Federal Reserve Bank of Kansas City 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 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. What Can Financial Stability Reports Tell Us About Macroprudential Supervision

Federal Reserve Bank of Kansas City 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 Outline of our Paper

Federal Reserve Bank of Kansas City 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 What is Macroprudential Supervision?

Federal Reserve Bank of Kansas City 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 Policy Steps under Macroprudential Supervision

Federal Reserve Bank of Kansas City 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). What are Financial Stability Reports?

Federal Reserve Bank of Kansas City 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. What are Financial Stability Reports?

Federal Reserve Bank of Kansas City 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. Overview of the Financial Crisis

Federal Reserve Bank of Kansas City 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. Overview of the Financial Crisis

Federal Reserve Bank of Kansas City Countries Effect on the Economy (OECD statistics) Effect on the Financial System Policy Actions United Kingdom 6 Quarters of GDP decline, Unemployment increased from 5% to nearly 8% Significant losses at FIs, funding concerns, collapse of several large FIs Takeover of some FIs, central bank rate lowered and lending liberalized, fiscal stimulus 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 Table 1A - Effect of the Financial Crisis

Federal Reserve Bank of Kansas City Country Low interest rates/spreads Increasing Asset Prices Increasing Debt Levels Trade Imbalances Risks from the U.S. Other Risks United Kingdom “if risk premia rose abruptly, asset prices would fall sharply” July 2006 FSR Asset prices high relative to expected income streams Households strong in aggregate, but signs of stress July 2006 FSR “there is a risk of disorderly unwinding” July 2006 FSR U.S. sub-prime market not large enough to be systemic April 2007 FSR Large FI’s expanding rapidly with wholesale funds Sweden Risk premiums historically low— risk of rapid price corrections Dec FSR Rapid increases in house prices and debt cannot continue Dec FSR Property companies’ borrowing is at a high rate Dec FSR Baltic current account deficits substantial Dec FSR Weakening of US economy expected to hurt euro area growth June 2008 FSR Pronounced economic slowdown in Baltics, financial infrastructure Netherlands Persistent risk tolerance reflected in low credit premiums March 2007 FSR House prices outpace inflation by 5% in early 2006 Sept FSR Household debt high when compared internationally March 2007 FSR Disorderly cor- rection of global imbalances not implausible March 2007 FSR Liquidity squeeze linked to subprime crisis Sept FSR Oil prices, complex credit products, spillovers from U.S. and others Spain Added to a greater risk appetite May 2006 FSR Trend of house price growth still high Household debt levels are a concern, U.S. negative savings rate and trade deficit Slowing real estate activity in the U.S. Use of whole- sale funding to replace deposits Norway Risk premiums historically low – increases vulnera- bility to shocks Dec FSR Growth in debt and asset prices may be source of instability June 2006 FSR Household debt and house prices at historically high levels.” June 2006 FSR Global trade and capital flow imbalances are increasing. June 2006 FSR US housing market is a source of uncertainty. Dec FSR Commercial property, lower capital under Basel II, avian flu Table 1 --What Risks Did the Countries Identify?

Federal Reserve Bank of Kansas City Countries Financial Indicators and Ratios Market Based Indicators Qualitative Indicators, Surveys, and Specialized Data Other Tests United Kingdom Ratio and trend analysis of global, corporate, household, and financial sectors Extensive use of a range of market based data Data on large FI counterparty exposures, market and systemic risk surveys Projected market values of mortgage-backed securities, modeling household distress, etc. Sweden Ratio and trend analysis of banks and their customers -- companies, households, and foreign borrowers Price data on equities, bonds, real estate, CDS, etc. Household finance data, KMV expected default frequencies, risk survey of market participants Major counterparty failure, household debt servicing ability Netherlands Charts and tables of selected economic and financial data (More are on Bank’s website) Selected charts on equity prices, CDS, credit ratings, etc. Bank lending survey Housing correction, vulnerable households, avian flu, macro model of liquidity stress Spain Trend and ratio analysis of financial and regulatory data Used to a lesser extent Data on all loans over €6,000 made in Spain Comparisons with U.S. mortgage markets, quality of Spanish MBS Norway Ratio and trend analysis of companies, households, and banks Equity and real estate prices Bank lending and liquidity surveys, counterparty exposure survey Gap indicator analysis, bank failure probabilities, house price estimates Table 2 -- What Did the Countries Use to Evaluate Risk?

Federal Reserve Bank of Kansas City CountryType of Model Financial Institutions Included Assumptions Used in Stress Tests General Results United Kingdom Macro forecasting model – models added for household, corporate, and banking sectors Major UK banks 2006 severe scenario: 1.5% decline in UK GDP 25% drop in house prices 35% drop for com. prop. Losses equal to 15% to 30% of Tier 1 capital (Used more qualitative approach after 2007) SwedenLoan portfolio modelFour largest banks 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 All 4 banks still meet Tier 1 capital standard, but several have large capital declines Netherlands Macro forecasting model -- individual banks also run stress tests Banks, insurance companies, and pension funds 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 SpainCredit risk model 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.” Norway Macro model -- models added for household, enterprise, and financial sectors 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 Table 3 - What Stress Tests Were Used?

Federal Reserve Bank of Kansas City 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. Evaluation of FSRs and the Implications for Macroprudential Supervision

Federal Reserve Bank of Kansas City 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. Evaluation of FSRs and the Implications for Macroprudential Supervision

Federal Reserve Bank of Kansas City 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. Evaluation of FSRs and the Implications for Macroprudential Supervision

Federal Reserve Bank of Kansas City “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 Evaluation of FSRs and the Implications for Macroprudential Supervision

Federal Reserve Bank of Kansas City 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. Evaluation of FSRs and the Implications for Macroprudential Supervision

Federal Reserve Bank of Kansas City 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. Evaluation of FSRs and the Implications for Macroprudential Supervision

Federal Reserve Bank of Kansas City 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. Concluding Comments