Part 1: Institutional Models for Macroprudential Policy – Strengths and Weaknesses. Prepared for COMESA Monetary Institute September 2015

Outline Introduction Institutional Models for Macroprudential Policy Criteria for the Assessment of Strengths and Weaknesses Stylised Models for Macroprudential Policy – Full Integration Model – Partial Integration Models – Separation Models Mechanisms to address weaknesses of models Conclusion 2

As economies’ continue to recover from the most recent financial crisis of , the issues of financial stability and crisis management are ever more apparent. Policy makers realised a purely micro-based approach to supervision and financial regulation is inadequate, and system-wide risk must be more of a focus. There is a need for the prudential regulatory framework for COMESA countries to be re-orientated to have a system wide focus. This will be achieved through developing skills on macroprudential policy tools to assist COMESA member countries to confront this changing reality of the global financial architecture. Introduction 3

There is no consensus on best practices; there is considerable variation across countries’ with respect to the institutional set-up and macroprudential policy implementation. Despite there being no clear consensus on best practices, there are two necessities: There is a need to appoint a macroprudential authority that takes the lead. Measures must be implemented to ensure coordination between relevant organisations. Given a central banks’ universal mandate of price and financial stability and thus its advantageous position, it must play a prominent role in the implementation of macroprudential policy. 4

Institutional Models While institutional models differ in a vast number of ways, Nier et al (2011) identify 5 key distinguishing dimensions of real-life models: Degree of institutional integration of the central bank and financial regulatory functions Ownership of macroprudential policy The role of the Treasury Institutional separation of policy decisions from control over policy instruments. Existence of a separate body coordinating across policies to address systemic risk. 5

A desirable institutional model should be conducive to effective mitigation of systemic risk, providing for: Effective identification, analysis and monitoring of systemic risk, including through: – Assuring access to relevant information; and – Using existing resources and expertise. Timely and effective use of macroprudential policy tools by: – Creating strong mandate and powers; – Enhancing ability and willingness to act; – Assuring appropriate accountability. Effective coordination in risk assessments and mitigation, so as to reduce gaps and overlaps in risk identification and mitigation, while preserving the autonomy of separate policy functions. 6 Strengths and Weaknesses

7 Stylised Models for Macroprudential Policy

Full Integration - Model 1 8 Under Model 1 essentially all financial regulatory and supervisory functions rest with the central bank. If the objective of the central bank is to maintain financial stability then the central bank becomes the owner of macroprudential policy. The Board of the central bank is responsible for macroprudential decision-making. Czech Republic, Ireland and Singapore have this set up.

Strengths: Management can provide incentives for proactive delivery of information to the Board. Central banks already have vast experience analysing systemic risk. Central banks already have practice communicating risks to both the market and the general public. They can also ensure that all officials speak with ‘one voice’. The central bank is both responsible and accountable for macroprudential policy. This strengthens the incentives for achieving its objectives. Failure to implement macroprudential policy successfully will have an adverse effect on the objectives of a central bank – price stability and the role of lender of last resort. 9 Full Integration - Model 1

10 Full Integration - Model 1 Weaknesses: Full integration hands a lot of power to the central bank, which is already responsible for monetary policy. Mechanisms to challenge views within the central bank are lacking. Failures in prudential policy could then affect the credibility of the central bank as monetary policy maker. Addressing systemic risk requires coordination with the government. The complete lack of involvement of the treasury under this setup can therefore diminish Treasury cooperation if they are excluded from discussions on policy action.

This setup involves close institutional integration between the central bank and the prudential supervisor and regulator of potentially systemic financial institutions, while the regulation of activities or ‘conduct’ in retail and wholesale financial markets is institutionally separate from the central bank. Countries following this setup include the United Kingdom, Malaysia, and Romania. The central bank retains access to relevant prudential data and strong control over prudential tools that can be employed to mitigate systemic risks. 11 Partial Integration – Models 2,3,4.

12 Partial Integration - Model 2 Given their similarities, Model 2 possesses many of the same strengths and weaknesses as Model 1. However, under this arrangement a dedicated macroprudential committee is set up within the central bank that has full responsibility for mitigating systemic risks to the system as a whole. Malaysia, Romania, Thailand and the UK have this set up.

13 Partial Integration - Model 2 Strengths The central bank retains access to relevant prudential data and expertise, helping risk identification. Risk mitigation is also clearly assigned to one body – the committee. Reputational risks are minimized. Failure to provide effective macroprudential policy lies with those responsible for delivering it. The monetary decision maker remains independent with their reputation unscathed. A dedicated macroprudential committee allows for treasury participation, without undermining the independence of the monetary policy function. Weaknesses The creation of a separate, dedicated macroprudential committee is at the expense of reduced coordination with monetary policy, potentially leading to a suboptimal policy mix. There may be inadequate coordination and support from the conduct and securities regulator in identifying systemic risk.

14 Partial Integration - Model 3 Under model 3, responsibility for financial stability lies completely with an independent policy-making committee, but has participation from the central bank. The committee is chaired by the treasury. Brazil, France and the U.S have this set up.

15 Partial Integration - Model 3 Strengths A balanced committee can challenge views that could otherwise become entrenched and unchallenged within one institution. The involvement of the treasury can lead to increased political support. Weaknesses When a number of key players are involved in macroprudential policy it can be difficult to establish clear accountability, and responsibility for prevention of systemic crises is unclear. Inefficiencies in risk assessment may arise due to no one institution having all the information needed to analyze the interlinked aspects of systemic risk. A strong treasury presence increases the risk that short-term political considerations bear more weight than mitigation of systemic risk.

16 Partial Integration - Model 4 This model is identical to Model 1, other than the fact the authority overseeing the retail and wholesale financial markets is separate from the central bank. Belgium, the Netherlands and Serbia have this set up.

17 Separation - Models 5-7 There is a much greater degree of institutional separation between the central bank and the supervisory agencies under Models 5-7. In addition to the securities regulators, prudential supervision and regulation of financial institutions are also institutionally separate from the central bank. As a result, the central bank is responsible for oversight of the payments system and control over the reserve requirement, but has no direct power over macroprudential tools such as liquidity requirements or loan- to-value ratios. Australia, Canada, Iceland and Switzerland are examples of some of the countries who have this set up in place.

18 Separation – Models 5-7 The identification and mitigation of risk is a multi-agency effort under this group of models. Decision making is distributed around the various agencies, with each one responsible for the macroprudential tools under its purview. Strengths Each agency remains focused on their main objective: for the central bank this is price stability; the banking supervisor is focused on the soundness of financial institutions. There is clear accountability between macroprudential and monetary policy. Institutional separation reduced the risk that one institution has dominance, as each institution has the ability to develop individual institutional culture.

19 Separation – Models 5-7 Weaknesses With each institution focused on their particular objective, the opportunity to bring together relevant expertise diminishes. Focus of each institution only on their objective can increase the risk of “gap” – unaddressed or unidentified risks. Having multiple institutions dilutes the accountability for systemic risk – when multiple agencies are cooperating for the desired policy outcome, no one agency is fully responsible if the cooperation fails. This can lower the incentive to cooperate in the reduction of systemic risk. Perspectives on risk may differ across the agencies which could lead to a delay in taking action. There may be disagreement surrounding the source of risk, or the best way to minimizing it. Separation may also lead to a suboptimal policy mix. For example, a central bank is concerned with financial stability, but most of the tools to achieve the objective are at the disposal of the prudential regulator.

20 Addressing Weaknesses of Models There is great variation in the strengths and weaknesses across each model, but they do all possess some drawbacks. It is possible to enhance the models by addressing each of the weaknesses. Mechanisms include: Mechanisms to discipline independent use of powers. A mandate needs to be established in law, simultaneously opening and constraining the discretionary use of powers. Accountability should be tied to the process, and not the outcomes of macroprudential policy. Composition of the internal decision making committee can enhance the effectiveness of internal checks and balances.

Mechanisms to compensate for separation of decisions from control over instruments. – This can include vesting the macroprudential authority with binding powers over specific and well-defined macroprudential instruments that are carved out of the policy domain of a separate regulatory authority. Mechanisms to address the risk of delayed action. – Carefully designed voting systems subject to majority rule. – Clear distinction between macroprudential policy and crisis management to reduce unnecessary treasury involvement. Mechanisms to address lack of cooperation in risk assessment and mitigation. – Establishment of a formal coordinating committee. – Legislation changes affecting access to confidential data. 21 Addressing Weaknesses of Models

Conclusion These 7 models have allowed us to capture the vast majority of arrangements that are in place or are being developed across countries. At the highest level, a desirable institutional model should be conducive to effective mitigation of systemic risk. Institutional arrangements need to take account of local conditions. There is no ‘one size fits all’. Despite there being no clear consensus on best practices, there are two necessities: There is a need to appoint a macroprudential authority that takes the lead. Measures must be implemented to ensure coordination between relevant organisations. 22

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