Issues pertaining to the implementation of macro-prudential tools May 2016

Outline A. Objectives of Monetary Policy, Micro- and Macro- prudential Policies B. Two dimensions of risk can contribute to systemic risk C. Counter-Cyclical (Macro) Prudential Tools D. Monetary policy and macro prudential policy E. Interaction between monetary policy and macro prudential policy F. Macro and Micro Prudential Policies Compared G. Interaction between macro prudential and micro prudential policies H. Challenges to implement macro-prudential policy / tools I. Going Forward 2

Objectives of Monetary Policy, Micro-Prudential and Macro prudential Policies The Objective of monetary policy is to achieve price and output stability. Micro prudential policy focus on the health and soundness of individual firms. Macro prudential policy's main objective is to ensure and maintain the health and soundness of the entire financial system by containing systemic risk (thus stabilizing the environment in which individual firms operate ). 3

Two dimensions of risk can contribute to systemic risk The time dimension: reflects the buildup of risk over time in the financial system. (e.g. rapid credit and income growth leading to more credit growth etc), with amplifying effects during periods of booms and busts. The cross-sectional dimension: reflects the distribution of risks in the financial system at a given point in time. It relates to the common exposures of institutions at each point in time. Macro prudential instruments are typically introduced with the objective of reducing the effect of systemic risk, either over time or across institutions and markets. 4

Counter-Cyclical (Macro) Prudential Tools Capital-Related Counter-cyclical leverage ratios Restrictions on profit distribution Through the cycle ratios Time varying / dynamic provisioning Counter-cyclical capital requirements Credit-Related Caps on foreign currency lending Ceiling on credit or credit growth Caps on the loan to value ratios Caps on the debt to income ratios Liquidity-Related Limits on net open currency (NOP) position / currency mismatch Limits on maturity mismatch Reserve requirements 5

Monetary policy and macro prudential policy To ensure macroeconomic stability, macro prudential policy complements monetary policy. Welfare maximization requires insuring financial stability as an intermediate goal for policy, between monetary and micro prudential policies; because financial instability signals distortion in the level and or/composition of output. Example: in the presence of financial market imperfections, individuals behavior is distorted giving rise to excessive leverage, large exposures to risky assets, boom and bust cycles are amplified. 6

Monetary policy and macro prudential policy Contd These distortions vary and affect one sector of the economy more than others, leading to distortions in the composition of output. Macro prudential tools reduces the amplitude of the financial cycle and associated systemic risk. By constraining leverage and help build buffers to absorb shocks. On the other hand, if financial distortions are more acute in some sectors of the economy than the others, monetary policy tools are insufficient, having additional macro prudential tool will be essential for financial stability and enhancing welfare. 7

“New” Framework of Macroeconomic and Micro- and Macro-prudential Policies 8

Interaction between monetary policy and macro prudential policy Monetary policy decisions concerning interest rates affect leverage and asset prices and hence financial stability. Low interest rate can increase asset prices, leading to increase in leverage and lead to asset price booms, conversely higher interest rates cause collateral constraints to bind, fire sales and adverse asset prices. Low interest rates relaxes collateral constraints, as asset prices and borrowers net worth increases, and lowers the cost of external financing, thereby easing overall credit conditions. Conversely a tightening of rates can adversely affect borrowers capacity to repay possibly leading to higher default rates and financial instability. 9

Interaction between monetary policy and macro prudential policy Contd Lower monetary policy rates can create incentives for banks to over leverage or reduce effort in screening Borrowers. On the other hand macro prudential policies can affect the level of output and prices by constraining borrowing and hence expenditure in one more sectors of the economy, macro prudential policy affect overall output and prices. Finally, macro policy tools can helps control unsustainable increase in credit and asset prices and mitigate pro-cyclical feedback between financial and real economy. 10

Interaction between monetary policy and macro prudential policy Contd Example: macro prudential policy in this case may use different tools to be customized to contain the effect of monetary policy decisions (in this case relaxing monetary stance). Putting conservative limits on DTI ratios, limiting LTV, higher capital requirements or tighter leverage or liquidity ratios can help contain increase in systemic risk in response to expected lax-monetary policy. 11

Macro and Micro Prudential Policies Compared Micro-prudentialMacro-prudential Limit distress of individual institutions Limit financial system- wide distress Proximate objective Consumer (investor / depositor) protection Avoid macroeconomic costs linked to financial instability Ultimate objective “Exogenous” (independent of individual agents’ behavior) “Endogenous” (dependent on collective behavior) Characterization of Risk IrrelevantImportantCorrelations and common exposures across institutions In terms of risks of individual institutions; bottom -up In terms of system-wide risk; top-down Calibration of prudential controls 12

Interaction between macro prudential and micro prudential policies Micro prudential policy and macro prudential policy complement one another to ensure financial stability. The major downside of micro- prudential policy is that it focuses on the risk positions of individual institutions and assumes that this will lead to overall balance of the financial system and the economy. Micro prudential policy ignores risks that are endogenous (dependent on collective behavior) and of systemic importance. Macro prudential policy tools are in fact the usual prudential tools that have long been used by micro prudential supervisors but the purpose is different. Exchange information and setting up well-defined mechanisms is essential to resolve any conflicts that may arise between the two policies. 13

Interaction between macro prudential and micro prudential policies Contd Example, in case of concentration risk, a well defined mechanism should be put in place to set the rule up to a certain limit (such as a maximum exposure of 25% of an issued capital) could be granted to a customer or related parties to be identified by macro- prudential, in addition there would remain a micro-prudential standard needed to avoid excessive risk within an individual institution. 14

Challenges to implement macro-prudential policy / tools Appropriate analytical capability is needed to quickly identify system-wide risks as well as to determine where and how instruments should be deployed in response to these risks. Human capital development and capacity, timeline IT systems are needed in order to implement improvements (new prudential rules, IFRS, Basel III) that need capacity building and higher skills and developed system. Availability, integrity and completeness of data generated by the banking sector has also been a challenge in this area. And this is necessary for effective implementation of tools and effective macro-prudential supervision. 15

Challenges to implement macro-prudential policy / tools Contd Designing and implementing an effective financial stability framework in order to insure proper coordination between macro-, micro-prudential, and monetary policies to achieve financial stability, taking into consideration the complex interaction between the tools for each policy and avoid potential conflict. Modelling the financial cycle also poses major analytical challenge and also require technical capacity to validate and monitor the more complex models (eg. in the implementation of Basel III and the application of countercyclical buffer) Lack of tools in some areas, as some African countries do not have tools to restrict large or inter-connected institutions while only a few countries have counter-cyclical tools in place to address risks associated with credit booms. 16

Going Forward As mentioned, the importance of the design of effective financial stability framework to ensure effective interactions between the different policies. Designing effective early warning tools / system that enables authorities to detect threats to financial stability early enough. Policymakers must develop a toolkit of supervisory policy instruments around macro-prudential policies and guidelines on how and when to deploy them. Coordination is needed between macro-prudential and monetary policy in the choice and implementation of tools to avoid potential conflict. 17

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