systemic risk and macroprudential regulation gerald p. dwyer clemson university university of carlos...
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Systemic Risk and Macroprudential Regulation
Gerald P. DwyerClemson University
University of Carlos III, Madrid
Acknowledgement
• John Devereux• James Lothian• Margarita Samartín
Systemic Risk
• The G10 Report on Consolidation in the Financial Sector (2001) suggested a working definition:
• "Systemic financial risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainly [sic] about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy."
Systemic Risk
• George G. Kaufman and Kenneth E. Scott (2003) define "systemic risk" in imprecise terms:
• "Systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by comovements (correlation) among most or all the parts."
Systemic Risk
• Darryll Hendricks (2009), who is a practitioner, suggests in a missive for the Pew Financial Trust, a more theoretical definition from the sciences:
• "A systemic risk is the risk of a phase transition from one equilibrium to another, much less optimal equilibrium, characterized by multiple self-reinforcing feedback mechanisms making it difficult to reverse."
Systemic Risk
• George G. Kaufman and Kenneth E. Scott (2003) define "systemic risk" in imprecise terms:
• "Systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by comovements (correlation) among most or all the parts."
Macroprudential Regulation
• “The objective of a macroprudential approach is to limit the risk of episodes of financial distress with significant losses in terms of the real output for the economy as a whole.” (Borio 2003)
Forecasting
• Usefulness depends on ability to forecast when crises will occur and when not
Types of Crises
• Banking crises• Sovereign-debt crises• Foreign exchange crises
Banking Crisis
• Losses at banks same order of magnitude as equity capital in banking system
Sovereign and FX Crises
• These are state-created problems!
Government Debt to GDP2000 to 2013
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 20130
20
40
60
80
100
120
140
160
180
200UK France Italy GermanyGreece Portugal Spain USIreland
Source of Data: Eurostat
Definition of A Banking Crisis• Laeven and Valencia (2013)• Significant signs of financial distress in the banking system as indicated by
– significant bank runs– losses in the banking system– and/or bank liquidations
• Significant banking policy intervention measures in response to significant losses in the banking system. At least three out of following six – deposit freezes and/or bank holidays– significant bank nationalizations – bank restructuring gross costs at least 3 percent of GDP – extensive liquidity support (5 percent of deposits and liabilities to
nonresidents)– significant guarantees put in place– significant asset purchases (at least 5 percent of GDP).
Data
• Data on real GDP and banking crises for• 21 countries generally from 1870 to 2009• 2,950 annual observations• 91 banking crises
Another Set of Data
• Data on real GDP and banking crises for• 176 countries from 1970 to 2011• 7,392 annual observations• 150 banking crises
Real GDP per Capita and Banking Crises
Source: Dwyer, Devereux, Baier and Tamura (2013)
Definition of Recession• General discussion
– Bry and Boschan (NBER, 1971)• Algorithm to determine contractions in economic activity• Peak when increase followed by five monthly decreases• Cycle at least 15 months long
– Harding and Pagan (2002)• Peak when increase is followed by two quarters of decline in real GDP• Partly reflects requirement that a contraction be at least six months long
• Annual data– Peak when an increase followed by a decrease in real GDP
• Peak when an increase followed by a decrease of real Gross Domestic Product (GDP) per capita– Jordà, Schularick and Taylor (2012) and others in crisis literature
How To Measure Output Loss
• Laeven and Valencia (2013) measure output losses as the sum of the difference between actual and trend GDP over four periods (T to T+3)– Expressed as a percentage of GDP for the starting
year of the crisis• Compute trend GDP by applying an HP filter
Examples in which This Approach Produces Plausible Results
The approach is plausible for economies with an apparent or seeming underlying trend growth.
This is not the case for all economies.
Source: Devereux and Dwyer (2014)
GDP losses without a GDP Contraction
Country Start End Output loss Laeven
and Valencia
Lebanon 1990 1993 102
Israel 1977 1977 76
Spain 1977 1981 59
Colombia 1982 1982 47
Swaziland 1995 1999 46
Turkey 1982 1984 35
Guinea-Bissau 1995 1998 30
Laeven and Valencia (2013)
An exampleFigure Two
Lebanon 1990 (loss 102 percent)
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Banking Crisis
A second ExampleIsrael 1977 (77 percent of GDP)
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TrendCrisis
Isolated Cases?
• Very large output losses in Laeven and Valencia (2013) indicate this is empirically important
Largest Output Lossesin Laeven and Valencia (2013)
Banking Crisis
Country Start End
Output loss Laeven and Valencia
Kuwait 1982 1985 143.4 Congo, DR 1991 1994 129.5 Burundi 1994 1998 121.2 Thailand 1997 2000 109.3 Jordan 1989 1991 106.4 Ireland 2008
106.0
Largest Output LossFigure Four
Kuwait 1982 (144 percent of GDP)
Source: Devereux and Dwyer (2014)
Measurement of Output Losses
• A trend in potential output for many countries is uninformative because a stable trend growth of GDP does not exist for countries without modern economic growth
• An almost intractable problem since it holds true, almost by definition, for most of the low income economies
• A similar point can be made regarding Reinhart and Rogoff’s (2009) use of GDP per capita– Modern economic growth is relatively rare– Venezuela/Argentina where income per capita takes from
twenty or over forty years to recover after a banking crisis
Association Between Banking Crises and Contractions in Historical Data
Banking Crisis Start
Yes No
Contraction in real GDP per Capita in Same Year
Yes 43 643
No 48 1949
Source: Dwyer, Devereux, Baier and Tamura (2013)
Association Between Banking Crises and Contractions in Historical Data
Banking Crisis Start
Yes No
Contraction in real GDP per Capita in Same Year or Following Year
Yes 67 1038
No 24 1564
Source: Dwyer, Devereux, Baier and Tamura (2013)
Association Between Banking Crises and Contractions in Historical Data
Banking Crisis Start
Yes No
Contraction in real GDP per Capita in Same Year or Following Two Years
Yes 69 1318
No 22 1284
Source: Dwyer, Devereux, Baier and Tamura (2013)
Source: Dwyer, Devereux, Baier and Tamura (2013)
Densities of Mean Growth Rate of Real GDP per Capita Before and After Banking Crises
Source: Dwyer, Devereux, Baier and Tamura (2013)
Recessions After Banking Crisisin Post 1970 Data
Year of Beginning of Recession After Banking CrisisYear of Crisis Year After Crisis Two Years After
CrisisNo Recession even Two Years After Crisis
54 41 1 44
Source: Devereux and Dwyer (2014)
Real GDP Growth and Banking Crisesin Post 1970 Data
Source: Devereux and Dwyer (2014)
United States Banking Crises
Source: Dwyer and Lothian (2012)
Frequency of Recessionsafter Banking Crises
• Many banking crises are not associated with decreases in real GDP
Frequency of Recessionsafter Banking Crises
• Many banking crises are not associated with decreases in real GDP
• Why big differences?– Prior conditions and severity of problems– Policies before and after crisis
Macroprudential Regulation Itself
• “The objective of a macroprudential approach is to limit the risk of episodes of financial distress with significant losses in terms of the real output for the economy as a whole.” (Borio 2003)
Macroprudential Regulation Itself
• “The objective of a macroprudential approach is to limit the risk of episodes of financial distress with significant losses in terms of the real output for the economy as a whole.” (Borio 2003)
• Can we predict with reasonable confidence when these relatively infrequent events will occur?
Is Macroprudential RegulationLikely to Work?
• Different strategies– Discretionary regulation
• Prevent banking crises• Limit the cost if they occur
– Rule-based regulation• Higher capital requirements at banks
• Different strategies– Anticipation
• Prevent banking crises
– Resilience• Limit the cost
Is Macroprudential RegulationLikely to Work?
• Discretionary regulation– Down-payment requirements for houses
• Rule-based regulation– Higher capital requirements at banks
Housing and Financial Crisis
• Common theory: Rising housing prices created bubbles in various countries and that was a proximate cause of the recent banking crisis
• Implication for some: Limit rises in housing prices– Decreases probability of crisis– For example, change down payment requirements
when housing market is over-heated
Changing Down Payment Requirements
• Problem: This works by locking many people out of the housing market– Not obviously desirable– Not obviously feasible in a democratic country– Certainly will have consequences for the regulator
• General problem: Changing relative prices and creating identifiable winners and losers in the general population– This is quite different than most rationales for
standard macroeconomic policy
Changing Down Payment Requirements
• Problem: This works by locking many people out of the housing market– Not obviously desirable– Not obviously feasible in a democratic country– Certainly will have consequences for the regulator
• General problem: Changing relative prices and creating identifiable winners and losers in the general population– This is quite different than most rationales for standard
macroeconomic policy• Works quite differently in practice as well
Raising Capital Requirements
• Creates winners and losers of course– Likely to be fewer or at least smaller banks– Fewer financial services– Quite possibly, fewer financial services
counteracts the provision of too many financial services due to deposit insurance and too-big-to-fail
– Makes financial system more resilient to losses seen in past banking crises
Effective Anticipation
• What would it be good to have for anticipation to be effective?– Foresight into cause of next banking crisis– Given infrequency, some estimate of when more
or less likely– A firm foundation for connection between policies
and probability of a crisis
Effective Resilience
• What would it be good to have for resilience to be effective?– Foresight into likely factors that would lessen
effects as commonly seen– Some estimate of when more or less likely if a
state-contingent policy is to be adopted– Depending on the cost of resilience, a connection
between policies and severity of a crisis
Compare and Contrast Two Policies
• Anticipation – Head off a bubble in housing prices
• Resilience – Require banks to have more capital
Conclusion
• There is little doubt that events such as banking crises, sovereign-debt crises and possibly other “crises” are important
• Do we know enough to help avoid these events or lower their costs?
• Is macroprudential regulation, with its constant oversight, likely to be effective for banking crises which may not happen once in fifty years?
Conclusion
• Regulation is different than fiscal or monetary policy in operation– Public-interest and private-interest theories of
regulation– I think an independent central bank engaging in
macroprudential regulation is unlikely and undesirable in any case
A Quest for Stability
Source: http://img2.travelblog.org/Photos2/
One Way to Avoid Banking Crises