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Macro-Prudential Policy:Rationale and Key Issues

Rio de Janeiro23 March 2012

Chief Economist OfficeLatin America and the CaribbeanThe World Bank

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Structure of the presentation

Systemic oversight and macro-prudential policy

Macro-prudential policy (MPP): distinct objective, independent instrument?

The fundamental rationale for MPP

Lines of MPP defense

Issues in MPP design

Final thoughts

[Extra slides – the empirical case for MPP in LAC]

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Systemic oversight and macro-prudential policy

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Systemic oversight – key distinctions

Systemic oversight “Macro-prudential” – the dynamic dimension of systemic regulation “Micro-systemic” – the cross-section dimension of systemic regulation “Systemic supervision” – the monitoring (and enforcement) dimension

“Micro-systemic” issues Regulatory perimeter

• Outer boundary – illuminating the shadows • Inner boundary – silos vs. universal banking license; conglomeration

The SIFI problem Systemic supervision issues

New connections: parts to whole, through time, stability & development Approach: top-down vs. bottom up; on-site & off-site; use of market discipline New tools; institutional arrangements; skills

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Macro-prudential policy

Distinct objective? Independent instrument?

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Distinct objective calls for independent instrument

Non-reducible, ultimate objective of macro-prudential policy (MPP) is to achieve sustainable financial system dynamics Focus of MPP—enhance financial system resiliency to fluctuations

(buffering) & mitigate financial-real amplification effects (dampening)

Objective of MPP is not perfectly correlated with that of monetary policy (MP) MP objective is to coordinate and anchor agents expectations around a

low and stable inflation target The “divine coincidence” is a special (not a general) case

• E.g., in the face of a negative aggregate demand shock, lowering the MP interest rate can also achieve MPP ad competitiveness objectives

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Distinct objective independent instrument (2)

MP can be a suboptimal tool achieve MPP objectives; conversely, MPP can overreach Given an MPP objective, the i-rate can be inferior to an MPP instrument An MPP instrument may be used to pursue non-MPP objectives (e.g., to

deal with “fear of appreciation”), for which it is not the best tool

There is a fuzzy area where MPP and other macro objectives overlap; hence, identifying the best policy tool might not be easy E.g., frothy capital inflows leading to excessive appreciation raise

concerns about competitiveness as well as about financial system risks

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The fundamental rationale for MPP

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Market failure stories that justify MPP (1)

Agency and collective action frictions/failures that amplify exogenous shocks in models with rational agents Typically modeled with rational expectations Shock tightens constraint (say, collateral or information) fire sales

asset/collateral prices fall more fire sales … and so on The un-internalized externalities of fire sales lead to socially excessive

leverage & credit expansion (Jeanne & Korinek, 2011) The amplified change in asset prices of fire sales ends up validated by

changes in fundamentals, as price setting shifts• From the more to the less informed (Shleifer & Vishny, 1997) • From agents with better technologies to agents with worse ones (Kiyotaki

and Moore, 1997)• From optimists to pessimists (Geanakoplos, 2009)

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Market failure stories that justify MPP (2)

Endogenous adverse dynamics driven and amplified by cognition frictions/failures reflecting bounded rationality Difficult to model mathematically (de Grauwe, 2009; Lo, 2009)

• In the tradition of Keynes, Minsky, Kilderberger, and Shiller …• … supported by growing behavioral finance evidence (Kahneman & Tversky,

2002; Montague, 2007) Focus is on non-reducible uncertainty, heuristically adjusted expectations,

and the associated mood swings• “The market will be subject to waves of optimistic and pessimistic sentiment,

which are unreasoning, yet in a sense legitimate … [because of uncertainty] … no solid basis exists for a reasonable calculation” (Keynes, 1936)

Up the cycle – exuberant euphoria, typically fueled by financial innovation Down the cycle – panic and acute uncertainty aversion, fueled by socially

costly flight to liquidity

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Market failure stories that justify MPP (3)

The two market failure stories clearly justify MPP …

… and lead to similar policy implications, in many respects

But, in some important respects, they have very different policy implications Buffers vs. dampeners: combating mood swings primarily implies

dampening (rather than buffering) Rules vs. discretion: mood swings are less predictable and less

responsive to incentives, hence calling for more discretion Price-based vs. quantity-based regulation: mood swings will be less

responsive to price incentives such as capital charges

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Lines of MPP defense

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Lines of macro-prudential policy defense

Avoid contributing to amplification – don’t rock the boat Remove pro-cyclicality in macro and traditional regulatory policy Allow prudential buffers to be true buffers—i.e., to be used without

penalty during downswings (Goodhart, 2010; Hellwig, 2010) Remove deeper pro-cyclical factors, such as currency mismatches and

social moral hazard (expectation of bailouts or “Greenspan put”) Enhance financial system resiliency to cycle – build a better boat

Add more, cycle-dependent buffers (liquidity and solvency) Dampen the cycle – tame the (excess) amplitude of the waves

Emphasis on MMP instruments as dampeners Nip the gestation of adverse amplifications in the bud

Induce the internalization of externalities (Pigovian taxes) Prevent buildup of exuberance (approval protocols for innovations)

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Issues in MPP design

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Sweet spot vs. overkill

Financial cycles in part reflect fundamental factors that are themselves pro-cyclical Investment opportunities and credit demand rise in the upswing and

riskiness of borrowers truly decline Schumpeterian creative destruction is intertwined with finance Rapid financial expansion may just be sustainable catch-up growth—i.e.,

difficult to distinguish financial development trends vs. cycles It thus makes no sense to aim at flattening the cycle altogether

The fact that only a small fraction (one in ten) of credit booms end up crashes is a warning against over-activism

The focus should be on containing the “excessive,” socially undesirable financial amplification effects and their implications

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Buffers vs. dampeners

The focal point: stronger boats or smaller waves? Buffers make the financial system more resilient to macro-financial

turbulence (main concern of supervisors) Dampeners limit the amplitude of macro-financial turbulence (main

concern of central bankers) The policy response

As one goes from agency frictions to externalities and to mood swings the MPP objective increasingly shifts from buffering to dampening

Buffers need to be usable in downswings modify traditional focus on fixed, cycle-independent minimum requirements

Big research agenda to ascertain effectiveness of alternative tools • Balance sheet (capital, provisions, leverage, liquidity): primarily buffering?• Lending (LTV, DTI, RR): primarily dampening?

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Rules vs. discretion

The focal point: automatic lower speeds or a vigilant captain Rules limit regulatory uncertainty (hence the cost of regulation) and

regulatory capture (hence the effectiveness of regulation) But in view of uncertainties, a pure rules-based MPP can be insufficient or

may introduce excessive deadweight costs The policy response

Untested nature of instruments and mood swings stories argue for tilting the balance in favor of discretion, which is congenial to MPP dampeners

Rules are more congenial to buffers and to a world of rational agents But discretion calls for a much bigger institutional reform agenda

• Judgment-based MPP would require governance (transparency, accountability) arrangements akin to those for MP—a tall order indeed

• Even more difficult for MPP compared to MP because policy costs of MPP are localized, hence are more likely to generate opposition and ill will

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Price vs. quantities

State-dependent choices Depend on uncertainty and the slope of the social marginal benefit

curve relative to the private marginal cost curve (Weitzman 1974)• Steeper social marginal benefit => quantities (plays it safe)• Flatter social marginal benefit => prices (maximizes efficiency)

Depend on financial intermediaries’ response to incentives• Tightly-controlled system => prices (nip it in the bud)• Unsound or exuberant systems => quantities (too late for prices)

The policy response In a world of pure agency frictions and rational agents a price-based

MPP policy is likely to dominate In a world marked by externalities and mood swings, quantities are likely

to dominate, reflecting uncertainty and non-linearities at the tails

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Specific vs. broad

Aggregate vs. institution-specific Across the board (top-down) application based on aggregate triggers may

have greater dampening effect … … but (bottom-up) application that is differentiated by institution is less

distortive – it does not punish the more prudent lenders All types of lending vs. targeted types of lending

E.g., housing lending-focused (such as adjustable LTV and DTI ceilings) Sector-specific interventions are better targeted to the epicenter of

amplification but may be harder to calibrate, more vulnerable to circumvention, and more likely to distort credit allocation

Things are further complicated by the lack of well-defined, easy-to-agree indicators and levers for MPP Implementation difficulties raise risk of doing more harm than good

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Final thoughts

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MPP – reminders as we move forward

Warnings A strong case for MPP that is, to a significant extent, judgment-based … but much uncertainty on effectiveness of MPP (big research agenda) Benefits and costs of MPP materialize at different points in time Deployment of MPP is not free of cost

Criteria Gradual approach: use the four lines of defense in organizing strategy Put in place a proper institutional framework for judgment-based MPP Use MPP as a complement (not substitute) to fiscal & monetary policy

E-rate flexibility enhances MP and MPP independence Tensions can arise: MPP can reduce the need for MP tightening and thus

limit e-rate volatility, which can in turn reduce MPP independence

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Thank you

Extra Slides

The case for macro-prudential policy in LAC

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Financial cycles in LAC’s history – stylized facts

Financial cycles in LAC have been quite frequent and more pronounced Capital flow cycles more frequent, house price booms less, credit similar Credit cycles of longer duration and greater amplitude than elsewhere

• The median drop in credit per capita in peak-to-trough phases has been 18%, four time higher than in advanced countries

Credit cycles (at turning points) have tended to precede output cycles and follow asset (equity and even housing price) cycles Unexpectedly, on average, capital flow bonanzas have been less likely to

be followed by credit booms in LAC LAC’s financial cycles have more often ended in crises

Frequency of banking crisis following credit booms has been higher Credit booms as the best predictor of crisis, even after controls

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The anatomy of LAC’s past financial cycles (1)

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Unconditional probability of booms and crises

0%

2%

4%

6%

8%

10%

12%

14%

16%

Banking Crisis Lending Booms Equity price booms Housing price booms Capital flow bonanzas

Industrial Countries Non-LAC EMs Latin America (LAC)

The anatomy of LAC’s past financial cycles (2)

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11.7.1 Average Duration of the Cycle of Real Credit per Capita

-10

-8

-6

-4

-2

0

2

4

6

8

1980-9 1990-9 2000-9 1980-9 1990-9 2000-9 1980-9 1990-9 2000-9

Industrial countries Latin America Non-LAC EMs

Upturn Downturn

11.7.2 Median Amplitude

-0.3

-0.25

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

0.15

1980-9 1990-9 2000-9 1980-9 1990-9 2000-9 1980-9 1990-9 2000-9

Industrial countries Latin America Non-LAC EMs

Upturn Downturn

The anatomy of LAC’s past financial cycles (3)

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[1] [2] [3] [4]

Credit

Real credit 1.1555 ** 1.3246 2.5876 * 2.6228 *

(amplitude of preceding upturn) (0.518) (1.027) (1.364) (1.405)

Capital flows

Ratio of non-FDI inflows to GDP .. -0.1269 -1.2177 -1.3084

(amplitude of preceding upturn) (1.844) (2.306) (2.308)

Asset prices

Real Exchange Rate .. .. 2.1246 2.2336

(amplitude of preceding upturn) (2.208) (2.291)

Stock prices (real) .. .. 0.1658 0.0984

(amplitude of preceding upturn) (0.523) (0.560)

Leverage of the banking system

Credit-Deposit ratio .. .. .. -0.3075

(T-P amplitude) (0.528)

Constant -1.4536 ** -1.3826 ** -1.8141 ** -1.7686 **(0.163) (0.256) (0.345) (0.366)

Nobs. 298 144 116 110

Log likelihood -108.4 -58.0 -38.3 -36.8

Pseudo R**2 0.0623 0.0581 0.2084 0.193

Size of Financial Booms and the Probability of Crisis: Probit AnalysisSample: 79 countries, 1970q1-2010q4

Numbers in parenthesis represent robust standard errors. * (**) indicates that the coefficient is statistically significant at the 10 (5) percent level.

Financial cycles in LAC– past, present and future

What does the past say about the future for LAC? In pre-crisis decades, the duration, amplitude and intensity of credit

cycles declined across the world … …. in LAC, accentuated by improved macro-financial “immune system” Hence, a simple extrapolation of past macro-financial turbulence not the

best guide to design future MPP for LAC … … but the relative importance of credit cycles and the sequencing results

will likely survive, given that financial structure changes slowly What is the present adding?

“Double tailspin push” (commodity prices & capital inflows) stemming from world-wide cycle asynchronicity is interacting with still stimulative macro in LAC credit boom formation (potential systemic risk buildup)

LAC macro constraints (fiscal rigidity, historically high i-rates, open capital account) and rising interconnectedness raise premium of MPP

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