Transcript What Can Financial Stability Reports Tell Us About

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