Transcript What is a macroprudential policy?

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)
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I.
Concept of Macroprudential Policy
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What is a „macroprudential“ policy?
• Following the global financial crisis, on the global, the EU level as well as
on the national levels the ways how to establish the additional pillar for
financial stability – macroprudential policy framework – has been
discussed.
• 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 henceforth).
• After the crisis, the term “macroprudential” has become a buzzword
(Clement, 2010) and the establishment of effective macroprudential
policy framework has become one of the prime objectives of the G20,
EU, IMF and other structures.
• In the EU, such a desire has already been reflected in the decision to
create the European Systemic Risk Board as the EU-wide authority of
macroprudential supervision and by number of iniciatives focusing on
defining the EU-wide framework for macroprudential regulation.
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What is a macroprudential policy?
• The term “macroprudential” as applied now is too embracive and
often used outside of the scope of its original meaning.
• The CNB looks at the concept of macroprudential policies 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 phenomenon of 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 are focused mainly on risks associated with
procyclicality, credit cycle in particular.
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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
(1993-2012, v %)
GDP growth and credit risk in the Czech Republic
(1993-2012, in %)
30
25
65
35
60
30
55
25
10
8
20
15
6
4
10
50
20
2
5
45
15
0
40
10
35
5
30
0
0
-2
-5
-4
-10
-15
I/93
I/96
I/99
I/02
credit growth (MA)
I/05
I/08
I/11
-6
-8
I/93
I/99
%NPL
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.
I/96
I/02
I/05
I/08
I/11
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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What is a macroprudential policy?
• Financial market structures matter as well.
• The other stream of macroprudential thinking is more micro-oriented and
focusing on individual institutions and their mutual interactions.
• By comparison with the BIS logic, in this approach systemic risk arises
primarily through common exposures to macroeconomic risk factors
across institutions, i.e canonical models of financial instability like Diamond
and Dybvig (1983) emphasizing interlinkages and common exposures
among institutions.
• The analyses of this sort (common exposures among institutions, network
risks, infrastructure risks, contagion ...) has been intensively studied by the
IMF (see special chapters in some Global Financial Stability Reports).
• The ESRB analytical work also puts more emphasis on structural issues
than conjunctural ones.
• The reason is natural – financial cycles differ significantly within EU
economies, the ESRB started to operate during financial crisis characterized
by number of contagion risk channels.
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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 and close to the
relatively narrow BIS interpretation
focusing primarily on risks associated
with the financial cycle.
• 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)
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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.
• 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,
excessive leverage are needed too.
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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)
•
•
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.
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Macroprudential policy and systemic risk - objectives
• The macroprudential policy objective is to prevent systemic risk from
forming and spreading in the financial system.
• 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 two dimensions of systemic risk cannot be strictly separated, as
they largely evolve jointly over the financial cycle.
• 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.
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Macroprudential policy and systemic risk - objectives
•
•
•
The time and cross-sectional dimensions to a large extent evolve jointly and so
cannot be strictly separated.
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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Macroprudential policy and systemic risk - definition
• Macroprudential policy can be defined as the application of a
set of instruments that have the potential to
• 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
• 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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II.
Financial Cycle and Systemic Risk
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Conseptual approach to macroprudential policy
• The key source of systemic risk is financial cycle and one of the key
concerns of macroprudential policy has to be containment of
procyclicality.
• In periods of fast economic growth the financial institutions and their
clients may start mispricing 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, in turn, 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 accept a higher level of debt and use it to buy risky assets.
• This sets off a spiral (positive feedback loop) manifesting itself as a decreasing
ability to recognize 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, financial
imbalances grow and systemic risk builds up unobserved.
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Conseptual approach to macroprudential policy
• 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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Credit cycle and systemic risk – the case for forwardlooking approaches in conduct of macroprudential policy
• In a credit cycle, systemic risk evolves differently in two stages:
accumulation (build-up) and materialization (manifestation).
• Note the financial (in)stability paradox: a system is most vulnerable when it
looks most robust.
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
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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, after
all 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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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 in practice again – corporate spreds today
• What do the low corporate debt spreads mean today?
Spreads of High-Yield Corporate Bonds
(in basis points)
2500
2000
1500
1000
500
0
US High Yield
Source: Bloomberg
Euro High Yield