Macro-Prudential Surveillance – Shaping the Future CCBS/PFTAC Workshop Nuku’alofa, Tonga August 2010

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you got to get up and dance. We’re still dancing.” Chuck Prince, former CEO of Citigroup, July 2007

Outline What is Macro-Prudential Surveillance?What is Macro-Prudential Surveillance? How is it different to Micro-Prudential Surveillance?How is it different to Micro-Prudential Surveillance? Two dimensions of RiskTwo dimensions of Risk The Australian framework of surveillanceThe Australian framework of surveillance Why the resilience of the Australian financial system?Why the resilience of the Australian financial system? Some principles for effective macro-prudential surveillanceSome principles for effective macro-prudential surveillance Discussion – implications for the Pacific Island Central BanksDiscussion – implications for the Pacific Island Central Banks

“Macro-prudential supervision seeks to ensure financial stability by limiting disruptions to financial services caused by an impairment of all or parts of the financial system and [and which have] the potential to have serious negative consequences for the real economy.” Source: Committee on the Global Financial System, May 2010

Macro-prudential and Micro-prudential Approaches Compared Macro-prudentialMicro-prudential Immediate Objective Avoid financial system- wide distress Limit distress of individual firms Ultimate Objective Avoid output (GDP) loss Depositor protection Characterisation of Risk Endogenous: dependent on collective behaviour Exogenous: independent of individual agents ’ behaviour Correlations and common exposures across institutions Seen as important Seen as irrelevant Calibration of Prudential Controls Top-down: specified in terms of system-wide risk Bottom-up: specified in terms of individual firms Source: BIS Working Paper No. 128, February 2003

Macro and Micro Prudential Surveillance The macro and micro approaches to prudential surveillance are complementary. The macro and micro approaches to prudential surveillance are complementary. A prudential supervisor that does not take systemic risks into account is failing in its micro- prudential mandate, as well as a macro- prudential one. A prudential supervisor that does not take systemic risks into account is failing in its micro- prudential mandate, as well as a macro- prudential one.

The Role of Macro-Prudential Policy Two dimensions of systemic risk: Two dimensions of systemic risk: Cross sectional – risk arising from linkages within the financial system. Cross sectional – risk arising from linkages within the financial system. Time – risk arising from the business/financial cycle. Time – risk arising from the business/financial cycle.

The Australian Framework for Macro Prudential Supervision Council of Financial Regulators – the primary (and formal) co-ordinating body for Australia’s main financial regulatory agencies – comprises the RBA (Chair), APRA, ASIC and Australian Treasury.Council of Financial Regulators – the primary (and formal) co-ordinating body for Australia’s main financial regulatory agencies – comprises the RBA (Chair), APRA, ASIC and Australian Treasury. The Council contributes to the effectiveness of financial regulation by providing a high-level forum for co-operation.The Council contributes to the effectiveness of financial regulation by providing a high-level forum for co-operation.

The Australian Framework for Macro Prudential Supervision (cont’d) 1. The Council of Financial Regulators: 2. shares information and views; 3. discusses regulatory reform or issues where responsibilities overlap; and 4. co-ordinates responses to potential threats to financial stability (if need be).

The Australian Framework for Macro Prudential Supervision (cont’d) “The Reserve Bank of Australia will be strengthened and its role focused on the objectives of monetary policy, overall financial system stability and regulation of the payments system.” Treasurer’s response to the Wallis Inquiry, 1997

The Australian Framework for Macro Prudential Supervision (cont’d) Communication: The RBA publishes a formal Financial Stability Review every six months (since 2004).The RBA publishes a formal Financial Stability Review every six months (since 2004). Macro-prudential indicators are shared with APRA on an ad hoc basis and through the regular Coordination Committee meetings between the RBA and APRA (Memorandum of Understanding, 1998).Macro-prudential indicators are shared with APRA on an ad hoc basis and through the regular Coordination Committee meetings between the RBA and APRA (Memorandum of Understanding, 1998).

The Australian Framework for Macro-Prudential Supervision APRA has a requirement to: “balance the objectives of financial safety and efficiency, competition, contestability and competitive neutrality and, in balancing these objectives, is to promote financial system stability in Australia.” APRA Act, 1998, Section 8(2)

Why the Resilience of the Australian Financial System? 1. Australian banks had not accumulated large exposures to US mortgage-backed securities – focused on domestic loan demand. 2. Household sector activity underpinned by tight labour market - strong growth in real average earnings and rising employment-to-population ratio. 3. Absence of housing supply over hang

Why the Resilience of the Australian Financial System? (cont’d) 4. Lending standards did not ease as much as in the United States, with APRA raising capital requirements on certain mortgage products. 5. Australian households cannot deduct interest on owner-occupied mortgage, reducing the incentive to keep mortgage balances high. 6. Loan-to-valuation ratios lower in Australia than United States with less people facing negative equity.

Some Principles for Effective Macro-prudential Oversight Desirable Institutional arrangements: 1. The need for an agency with an explicit mandate to monitor and analyse systemic risk in the financial system. 2. The need for financial regulators to share information and co-operate to identify and respond to systemic vulnerabilities. 3. The systemic risk regulator, either independently or through a formal body (the Council of Financial Regulators in Australia), should have a mandate to call for institutional changes needed to forestall the build-up of systemic vulnerabilities.

Some Principles for Effective Macro-prudential Oversight (cont’d) Conduct of macro-prudential oversight and analysis 4. The systemic risk regulator should regularly conduct and publish analysis about systemic risks and vulnerabilities, (the Financial Stability Review in Australia). 5. The supervisory frameworks of all prudential and market integrity regulators should accommodate systemic concerns. 6. Supervisory responses should be informed by, but not mechanically driven, by macroeconomic variables.

Implications for the Pacific For Discussion: Is there a need for Pacific Island central banks to enhance their macro-prudential surveillance, given low level of integration with global financial system and low level of connectedness domestically? Is there a need for Pacific Island central banks to enhance their macro-prudential surveillance, given low level of integration with global financial system and low level of connectedness domestically? What form should surveillance take, given limited resources and dominance of foreign-owned banks? What form should surveillance take, given limited resources and dominance of foreign-owned banks? A macro-prudential surveillance approach requires regulators to monitor developments in the global banking system as well as national systems. How well are Pacific islands central banks placed to carry out this function? A macro-prudential surveillance approach requires regulators to monitor developments in the global banking system as well as national systems. How well are Pacific islands central banks placed to carry out this function?