Developing Macro-prudential Supervision and Regulation

Philipp Hartmann

European Central Bank, DG Research

CMFE Conference on “Economic and Financial Crisis: Lessons from the Past and Reforms for the Future”, Carleton University, Ottawa, 12 May 2010

Disclaimer: Any opinions expressed are only the presenter’s own and should not be regarded as opinions of the European Central Bank or the Eurosystem.

Systemic risk

•

Fundamental phenomenon and concept underlying macro-

prudential supervision is systemic risk

•

Relevance made crystal clear by the financial and economic crisis

•

One definition

(ECB 2009): Risk that financial instability

becomes so widespread that it impairs the functioning of a financial system to the point where economic growth and welfare suffer materially

•

Can involve all components of financial systems…

–

intermediaries,

–

markets and

–

market infrastructures

…and two-way relationship with the economy at large

Past and present view on systemic risk

“Systemic risks

are for financial

market participants what Nessie, the

monster of Loch Ness, is for the

Scots (and not only for them):

Everyone knows and is aware of the

danger. Everyone can accurately

describe the threat. Nessie, like

systemic risk, is omnipresent, but

nobody knows when and where it

might strike. There is no proof that

anyone has really encountered it, but

there is no doubt that it

exists.”

Sheldon and Maurer (1998)

Outline

•

The problem: Systemic risk

–

Definition

–

Origins

–

Variants

•

The answer: Macro-prudential supervision and regulation

–

Definition

–

Risk identification

–

Policy instruments

•

Conclusions

•

Annex

Ultimate sources of systemic risk

Powerful feedbacks and amplification:

Non-linearities/ regime changes

Information intensity

of financial contracts

Balance-

sheet

structuresof inter-

mediaries

High degree of

connected-

ness

SPECIAL FEATURES OF THE FINANCIAL SYSTEM

Incomplete markets

Externalities

Asymmetric and imperfect information

Public good characterof systemic stability

Multiple equilibriaMA

RK

ET

IM

PE

RF

EC

TIO

NS

Source: Author based on de Bandt

and Hartmann (2000) and ECB (2009)

Three “forms” of systemic risk: The cube

idiosyncratic systematic

ORIGIN

sequential

simultaneous

IMPACT

exogenous

endogenous

Aggregate shock

Contagion

Unravelling of imbalancesT

RIGGER

• SR 1: Contagion

(Allen and Gale 2000, King and Wadhwani

1990)• SR 2: Endogenous build-up and unravelling of imbalances

(Minsky

1977, Kindleberger

1978)• SR 3: Aggregate shocks

(Gorton 1988, Demirgüc-Kunt

and Detragiache

1998)

Source: Author based on Trichet

(2009), de Bandt, Hartmann and Peydro (2009) and ECB (2009)

Broad policy response

•

Strengthen macro-prudential

wing of supervision and

regulation

•

Origins: Cross Report (1986), Crockett (2000)

•

Macro-prudential supervision: Public oversight that aims at identifying and containing systemic risks

•

Macro-prudential regulation: Public regulations that aim at maintaining systemic stability (relatively “new” policy area)

•

Typically more realm of central banks

•

Micro-prudential

supervision: Oversight of specific

intermediaries or markets (lesson: not sufficient)

•

Distinction from micro-prudential regulation by objective

•

But known instruments similar in character, closely related

Objective of macro-prudential policy

•

Systemic stability

is an extraordinarily complex target

•

There is no simple metric to measure it, multi-faceted phenomenon

•

Very different from price stability objective in monetary policy

•

“Prudential” policy focuses on ex ante activities (not ex post: crisis management) –

“asymmetric” in this sense

•

Bank of England (2009): The goal of financial stability policies should be the stable provision of financial intermediation services to the wider economy –

payment

services, credit intermediation and insurance against risk

•

More ambitious and “symmetric” than ensuring systemic stability?

Proposed EU supervisory structureECBECB

Analytical, logistical, statistical & administrative supportAnalytical, logistical, statistical & administrative support

Early risk Early risk warnings warnings

++Policy Policy

recommendationsrecommendations

..

.

EECCOOFFIINN

EEUU

CCoouunnttrriieess

MicroMicro--prudential informationprudential information Information on systemic riskInformation on systemic risk

Source: Author based on EU Commission (2009a,b)

Identification and assessment of systemic risks

•

Market intelligence (e.g. understanding the role and risks of financial innovations)

•

Data and statistics (e.g. assets, liabilities and bilateral exposures)

•

Analytical tools and models

–

Identification of systemic crisis: Composite coincident indicators (e.g. ECB “CISS”)

–

Contagion: Contagion and spillover

models

(e.g. counterfactual simulations with balance-sheet data, flow-of-funds analysis)

–

Build-up of widespread imbalances: Early-warning signal models

(e.g. credit-to-GDP gaps or leverage) and forward looking financial stability indicators

–

Aggregate shocks: Macro-stress testing models

•

Experience and judgement

Composite indicator of systemic stress (CISS)

•

Scope: Equity, bond, money, FX markets and intermediaries (various sub-items) -

real time•

Basic sub-measures

include volatilities, trends, spreads, recourse to marginal lending (weekly data)•

Normalisation

between 0 and 1 and aggregation

weighted with correlations (“systemic”)

Source: Hollo, Kremer and Lo Duca

(2010)

0.00

0.25

0.50

0.75

1.00

1/8/1999

7/8/1999

1/8/2000

7/8/2000

1/8/2001

7/8/2001

1/8/2002

7/8/2002

1/8/2003

7/8/2003

1/8/2004

7/8/2004

1/8/2005

7/8/2005

1/8/2006

7/8/2006

1/8/2007

7/8/2007

1/8/2008

7/8/2008

1/8/2009

7/8/2009

1/8/2010

0

1

September 11, 2001

Enron bankruptcy

W orldCom bankruptcy

Iraq W ar

Reported problems in banks' investment and hedge funds

Subprime ABS downgrades

Lehman Brothers bankruptcy

Pressfocus on public debt

Peak of"dot.com

bubble"

Credit gap as EWI for “costly” asset bubbles

•

—— De-trended private credit to GDP ratio (GDP-weighted average across countries)•

– –

“Optimal” signal threshold (each time 70th percentile –

“quasi” real time)•

Widespread mortgage/equity bubble episode (≥8 countries 1.75 SD above trend)•

“Costly” bubbles (followed by 3 years of GDP growth 3 p.p. below

potential)

Source: Alessi

and Detken

(2009)

-1.5

-1

-0.5

0

0.5

1

1.5

1979Q1 1983Q1 1987Q1 1991Q1 1995Q1 1999Q1 2003Q1 2007Q1

Housing/Savings and Loans

dot.com Credit

Early risk warnings

•

General problem: Hard to predict crises

•

Lesson from this crisis: Warnings were not heard/too weak

•

General public/markets or among policy authorities

•

Intermediate goals

–

Change market behaviour

–

Encourage preventive policy action

•

Challenges for public warnings

–

Type I errors (false alarms): Endanger credibility for next time

•

If warnings are successful in changing market behaviour then crises may not be observed (difficulty to ascertain counterfactual)

–

Type II errors (missed crises): Mandate not fulfilled

•

“Art” to make communication effective

Macro-prudential policy instruments 1

•

To contain contagion

risks

–

Enhance capital for counterparty exposures, introduce capital surcharge or levy for systemic risk

–

Introduce procedures for orderly resolution (incl. living wills)

–

Move derivatives trading on central clearing counterparties

•

To prevent the build-up of widespread imbalances

–

Counter-cyclical capital requirements and dynamic provisioning

–

Limit leverage and maturity mismatches

–

Balanced accounting approach (market prices, liquidity)

–

Influence compensation practices to remove incentives for risk taking and herding

–

Loan-to-value ratios and debt-to-income caps

Macro-prudential policy instruments 2

•

Ensure resilience against unexpected aggregate shocks

–

High capital and liquidity levels (e.g. based on stress tests)

–

Additional contingent capital

–

FX reserves (emerging economies)

•

Challenges

–

Transmission channels not well understood (impact assessments)

–

Calibration of individual instruments difficult

–

Interaction of different instruments major problem

–

Level playing field across financial sub-sectors and avoidance of regulatory arbitrage (shadow banking)

–

Effects on overall economy (benefits and costs)

How to ensure that timely action is taken?

•

Challenges

1) Difficult to “take away the punch bowl” when things go well

2) Macro-prudential body may not be equipped with instruments itself

•

Potential answers

Ad 1) Rules versus discretion

•

Mixture (pillar 1 and pillar 2)

•

Constrained discretion

Ad 1) Political independence

Ad 2) “Comply or explain” rule and/or public recommendations

Interaction with other policies

•

Macro-economic stabilisation policies

–

Fully developed macro-prudential policy could join monetary and fiscal policy as third aggregate stabilisation policy

–

Monetary policy

•

Relieve pressure for “leaning against the wind” (assignment)

•

Angeloni

and Faia

(2009): Monetary policy that puts strong emphasis on price stability, leans against asset bubbles/leverage and counter-cyclical capital requirements

•

Differentiation from monetary policy implementation

–

Fiscal policy

•

Relevant systemic risk factor

•

Corporate taxation and bank levies, tax treatments of interest rates or loan losses

•

Other (e.g. social policies fostering home ownership)

Conclusions

•

Economic and financial crisis has shown the devastating effects of systemic risk

•

The macro-prudential approach to supervision and regulation is an adequate broad policy response

•

But important challenges remain

–

Difficulties to identify risks early and doubts about the effectiveness (and costs) of regulatory measures lead some to favour ex-post and insurance-type policies over preventive policies

–

We need to invest in collecting all the data and in enhancing our understanding of systemic risk and how to fight it

•

Fully developed macro-prudential supervision and regulation can make a difference, even though expectations need to remain realistic

Thank you for your attention!

Philipp Hartmann

European Central Bank, DG Research

Disclaimer: Any opinions expressed are only the presenter’s own and should not be regarded as opinions of the European Central Bank or the Eurosystem.

CMFE Conference on “Economic and Financial Crisis: Lessons from the Past and Reforms for the Future”, Carleton University, Ottawa, 12 May 2010

Annex

Systemic intermediaries: Standard answers

•

2X2 problems

–

X=big

–

X=complex/opaque

–

X= interconnected

–

Xs are related but not identical

•

Public support in crises is fact of life, go on as before

•

Improved and stricter regulation (more and better capital and liquidity buffers)

•

Improved and stricter supervision (governance and compensation, risk management, stress testing etc.)

•

Separation (“Volcker

rule”) or ring-fencing of risky activities

(subsidiaries), narrow banking

Systemic intermediaries: Innovative answers

•

Make capital/liquidity buffers dependent on X (Geneva Report, US treasury)

•

Private capital insurance (Kashyap, Rajan

and Stein)

•

Access to pool of funds against Pigou

or Tobin tax (Perrotti

and Suarez, UK)

•

Contingent capital

–

Convertible debt (Flannery, Dudley)

–

Compulsory equity issuance in response to CDS spreads (Hart and Zingales)

•

Living wills (Squam

Lake Working Group on Financial

Regulation)

•

Strengthen competition policy in banking (Perrotti

and

Suarez; Carletti, Hartmann and Ongena)

References 1

•

Acharya

and Richardson (eds. 2009), Restoring Financial

Stability: How to Repair a Failed System, Wiley

•

Allen and Gale (2000), Financial contagion, Journal of Political Economy

•

Angeloni

and Faia

(2009), A tale of two policies: Prudential

regulation and monetary policy with fragile banks, Kiel Working Paper, no. 1569, October

•

Bank of England (2009), The role of macroprudential

policy,

Discussion Paper, November

•

Borio

(2003), Towards a macroprudential

framework for

financial supervision and regulation?, CESifo

Economic Studies

•

Brunnermeier, Crockett, Goodhart, Persaud, Shin (2009), The fundamental principles of financial regulation, Geneva Report on the World Economy, no. 10, July

References 2

•

Carletti, Hartmann and Ongena

(2007), The economic

impact of merger control, ECB WP, no. 786, July

•

Crockett (2000), Marrying the micro-

and macro-prudential

dimensions of financial stability, remarks before the Eleventh International Conference of Banking Supervisors, Basel, September

•

De Bandt

and Hartmann (2000), Systemic risk: A survey,

ECB WP, no. 35, November

•

De Bandt, Hartmann and Peydro-Alcalde

(2009), Systemic

risk: An update, Berger, Molyneux

and Wilson (eds.), Oxford

Handbook of Banking, Oxford University Press

•

Demirgüc-Kunt

and Detragiache

(1998), The determinants

of banking crises in developing and developed countries, IMF Staff Papers

References 3

•

Dudley (2009), Lessons from the financial crisis, Remarks at the Institute of International Bankers Membership Luncheon, New York City, October

•

EU Commission (2009a), Proposal for a regulation of the European Parliament and the Council on Community macro prudential oversight of the financial system and establishing a European Systemic Risk Board, 23 September

•

EU Commission (2009b), Proposal for a Council Decision entrusting the European Central Bank with specific tasks concerning the functioning of the European Systemic Risk Board, 23 September

•

European Central Bank, Financial stability review (various)

•

Evanoff, Hartmann and Kaufman (eds., 2009), The First Credit Market Turmoil of the 21st

Century, World Scientific Publishers

References 4

•

Ferguson, Hartmann, Panetta and Portes

(2007),

International financial stability, Geneva Report on the World Economy, no. 9, November

•

Financial Services Authority (2009), The Turner review: A regulatory response to the global banking crisis, March

•

Flannery (2009), Stabilizing large financial institutions with contingent capital certificates, mimeo., Florida State University

•

Gorton (1988), Banking panics and business cycles, Oxford Economic Papers

•

Hart and Zingales

(2009), A new capital regulation for large

financial institutions, mimeo., University of Chicago

•

High-level Group on Financial Supervision in the EU (2009), Report , Brussels, 25 February (de Larosière

Report)

References 5

•

Hollo, Kremer and Lo Duca

(2010), CISS –

A composite

indicator of stress in the financial system, mimeo., ECB

•

Kashyap, Rajan

and Stein (2008), Rethinking capital

regulation, Maintaining Stability in a Changing Financial System, Federal Reserve Bank of Kansas City

•

Kindleberger

(1978), Manias, Crashes and Panics: A History of

Financial Crises, Macmillan

•

King and Wadhwani

(1990), Transmission of volatility

between stock markets, Review of Financial Studies

•

Le Pan (2009), Look before you leap: A skeptical

view of

proposals to meld macro-

and microprudential

regulation,

C.D. Howe Institute Commentary, no. 296, September

References 6

•

Minsky

(1977), A theory of systemic fragility, in Altman and

Sametz

(eds.), Financial Crises: Institutions and Markets in a

Fragile Environment, Wiley

•

Perotti

and Suarez (2002), Last bank standing: What do I

gain if you fail?, European Economic Review

•

Sheldon and Maurer (1998), Interbank

lending and systemic

risk: An empirical analysis for Switzerland, Swiss Journal of Economics

•

Squam

Lake Working Group on Financial Regulation,

various reports

•

Hollo, Kremer and Lo Duca

(2010), CISS –

A composite

indicator of stress in the financial system, mimeo., ECB

References 7

•

Study Group by the Central Banks of the Group of Ten Countries (1986), Recent innovations in international banking (Cross Report), Basel, April

•

Trichet

(2009), Systemic risk, Clare College Lecture in

Economics and Public Policy, Cambridge, December

•

US Treasury (2009), Financial regulatory reform –

A new

foundation: Rebuilding financial supervision and regulation, Washington (DC)