MACRO-PRUDENTIAL POLICY: BANKS RISK & CAPITAL CONTROLS

Adrian Blundell-WignallSpecial Advisor on Financial Markets to the OECD Secretary General.

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Macro-prudential over time

• The Cross Committee 1986: the sense is innovation and off-balance sheet issues in big banks can cause macro problems.

• Crocket 2000—(1) pro-cyclicality of the financial cycle and the need for countercyclical buffers; (2) connected institutions that have systemic consequences when they have similar exposure. A calibration of tools is required, as we succeed conceptualising the tasks of micro and macro-prudential.

• FSB 2011: macro-prudential is: “the uses of prudential tools to limit systemic or system-wide financial risk”.

• This is where the problems start.

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4 Requirements of macro-prudential

• Identify imbalance before they become a problem.

• Select the appropriate prudential tool, or tools;• Decide how to calibrate (data and modeling) and

time the intervention;• Coordinate all the responsible regulators and

supervisors to bring it about, including achieving political support for the actions—and since the tools may vary from one situation to the next, a macro-prudential regulator will need to be involved in the coordination at both the domestic and international levels.

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Identify Imbalances Before they Become a Problem

• Failure to predict the Mexico crisis.• Failure to predict the Asia crisis.• The IMF in April 2007 Financial Stability Report:

“The weakness has been contained to certain portions of the subprime market…….and is not expected to pose a serious systemic threat. Stress tests…..show that even under scenarios of nation wide house price declines that are

historically unprecedented, most investors with exposure to subprime mortgages through securitised structures will not face losses.”--IMF Global Financial Stability Map shows credit crisis the least likely of all events.• These were massive crises and no global institution came

even close. I am very pessimistic about this. Rules based approaches are going to be better.

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Tools For Balance Sheets

For influencing financial institution balance sheets, where solvency and liquidity risks might be the source of systemic stability concerns, the policy tools include inter alia:

• Counter-cyclical capital buffers;• Time varying systemic surcharges;• Systemic capital surcharges;• Systemic liquidity surcharges and supporting measures such as

caps on loan-to-deposit ratios, the liquidity coverage ratio (LCR) the net stable funding ratio (NSFR);

• Capital surcharges on OTC derivatives not cleared centrally;• A capital surcharge for global systemically important financial

institutions (GSIFI’s);• Varying the capital plans of individual banks after stress testing

exercises; and• Dynamic provisioning.

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Tools for Borrowers & Lenders, International Spillovers, & Network Risk

Where non-bank borrowers and financial institution lenders are judged to be taking excessive risks the available tools include:

• Variations in require Loan/valuation ratios (linked to the house price cycle);

• Imposing caps on the ratio of debt service to disposable income ratios;• Setting rules to avoid currency mismatches for borrowers and lenders;• Ceilings on credit growth; and• Rules on the reference interest rates for mortgage lending.Where international interconnectedness issues are judged to be a source of

instability in the domestic economy due to spillovers—such as the current low rates in the West and quantitative easing policies, the tools include:

• Cross-border supervision; and• Controls on international capital flows (with an emerging market economy

--EME --focus).Where counterparty risk and complex network effects are a source of

systemic concern the favoured tools seem to be:• Though the cycle variation of haircuts and margins;• Limits on interbank exposures;• Variations in Basel risk weights, such as the CVA charge; and• Transactions taxes.

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Calibration is a Problem: DTD Model—What Factors Matter for Bank Default Risk

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Correlation Matrix: Variables Key for the DTD of Banks, and Monetary & Macro-prudential Policy

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Complexity: DTD Study Implications

• The three monetary policy variables are most highly correlated with the per cent change in the national house price indexes. This is consistent with leaning-into-the-wind monetary policy taking into account the key housing asset price cycle.

• The change in the Tier 1 ratio appears to be negatively related to the house price index variable, (higher Tier 1 is associated with a weaker asset price cycle) which suggests it is a contender.

• However, the change in the Tier 1 ratio is also highly significantly correlated with the GMV of derivatives in a perverse way. That is, a tightening up of the T1 ratio is associated with the increased use of derivatives in off-balance sheet products, CVA desk arbitrage, and other forms of regulatory arbitrage. The GMV of derivatives variable has one of the biggest independent negative influences on the DTD.

• All three business model influences on the DTD, (the GMV of derivatives, wholesale funding, and trading securities) are correlated with each other, and to leverage, but they aren’t correlated with monetary policy, and they are perversely correlated to the Tier 1 ratio. This block of influences on the DTD must be treated separately from macro-prudential considerations.

• While countercyclical rules may be effective in the traditional bank segment of the market, those same policies will interact with the GSIFI bank group, where destabilising factors can come into play.

• The OECD has long recommended separating off securities businesses that engage in activities such as prime broking, market making, underwriting and origination. This would pave the way for more effective macro-prudential policy for core deposit banking.

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Governance

• In regard to the fourth requirement for successful macro-prudential policy, governance, it is likely that coordination issues will be problematic.

• The supervisors for banks and all of the shadow banks are different in most jurisdictions, and include central banks, prudential regulators, consumer protection agencies, federal level regulators, state level regulators and international regulatory bodies.

• The responsibility for any one of the above list of tools varies widely from one jurisdiction to the next, and there are overlaps of responsibilities within and between countries.

• Data for surveillance have holes, especially in the shadow bank sector.

Capital Controls

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Many EME’s also use capital controls to manage the capital account when they perceive they are in disequilibrium, and count it as a macro-prudential tool. Measures to support a macro policy of managing the exchange rate include, inter alia:• Ceilings on foreign exchange forward positions.• Guidance from authorities on the extent of foreign

currency borrowing and swap activities.• Restrictions on bank loans in foreign currency.• Limiting foreign exchange transactions to those

supporting underlying trade and investment activities.• Imposing minimum holding periods on domestic

government securities.• Variation in taxes on cross-border flows.

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International Reserves Re-investment in Treasuries

0

1000

2000

3000

4000

5000

6000$bn

ÖtherCarrib.BrazilKoreaUKOPECSEAJapanChinaFed Balance SheetUS Fed Hld Tsy

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Impact on US 10 Year—Carry Trade Catalyst

-4

-3

-2

-1

0

1

2

1998

M12

1999

M12

2000

M12

2001

M12

2002

M12

2003

M12

2004

M12

2005

M12

2006

M12

2007

M12

2008

M12

2009

M12

2010

M12

2011

M12

2012

M12

Contribution (%) to US 10Y Sov Bond

Yield

Contribution of CPI_MOM

Contribution of LIBOR_3M

Contribution of TS_FHDL_GDP

Carry Trade Returns: US vs Emerging

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50

70

90

110

130

150

170

190Ja

n-07

Jun-

07No

v-07

Apr-0

8Se

p-08

Feb-

09Ju

l-09

Dec-

09M

ay-1

0Oc

t-10

Mar

-11

Aug-

11Ja

n-12

Jun-

12No

v-12

Apr-1

3Se

p-13

Feb-

14Ju

l-14

Dec-

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Index

US Tsy Tot Ret 1-3yUS Tsy Tot Ret 10y+Merrill Tot Ret EM Credit

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Saving Investment Correlation, EME/OECD, Rolling Window

Source: OECD.

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1982 Q1-86 Q4

1984 Q1-88 Q4

1986 Q1-90 Q4

1988 Q1-92 Q4

1990 Q1-94 Q4

1992 Q1-96 Q4

1994 Q1-98 Q4

1996 Q1-00 Q4

1998 Q1-02 Q4

2000 Q1-04 Q4

2002 Q1-06 Q4

2004 Q1-08 Q4

2006 Q1-10 Q4

Emergers OECD All

If EME investment and saving correlation is represented by: and OECD by: , as implicit in the correlations shown here, then .

A significantly large EME world would become destabilising if the correlations did not begin to change.

OECD—Non-OECD

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0

10

20

30

40

50

60

70

80

90

100

1980 1990 2000 2008 2013 2018

%Other

BRICS

Japan

Other AngloSaxon

EU

USA

Conditional Variance Measure of Controls

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Capital Controls and Investment

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Capital Controls OECD Study

• The OECD duplicated the IMF Ostry study and finds it is not robust. An OECD panel regression study for the effects of IMF capital controls data on GDP growth shows interesting results. Capital controls are not an appropriate macro-prudential tool for EME’s or any other country.

• The apparent effectiveness of this tool at times may stem from the fact that these countries prefer to target the exchange rate versus the US dollar. During inflow periods economic growth is strong. Capital controls have a positive effect on GDP, because they help the targeting of the exchange rate, and reduce domestic monetary creation that follows from foreign exchange market intervention. Growth is not damaged as company cash flow is more plentiful, and some domestic monetary creation is difficult to avoid.

• However, when risk aversion rises, economic growth slows down and capital outflows begin to dominate, the evidence suggests that the presence of capital controls is very damaging. Domestic money creation reverses, there is no upward pressure on the exchange rate anyway, and company cash flows begin to suffer. It is at this time that capital inflows are needed, in both FDI and through the banking system. Countries with the highest capital controls become the least desirable destinations for foreign investors. Growth suffers as a consequence.

• Such policies risk countries not getting the right fiscal and monetary policy balance, and the requisite need for exchange rate flexibility. They also cause EME’s to delay the need for structural reforms, which includes the financial sector.