1. Macroprudential policy – indicators and tools Jan Frait Executive Director Financial Stability Department

2. 222 Credit cycle and systemic risk – the case for forward- looking approaches in conduct of macroprudential policy In a credit cycle, systemic risk evolves differently in two stages: accumulation (build-up) and materialization (manifestation). Note the financial (in)stability paradox: a system is most vulnerable when it looks most robust. period of financial exuberance time Build-up of systemic risk marginal risk of financial instability period of low current risk time degree to which risks materialise as defaults, NPLs and credit losses Materialisation of systemic risk period of financial distress normal conditions period of high current risk

3. 3 Systémové riziko a finanční cyklus Systémové riziko vzniká v průběhu finančního cyklu, kdy finanční instituce vytvářejí rostoucí a vzájemně korelované expozice (typicky hypoteční úvěry) citlivé na shodné makroekonomické faktory. Špatné úvěry vznikají obvykle v dobrých časech, což se ukáže v následující recesi.

4. 4 Conseptual approach to macroprudential policy The key concept describing the time dimension of systemic risk over financial cycle is leverage (the indebtedness of economic agents, stocks of loans, the ease of obtaining of external financing, the size of interest rate margins and credit spreads, etc..). The leverage can be approximated by credit-to-GDP ratio: increases until the financial cycle turns over; normally the turnover happens in an orderly way (a case of cycle without a crisis in Chart) without a need for an extra policy action. sometimes the turn is disorderly and presents itself as the eruption of financial crisis. then leverage starts to decline, although in the early phase of the crisis remains high (given falling nominal GDP it can even rise in the initial post- crisis years). The deleveraging phase can therefore last several years, and in the event of a deep crisis the leverage ratio can, after a time, fall below its long-term normal value. consequently, the leverage ratio adjusts to economic conditions after a considerable lag, so stock measures have only a limited information value as a guide for the macroprudential policy response during the financial cycle. for this reason, forward-looking variables are needed that can be used to identify situations where the tolerable limit for systemic risk has been exceeded.

5. 55 Leverage over credit cycle – a slow motion process

6. 6 I. Systemic Risk Indicators

7. 77 Prevention and forward-looking indicators The main task of financial stability analysis as regards prevention is timely identification of the risk of financial instability – the marginal contribution of the current financial environment to the build-up of risks of a future financial crisis. In this phase, macro-prudential analysis must be focused primarily on the identification of hidden risks to financial stability being generated in the balance sheets of financial intermediaries and their clients. Analytical attention, however, must also be paid to the quality of cash flows, as financial institutions with structural problems in their balance sheets, weak balance- sheet liquidity and long maturity transformations are naturally far more prone to cash-flow problems. Authorities need a set of forward-looking indicators providing information on the possibility of materialisation of systemic risk in the future as a result of currently emerging financial imbalances. This refers mainly to “gap” indicators based on the assessment of deviations of factors determining the degree of leverage from their equilibrium or normal values. As regards the possibility of using forward-looking indicators to construct early- warning systems, we feel that their information value and practical applicability remain limited. Beware of financial markets‘ data signals – IMF, ESRB ….. Analytically, it is also possible to use the FS paradox – extremely good values of parallel indicators tell us that something strange is going on in the system.

8. 88 Mitigation and identification of discontinuities In the systemic risk materialisation phase, the macroprudential policy focus must be shifted to mitigating the impact of the crisis. In this phase it is vital to assess the scale of the risk materialisation problem and the resilience of the financial system. Stress tests of the financial system’s resilience are a suitable analytical instrument for performing this task. Macroprudential analyses must take into account the high degree of discontinuity in the evolution of systemic risk – the potentially sharp transition from good to bad times. To this end it is necessary to construct indicators characterising the start and end of the materialisation of financial instability. In a small open economy, financial or informational contagion resulting from the links between an economy and its institutions and the external environment can be a major source of materialisation of systemic risk and of discontinuity in the evolution of such risk. The analytical approach will differ significantly from country to country (share of foreign ownership of financial institutions, dominance of subsidiaries or branches of foreign banks, share of foreign currency loans, net external and foreign exchange position of the banking sector and entire economy...).

9. 99 Countercyclical capital buffers – the example of policy period of financial exuberance time Credit-to-GDP over financial cycle turning point (start of crisis): credit-to-GDP still very high, but policy has to change sharply period of financial distress long-term „normal“ level of credit-to GDP period of financial exuberance time Credit dynamics (e.g. y-o-y growth) period of financial distress turning point (start of crisis): credit growth falls, lending conditions tighten CCB set to zero CCB set to zero again CCB set at maximum 2,5 % Policy of countercyclical capital buffers should follow the developments of leverage over financial cycle and associated risk for financial stability.

10. 10 How to Tell Normal Times from the Not So Normal Ones Financial exuberance period - in addition to the availability of cheap credit, the emergence of overly optimistic expectations about future income and asset prices required. Financial distress period - in addition to the limiting the availability of credit, economic agents become over-pessimistic. To identify the onset of or exit from not so normal times - the gaps based on the indicators‘ level relative to their long-term average or trend reveal the story: credit growth, credit-to-GDP; debt-to-income, debt-to-assets dynamics; money market risk premia, credit spreads and CDS spreads; financial investors’ lever length; length of maturity transformation by banks; lending standards, credit risk gauges,... Bad news: the framework is still more philosophical than operational!