1. Discussion of session on “Macroprudential Regulation” by Claudio Borio* Head of Research and Policy Analysis Bank for International Settlements, Basel Prepared for the Joint Conference of the Inter-American Development Bank and the Reserve Bank of Atlanta’s Americas Center: “Toward Better Banking in Latin America” Washington DC, 30 September 2005 * The views expressed are those of the author and not necessarily those of the BIS

2. 1 Structure of remarks From Microprudential (MiP) to Macroprudential (MaP) BIS research perspective Specific comments on thought-provoking papers 1

3. 2 What is meant by Macroprudential? Broader (least interesting): -synonymous with systemic risk Narrower (more interesting): 4 features (Borio 2003) -costs of financial instability i.t.o. real economy -system-wide shocks rather than idiosyncratic shocks plus contagion -endogenous risk -dynamic interaction financial system-real economy

4. 3 What is MaP in the papers? JR -aggregate shock -calibration of instruments w.r.t. individual exposures to the shock AK -procyclicality of regulation and capital flows C&G -dynamic GE modelling of real-financial interactions -regulation and procyclicality

5. 4 Why the focus on MaP now? Asian financial crisis Basel II

6. 5 Research at the BIS Focus on MaP and procyclicality since late 1990s Highlight 3 points -it is the financial sector that is potentially excessively procyclical  do not over-emphasize regulation! -cause? “risk perceptions gap” and “incentives gap” -empirical evidence supports this  real-time indicators of joint excessive credit-asset price expansion have good predictive content for banking crises (3-5 years ahead) (Borio & Lowe 2002, 2004)  these indicators add explanatory power to Merton- type default predictors (Tarashev 2005)

7. 6 JR: what does he argue? Lack of independence of supervisors as main cause of banking crises - failure to pre-commit not to bail out (LoLR) arises from political pressures Arrangements should have 2 features -prudential instruments and LoLR calibrated w.r.t. exposures to macro-shock  no LoLR for institutions whose exposures are “excessive”  capital requirements (KRs) increase with the exposures -strict independence of supervisors with full control over LoLR

8. 7 JR: what I liked? Shift from MiP to MaP -calibration of instruments w.r.t. systematic risk Call for greater autonomy for supervisors -great merit of JR

9. 8 JR: some reservations/questions (1) Failure to pre-commit as primary source of banking crises? -banking crises preceded safety nets and (some) were exacerbated by ex post inaction -more fundamental causes? (eg, the two “gaps”) Too much emphasis on illiquidity rather than insolvency? -illiquidity as late-stage exacerbating factor -predictive content of indicators of (masked) asset quality deterioration -KRs would rise in downturns?

10. 9 JR: some reservations/questions (2) Framework not MaP enough? -in equilibrium, real economy costs are not dependent on joint failures -no feedback on financial sector Overestimation of political pressures on failure to pre-commit? -especially important in case of idiosyncratic shocks -a new perspective on deposit insurance

11. 10 AK: what does he argue? Fragility view of intermediation: -KRs etc have real costs -link to procyclicality Excessive procyclicality of Basel II could be a problem - especially for high quality (largest) banks in a recession Shift towards Fair Value Accounting (FVA) could add to procyclicality - especially in conjunction with earnings management For EMEs, should strive to develop insurance markets - not seek to lengthen maturities, etc

12. 11 AK: what did I like? Procyclicality of Basel II -an issue but we do not know the impact of the overall package -could even be less procyclical than current one! Stress on implications of accounting reform -badly underestimated -call for forward looking provisioning (Borio & Lowe 2001) Stress on need for structural reform in EMEs

13. 12 AK: some reservations/questions (1) Link asset quality – procyclicality unambiguous? What roles for accounting and prudential supervision? Need for reconciliation (Borio & Tsatsaronis 2004) -accounting: to provide best approximation to unbiased valuations and performance, including risk information -prudential supervision: instil the desired degree of prudence in behaviour -need for close cooperation in developing and implementing corresponding measurement/information system (valuation; risk profiles; and uncertainty surrounding both)

14. 13 AK: some reservations/questions (2) Unwise to suggest that EMEs should not seek to lengthen maturities -“excessive” short-term debt can arise from a number of less benign factors -could have inhibited improvements in debt management in recent years (including FX) Overestimate benefits and practicality of insurance markets for EMEs? -if risk factors truly independent of own behaviour, benefits may be smaller (see evidence on crises) -if not independent, insurance harder and more costly

15. 14 C&G: what do they argue? Adjustment of KRs should be shock-dependent -not necessarily countercyclical -lowered (loan demand shock) but raised (credit crunch shock)

16. 15 C&G: what did I like? Dynamic interaction between real economy and financial sector in a GE model Countercyclical KRs described as “standard view”!

17. 16 C&G: some questions/reservations Is the introduction of KRs somewhat artificial? -constraint reduces welfare Do prescriptions really differ that much from standard view? -KRs are minima: not binding in a credit crunch How realistic is the model?

18. 17 References Amato, J and C Furfine (2003): “Are credit ratings procyclical?”, BIS Working Papers, no 129, February. Borio, C (2003): “Towards a macroprudential framework for financial supervision and regulation?”, CESifo Economic Studies, vol 49, no 2/2003, Summer, pp 181-215, (also available as BIS Working Papers, no 128). Borio, C, C Furfine and P Lowe (2001): “Procyclicality of the financial system and financial stability: issues and policy options”, in Marrying the macro- and micro-prudential dimensions of financial stability, BIS Papers, no 1, March, pp 1-57. Borio, C and P Lowe (2001): “To provision or not to provision”, BIS Quarterly Review, June, pp 36-48. Borio, C and P Lowe (2002): “Assessing the risk of banking crises”, BIS Quarterly Review, December, pp 43-54. Borio, C and P Lowe (2003): “Securing sustainable price stability: Should credit come back from the wilderness?”, paper prepared for ECB Workshop on “Asset prices and monetary policy” in December 2003, BIS Working Papers, no 157, July 2004. Borio, C and K Tsatsaronis (2004): “Accounting and prudential regulation: from uncomfortable bedfellows to perfect partners”, paper prepared for the maiden issue of the Journal of Financial Stability, no 1, September. Crockett, A (2000): “In search of anchors for financial and monetary stability”, BIS Speeches, 27 April. Crockett, A (2001): “Marrying the micro- and macro-prudential dimensions of financial stability”, BIS Speeches, 21 September. Lowe, P (2002): “Credit risk measurement and procyclicality”, BIS Working Papers, no 116, September. Segoviano, M A and P Lowe (2002): “Internal ratings, the business cycle and capital requirements: some evidence from an emerging market economy”, paper presented at the Federal Reserve Bank of Boston Conference on “The impact of economic slowdowns on financial institutions and their regulators”, BIS Working Papers, no 117, August. Tarashev, N (2005): “An empirical evaluation of structural credit risk models”, BIS Working Papers, no 179, July.