Part 2: Creating a Comprehensive Macroprudential Policy Framework: Key Components and Challenges Prepared for COMESA Monetary Institute September 2015

Agenda Importance of Macroprudential Policy Framework The three pillars – 2.1Analytical Framework – 2.2Institutional Framework – 2.3Policy Measures Challenges: Developing Country Context Conclusion and Recommendations 2

Importance of Macroprudential Policy The European Central Bank (ECB) defines systemic risk as ‘the risk that financial instability becomes so widespread that it impairs the functioning of a financial system to the point where economic growth and welfare suffer materially’. Macroprudential policy is seen as a tool to not only mitigate the build-up of systemic risk in the financial sector, but enhance the resilience of financial institutions against such risks. By combining macroprudential policy with traditional methods that tend to focus on the soundness of individual institutions will enable countries to have a more holistic view of the financial sector. 3

Importance of Macroprudential Policy Traditionally, there were 3 key areas; fiscal policy, monetary policy and microprudential policy. By focusing on the health of the financial system as a whole, Macroprudential policy can improve the authorities’ grasp of the web of connections between financial institutions, markets, and the macro-economy. 4 Figure 1: Framework for Financial Stability

Importance of Macroprudential Policy Policy makers’ ability to cope with two, interrelated drivers of systemic risk; – the risks associated with swings in credit and liquidity cycles and; – the concentration of risk in certain financial institutions and markets that are highly interconnected within, and across, national borders. – is enhanced by combining efforts; However, It must be made clear that macroprudential policy should be seen as a complementary policy measure aimed at strengthening the financial sector. Monetary and fiscal policies should remain the first line of defence against macroeconomic distortions and imbalances with macroprudential policies supplementing these policies 5

Tree Pillars of a Macroprudential Framework Though the governing body appointed to handle macroprudential policy varies across countries and institutional set-ups, there are three key pillars that should be adhered to regardless. An Analytical Framework: set up for the identification and monitoring of systemic risk; 6

Analytical Framework There are two dimensions of systemic risk that the Macroprudential authority must look out for; the cross- sectional and time-variant dimension. Table 1: Types of Systemic Risk 7 Type of RiskDefinitionExample(s) Cross-Sectional Dimension Preventing the emergence of too big to fail (TBTF) institutions; containing interconnectedness. Modern era financial systems are sustained by a complex web of interconnections between financial institutions, financial markets and financial infrastructure, double functioning as contagion channels in times of financial distress. Extra capital surcharges for SIFIs (Systemically Important Financial Institutions); restrictions on investment banking activities; strengthening resolution tools for failing financial institutions’ emphasis on prudential requirements anchored on an institution’s contribution to systemic risks. Time-Series Dimension Countercyclical financial regulation to moderate the financial cycle; using the upturn of the cycle more effectively to create buffers. Inherent bipolar tendencies of financial systems, i.e. overexposure to risk in the upturn of the financial cycle, excessive risk-aversion in downturns; financial system acts as an amplifier of economic shocks. Countercyclical provisioning and time-varying capital buffers (Basel III); time-varying Loan-To- Value requirements for real estate; ad-hoc increases in risk weights for specific categories of loans (e.g. foreign-denominated loans); anti-cyclical use of reserve requirements.

As aforementioned in Part 1, whether the institutional model selected be the full integration, Partial Integration or Separate Model, a comprehensive framework for the implementation of macroprudential policy must include: – A clear objective; – The incentive and tools to enable the achievement of the objective; – Accountability and transparency throughout the decision making process; and – Effective coordination across policy areas that have a bearing on financial stability. 8 Institutional Framework

The macroprudential authority must be provided with the powers to effectively carry out its responsibilities. Its mandate must include: 1.Information collection powers 2.Powers to define the regulatory perimeter 3.Rulemaking powers 9 Institutional Framework Figure 2: Spectrum of rulemaking powers

The macroprudential authority must put together a set of policy measures aimed at strengthening domestic financial sectors. 10 Policy Measures Table 2: Selected macroprudential measures CountryMeasure Belgium Increased risk weights for mortgage loans Increased capital requirements for high-risk trading activities Hong Kong LTV limit for mortgage loans Transaction tax where homes are resold Ireland LTV and loan-to-income (LTI) limits for mortgage loans Netherlands Higher capital buffers for systemically important banks LTV limit for mortgage loans United Kingdom Increased risk weights for commercial property LTI limit for mortgage loans United States Higher leverage ratio for banks South Korea Taxes on foreign capital flows to banks Sweden Increased risk weights for mortgage loans Higher capital buffers for systemically important banks Countercyclical capital buffer Switzerland Higher capital buffers for systemically important banks Countercyclical buffer for mortgage loans

Additionally, there is a need for” Accountability and communication – The macroprudential authority must also be granted independence to avoid and be protected against any excessive political and/or industry interference, as well as measures implemented to ensure accountability. Domestic policy coordination – As macroprudential policies do not take place in a vacuum and are likely to affect sectors not necessarily regulated, effective coordination between the macroprudential authority and other regulators is apparent. This will allow for avoidance of contradictory measures being implemented. 11 Policy Measures

The lack of a one-size-fits-all approach to the implementation of macroprudential policy makes decision making in this area particularly difficult. The tools to identify and monitor systemic risk, the operational toolkit, and the chosen institutional set-up will vary from country to country, depending on the level of development, financial structure, policy regime, and other historical and political factors. Given developing countries’ are still in a period of transition and macroprudential policy implementation is still in its infancy, it may take several attempts before the right approach is adopted. 12 Challenges: Developing Country Context

Macroprudential policy often involves ‘leaning against the wind’; that is, for example, where a macroprudential policy measure is tightening a certain area of the financial sector despite the economy being in an upswing. – These types of measures are often unpopular. For COMESA, cooperation in macroprudential policies across the region is a necessity in order to reduce the scope for international regulatory arbitrage that may undermine the effectiveness of national policies. 13 Challenges: Developing Country Context

Macroprudential policy is an area that is still early in its development, as are the approaches and tools adopted to implement macroprudential policy and mitigate systemic risks When beginning the process of implementing macroprudential policy, we must remember that there will be deeply rooted institutional arrangements already in place in some countries and unnecessary change could incur high transitional costs. 14 Conclusion and Recommendations

Ultimately, all macroprudential policy authorities should: – Ensure the central bank plays a key role in macroprudential policymaking; – Provide for effective identification, analysis, and monitoring of systemic risk; – Provide for timely and effective use of macroprudential policy tools; – Provide for effective coordination across policies to address systemic risk. 15 Conclusion and Recommendations

Thank You! 16