state of seemingly independent parts, for the trees the forest is not seen.
Hanson et al. (2011) mark the microprudential approach as partial equilibrium
conception while macroprudential approach as one in which general equilibrium
effects are recognized.
14
Macroprudential policy view in the CNB
• The key macroprudential policy objective is to prevent systemic risk
from forming and spreading in the financial system.
• The objective of macroprudential policy cannot be to secure financial
stability at any point in time and prevent any stresses in financial
system (make sure it never happens again),
• pursuing such objective would lead to general elimination of risk-taking of
economic agents, innovations and economic dynamics.
• Macroprudential policy is comprised of application of macroprudential
regulation and macroprudential supervision/surveillance for pursuing
financial stability objective.
• Macroprudential regulation – definition of rules and tools for their
enforcements for keeping systemic risk in reasonable level.
• Macroprudential supervision/surveillance – macro-off-site supervision
consisting of monitoring of systemic risk, setting macroprudential
instruments, issuing warnings and recommendations for microprudential
regulation and supervision, or other policies.
15
Macroprudential policy and systemic risk dimensions
• Systemic risk has two different dimensions:
• The time dimension (cyclical, conjunctural dimension) reflects the buildup of systemic risk over time due to the pro-cyclical behaviour of financial
institutions contributing to the formation of unbalanced financial trends.
• The second dimension is cross-sectional (structural dimension) and
reflects the existence of common exposures and interconnectedness in
the financial system.
• The experience commands that the time dimension of systemic risk
has to be regarded as more important.
• Cross-sector dimension cannot be ignored especially due to the risk of
contagion from domestic as well as foreign environment.
• The time and cross-sectional dimensions to a large extent evolve
jointly and so cannot be strictly separated.
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Macroprudential policy and systemic risk dimensions
•
•
Shin (2010) argues that increased systemic risk from interconnectedness of banks is
a corollary of excessive asset growth and a macroprudential policy framework must
therefore address excessive asset dynamics and fragility of bank liabilities.
• In a growth phase of the financial cycle, rapid credit growth is accompanied by a
growing exposure of a large number of banks to the same sectors (usually the
property market) and by increasing interconnectedness in meeting the growing
need for balance-sheet liquidity.
• Financial institutions become exposed to the same concentration risk on both
the asset and liability sides. This makes them vulnerable to the same types of
shocks and makes the system as a whole fragile.
• When the shock comes, banks face problems with funding, their lending is
tightened and all market participants try to sell their assets at the same time,
which creates the downward spiral in both the financial and the real sectors.
The time dimension shows up in degree of solvency, while the cross-sectional
dimension manifests itself in the quality of financial institutions’ balance-sheet
liquidity. However, solvency and liquidity are also interconnected, as liquidity
problems often transform quite quickly into insolvency.
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II.
Financial Cycle and Systemic Risk
18
Good times and virtuous cycle
• In good times the financial institutions and their clients may fail to price
correctly the risks associated with their decisions or may even be
incentivized to increase the extent of risk taken.
• In such periods, access to external sources of financing improves
significantly - such access is more dependent on current risk perceptions
on the side of both banks and their clients, which are strongly dependent
on current economic activity.
• If economic agents start to misconstrue a temporary cyclical improvement
in the economy as a long-term increase in productivity, virtuous cycle can
start to develop, supported by an increased willingness of households,
firms and government to take on a debt and use it to buy risky assets.
• This sets off a spiral (positive feedback loop) manifesting itself as a
decreasing ability to recognise risk, trend growth in asset prices, weakened
external financial constraints and high investment activity supported by
output growth, increased revenue growth and improved profitability.
• In the background of this cycle, credit picks up, financial imbalances grow
and systemic risk builds up unobserved.
19
Credit bust and vicious circle
• Systemic risk often shows up openly later on, when economic activity
starts to weaken as a result of a negative stimulus.
• Recession subsequently sets in, opposite processes take place, and the
spiral turns around.
• Economic agents realise that their income has been rising at an
unsustainably high rate, they are burdened with too much debt, their assets
have fallen in value and so they need to restructure their balance sheets.
• Both banks and their clients start to display excessive risk aversion and
vicious circle gains momentum.
• To a large extent, the processes described above are as natural as the
business cycle itself.
• However, the financial imbalances can sometimes get too big and, as a
result, a dangerous vicious cycle can arise in the contraction phase.
• If the desirable adjustment is combined with strong increase in general and
with fire-sales of overvalued assets, the downward movement can become
extremely rapid and destabilising.
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Conseptual approach to financial cycle
• The key concept describing the time dimension of systemic risk over financial
cycle is leverage (the indebtedness of economic agents, stocks of loans, the
ease of obtaining of external financing, the size of interest rate margins and
credit spreads, etc..).
• The leverage (can be to some extent approximated by credit-to-GDP ratio):
• increases until the financial cycle turns over, sometimes the turn is
disorderly and presents itself as the eruption of financial crisis.
• then starts to decline, although in the early phase of the crisis remains high
(given falling nominal GDP it can even rise in the initial post-crisis years).
• The deleveraging phase can therefore last several years, and in the event of
a deep crisis the leverage ratio can, after a time, fall below its long-term
normal value.
• Consequently, the leverage ratio adjusts to economic conditions after a
considerable lag, so stock measures have only a limited information value as a
guide for the macroprudential policy response during the financial cycle.
• For this reason, forward-looking variables are needed that can be used to
identify situations where the tolerable limit for systemic risk has been exceeded.
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Leverage over credit cycle – a slow motion process
• Conduct of macroprudential policy changes throughout financial cycle.
leverage
Good times (systemic risk
accumulation):
leverage phase with
excess optimism
turning point (start
of crisis)
Bad times (systemic risk
materialization):
deleveraging phase with
excess pessimism
time
Normal level
of leverage
Signal for macroprudential tools
activation: forward-looking or
leading indicators (credit-to-GDP
gap, real estate prices gap …)
Discontinuity in marginal risk of
financial instability: e.g.financial
markets indicators (credit
spreads, CDS spreads) or
market liquidity indicators
Signal for termination of
supportive policies:
contemporaneous indicators
(default rates, provision rates,
NPL rates, lending conditions)
and financial markets indicators
22
Counter-cyclical macroprudential policy
• Macroprudential policy has to be
• neutral in normal times,
• counter-cyclical in not-so normal times.
• Counter-cyclical approach requires
• increase preventively the resilience of the system, in the accumulation
phase of systemic risk, against the likelihood of emergence of financial
instability in the future by
• creating capital and liquidity buffers,
• limiting procyclicality in the behaviour of the financial system (including
large credit upswings),
• containing risks that individual financial institutions may create for the
system as a whole.
• mitigate the impacts, in the materialization phase of systemic risk, of
previously accumulated risks if prevention fails.
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Stages in systemic risk development
• In a financial cycle, systemic risk evolves differently in two stages:
accumulation (build-up) and materialization (manifestation).
• Note the financial (in)stability paradox:
• System is most vulnerable when it looks most robust.
• Risk is not born in period of distress.
Build-up of systemic risk
period of financial
exuberance
Materialisation of systemic risk
period of financial
distress
period of low
current risk
time
period of high
current risk
time
normal conditions
marginal risk of
financial instability
degree to which risks
materialise as defaults, NPLs
and credit losses
24
Paradox in practice – the case of Irish boom and bust
• Remember Ireland – it looked so well in 2007:
• real-estate-price gap and credit-to-GDP gap indicated exuberance,
• sources of systemic risk may be increasing when banks and their clients
consider their business risks to be the lowest - non-performing loans ratio
close to zero “indicated“ resilience.
Ireland (end 2007 vs. June 2010)
(credit risk ratios in %)
80%
Leading Indicators of Systemic Risk
Accumulation in Ireland
Coverage ratio (provisions to NPLs)
60
40
20
0
-20
60%
40%
20%
0%
0%
-40
I/00
I/02
I/04
I/06
credit-to-GDP gap (IE, %)
real estate price gap (IE, %)
Source: IMF.
5%
10%
20%
25%
Non-performing loans ratio
Note: Size of the ring indicates relative volume of non-performing loans
Source: Central Bank of Ireland
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Paradox of financial instability and forward-looking view
• Forward-looking approach in both analyzing and policy-making needed:
• Bad loans are being created in good times, true information about it comes in
subsequent bad times.
• Low level of non-performing loans is not a sign of robust banking sector.
Procylical behaviour in the Czech economy
(1999-2015 H2, y-o-y in %)
Provisions and NPLs (bn. CZK)
(January 2001-June 2015)
40
200
180
30
160
20
140
120
10
100
80
0
60
-10
40
20
Source: CNB, IRI
Nore: Offer prices for Prague residental real estate.
GDP growth
0
provisions
Source: CNB
1-15
credit growth
IV I/14 II
1-13
III
1-11
IV I/09 II
1-09
real estate prices
III
1-07
IV I/04 II
1-05
III
1-03
I/99 II
1-01
-20
NPLs
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Paradox of financial instability and systemic risk measurement
• Paradox of financial instability necessitates forward-looking approach
in systemic risk detection and measurement.
• Do not look so much at measures of systemic risk materialization like
indices of financial stress.
• Focus on actual risk, not a perceived one (Danielsson et al., 2012)!
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Good booms, bad booms and systemic risk
• It is difficult to convince people of the system heading into a big mess.
• A tranquil situation of this sort does not always mean that the financial
system accumulates systemic risk dangerously.
• A low level of risk indication can simply mean that a truly good and longlasting boom is under way.
• At any particular point in time it is likely that some indicators are giving
contradictory results.
• The financial instability paradox occurs only occasionally and irregularly.
• Still, the analysts have to keep in mind the risk of being trapped by the
financial instability paradox, i.e. that unusually good values of current
indicators signal a growing risk of financial instability.
• One can be rather sure that if credit and some asset prices are going up
quickly and moving away from historical norms, and both the quantitative
and qualitative evidence indicates excessive optimism and mispricing of
risk, there is a problem ahead, unless decision-making bodies take action.
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Aggregate macroprudential dashboard I (FSR 2014/2015)
• Backward-looking perspective (where we have moved)
• A strengthening of the resilience of the Czech financial sector to
potential adverse shocks:
• a rise in capital adequacy,
• favourable liquidity developments,
• positive changes in risk management by financial institutions.
Financial sector resilience
Cyclical risks
Structural risks
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Aggregate macroprudential dashboard II (FSR 2014/2015)
Financial sector resilience
Cyclical risks
Structural risks
• Forward-looking perspective (how strong the potential sources of
risk are)
• A moderate decline in structural risks:
• introduction of the systemic risk buffer,
• a decrease in interconnectedness of institutions in the financial sector.
• A slight increase in cyclical risks:
• a recovery in demand for loans and an easing of credit standards,
• a drop in interest rates on loans and interest rate margins,
• a decrease in yields on high-quality assets to very low levels.
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References
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