1. MACROPRUDENTIAL REGULATION – THE MISSING POLICY PILLAR E Philip Davis NIESR and Brunel University West London e_philip_davis@msn.com www.ephilipdavis.com groups.yahoo.com/group/financial_stability Course on Financial Instability at the Estonian Central Bank, 9-11 December 2009 – Lecture 6

2. Introduction Talk based on background paper co-authored by Dilruba Karim, forthcoming in NIER Macroprudential defined (Borio 2009) as: – policy focused on financial system as a whole; –treats aggregate risk as endogenous with regard to collective behaviour of institutions; –aims to limit system wide distress so as to avoid output costs associated with financial instability. We assess the need for a macroprudential policy pillar and the degree to which progress has been made in instituting one, viewed in light of lessons learnt in field of financial stability over past decade from research, experience and policy development

3. Outline 1Introduction 2Why we need macroprudential regulation - developments in the understanding of the process of financial instability 3Progress with the macroprudential pillar - the development of macroprudential oversight 4Policy issues – making macroprudential regulation operational 5Conclusion

4. 2 Why macroprudential regulation - developments in understanding financial instability (a) A generic approach Seen as most appropriate – key common features of crises Exogenous and endogenous aspects….. …..which may be diverse or common in generic terms While key additional generic aspect is high cost in fiscal and GDP terms

5. Generic features of instability

6. (b) Types of crises Traditional banking crisis, bank failures following loan losses, but given securitisation also: Extreme market volatility after shift in expectations Protracted collapse of debt or derivatives market liquidity and issuance, including interbank market Subprime crisis typifies the third type, as did Russia-LTCM

7. (c) Lessons from theory “Financial fragility” view of credit/asset price cycle from Kindleberger and Minsky repeatedly vindicated Heightened “uncertainty” over innovations not tested in a downturn “Disaster myopia”, short memories of instability and role of incentives (including bonuses) in underpricing of risk Recent models can add to understanding (Lectures 1 and 4)

8. 3 Progress with the macroprudential pillar - the development of macroprudential oversight (a) Definition Early realisation of need for early warnings on crises for policy and markets ‘Macroprudential surveillance’ – monitoring of conjunctural and structural trends in financial markets so as to give warning of the approach of financial instability – become a core activity for many central banks Necessary but not sufficient for a policy pillar

9. (b) Methods of surveillance Production of financial stability reviews by over 50 central banks Data needs: –macroeconomic and financial data for assessing conjunctural conditions –non-financial sector debt, leverage and asset prices for considering vulnerability of borrowers –bank balance sheets and income and expenditure for considering robustness of banks –risk measures derived from financial prices to complement leverage and income indicators –stress tests and forecasts of indicators and derived stability indicators such as defaults and bankruptcies, including risks to the central projection

10. Detail on data needs Whole economy –Macroeconomic forecasts and related simulations, including fiscal debts and deficit projections –Prediction of crisis from logit model using current outturns and macro forecasts –Prediction of crisis from signal extraction indicators using current outturns and macro forecasts –Prediction of crisis from binomial recursive tree model using current outturns and macro forecasts –CDS spreads –Conditional volatility of industrial production, retail sales and inflation

11. Banking sector –Non performing loans as a share of total loans –Banks’ return on assets –Banks’ return on equity –Banks’ unadjusted capital adequacy –Banks’ risk adjusted capital adequacy –Net interest income to total gross income –Non interest expenses to total gross income –Liquid assets to total assets –Foreign borrowing by banking sector –Interbank spreads

12. Household sector: –Sectoral debt to personal income ratios –Currency composition of household sector debt –House prices Corporate sector: –Debt to equity ratio –Corporate profitability –Altman index and its components –Corporate bankruptcy rate –Currency composition of corporate sector debt

13. Market indicators: –Standard deviation and correlation of equity prices –Equity risk premium and correlations –Nominal and real interest rate volatility –Exchange rate risk premia –Conditional volatility and covariance of equity prices –Conditional volatility and covariance of exchange rates –Key macro determinants of equity and exchange rate volatility Key background features –Trade relations matrix –Exchange rate regime and its sustainability –Size and foreign ownership of banking system –Size of equity market

14. Key lessons –Need for economy in number of variables –Derivation of data needs from theory and experience –Qualitative and quantitative aspects (regulation, competition, innovation) –Benchmarks and norms for economy, also allowing for changes (liberalisation, yields) –Cross border and domestic aspects –New players and instruments (hedge funds, CDOs, SIVs)

15. Observation of overall patterns in light of theory, experience, generic view Judgemental approach in drawing conclusions Concept of implicit corridor (ECB), then focus on vulnerabilities, risk scenarios, causes of scenarios, likelihood of them arising, costs of them

16. (c) Tools for macroprudential surveillance Distance to default measuring credit risk by expressing net worth as proportion of asset price volatility – mainly institution level Value at risk – flawed due to assumptions such as normality, correlations Stress tests at institution, banking system and economy wide level Bubble detection

17. Early warning systems –Multinomial logit using macro, structural and financial variables for binary variable of banking crisis – samples generally dominated by EMEs –Signal extraction EWS using relation of individual time series to banking crises – can use country specific data –Binary recursive tree - “which non-linear variable interactions make an economy more vulnerable to crisis than others?” liquidity, credit and market risks potentially non-linear – seeks key discriminator between crisis and non crisis

18. (d) Limits of macroprudential oversight – subprime crisis Davis and Karim – leading producers of MPS failed to predict subprime crisis –Multiplier effect of subprime losses via CDOs –Conduits and SIVs –Collapse of interbank market –Links to real economy But equally early warning systems showed limitations –Too much focus on EMEs –Usefulness of generic feature checklist

19. 4 Policy issues – making macroprudential regulation operational (a) The broad issue Whereas MPS may help to detect incipient crises, and encourage firms to stress test, what policy to pursue when warnings received? Options include moral suasion, speeches and intensified supervision – how effective? Monetary policy up to now resist use in MP field – focus on consumer prices only Variation in prudential parameters?

20. Rationale of macroprudential regulation is that individual bank supervision insufficient Basel 1 had a number of adverse incentive aspects…. ….and procyclicality of financial system may be worsened by Basel 2…. ….while banks may act endogenously to worsen financial system risk So design standards against financial fragility –appropriate design of a countercyclical regulatory framework (the time series dimension) –increasing risk weights for risks that are common across institutions rather than idiosyncratic (the cross section dimension)

21. (b) Countercyclical regulation Ongoing global regulation –Improvements to Basel 2 to make it less procyclical –Also tougher liquidity standards following crisis –Albeit partly offset by mark-to-market effects National regulation against procyclicality –Some ad hoc responses to recent boom –Dynamic provisioning in Spain – tax and accounting problems

22. Measures under consideration –Leverage ratio (FSA) –Capital surcharge based on MPS judgements (Bank of England) –Time varying capital requirements linked to lending growth, and catastrophe capital insurance –Relate capital requirements to asset price growth –Limit bank asset growth to level consistent inflation target Rules or discretion? Wider range of policies affecting procyclicality

23. (c) Cross section regulation Selection of systemically important institutions –Closer supervision –Higher capital? (regulatory vs economic capital) Higher capital charges on behaviour common across institutions –Controls on real estate lending, including lower LTVs? –Higher capital for higher wholesale funding? Tougher testing of financial innovations –Higher capital charges till seen in recession –A “drug testing” regime?

24. (d) Changes in the structure of regulation Dealing with the boundary problem as regulated sector disintermediated A move back to structural regulation? A single regulatory structure across economic units such as Euro Area (EU?) In home/host debate MP considerations favour host regulation New institutions needed?….. ….or more care in dividing between central bank and regulator?

25. 5Conclusion Recent focus of research on financial instability, spurred by recurrent crises Development of macroprudential surveillance by central banks…. ….but sub prime crisis showed limitations… ….not only in accuracy but also absence of policy tools for the “pillar” Need in particular for tools to limit ex ante the scope of systemic risk, in time series and cross sectional terms

26. References Davis E P and Karim D (2009), "Macroprudential regulation - the missing policy pillar" Keynote address at the Euroframe Conference, London, June 2009, forthcoming in National Institute Economic Review