Notes on Macro Prudential Policy (Regulation/Supervision)

1. Notes on Macro Prudential Policy (Regulation/Supervision) Bashu Dev Adhikari BFI Regulation Department

2. Background • Financial Crisis with Traditional Banking Behavior • Financial Crisis in Sound Macroeconomic regime • Financial Crisis in Weak Macroeconomic regime • Financial Crisis in Weak Market Infrastructure • Financial crisis in Deregulated Regime • Financial soundness: Essential in Micro/Macro Level • Composite of Micro Behavior reflects in macro level confidence

3. quote • When the music is playing, you have to get up and dance - Chuck Prince, CEO, city group • Prevention is not only better but cheaper than cure • Bosil Batter

4. Stimulus for Macro Prudential Approach • The global financial crisis of 2007–2009 exposed critical weaknesses in the financial system • Prior regulation was focused on the health of individual firms rather than the stability of the financial system as a whole (Nicholas Bealea,David G. Randb, Heather Batteyc, Karen Croxsond,Robert M. Maye, and Martin A. Nowakb; Individual versus systemic risk and the Regulator’s Dilemma: Princeton University Paper, 2011) • Large private return, but where are the Social returns?

5. Concepts • Care the forest not the trees only • Industry wide concept • Coordinated Approaches • ‘Push me, pull you’ theory • Stability Issue • Qualitative/Quantitative Issue → Basel III doctrine

6. Definition • MPP (Borio 2009) as: • policy focused on financial system as a whole; • treats aggregate risk as endogenous with regard to collective behaviour of institutions; • aims to limit system wide distress so as to avoid output costs associated with financial instability. • To identify, monitor & manage systemic risks in the financial sector

7. Definition… • MPP is defined by its aim(limiting system wide F risk), the scope of analysis(the financial system as a whole & its interaction with real economy), a set of powers & instruments & their governance (prudential tools & those specifically assigned MP authorities) - Jaime Caruana, GM, BIS

8. Definition… A policy that uses primarily prudential tools to limit systemic or system-wide financial risk, thereby limiting the incidence of disruptions in the provision of key financial services that can have serious consequences for the real economy, by 1. dampening the build-up of financial imbalances and building defences that contain the speed and sharpness of subsequent downswings and their effects on the economy; 2. identifying and addressing common exposures, risk concentrations, linkages and interdependencies that are sources of contagion and spillover risks that may jeopardise the functioning of the system as a whole. (MPP tools and frameworks, 2011: FSB/BIS/IMF)

9. MPP: Synonyms of Stability !

10. Source: FSAP: Experience and Issues Going Forward, Stefan Ingves, Economic Forum, 16 December 2003

11. Evolution & Emergence of MPP • Concepts & wording in the unpublished documents in late ’70 (minutes of the meeting of Crook committee and the document prepared by Bank of England) • used formally by George Blunden(Ist chairman of BIS) in his speech at 1987 • Influential speech by Andrew Crockett, GM, BIS(during 2000 on MPP in Colombo workshop) • Term more common during Financial Crisis

12. Aim: Financial Stability Two faces of Financial Stability • FS in terms of robustness of the F System to external shocks • Endogenous nature of financial distress, FS in terms of resilience to shocks originating within the financial system

13. Scope & Uses • Prevents Future crisis Occurrence • Protecting the economy against the consequences of financial instability • Limiting risks & cost of Systemic Crisis • Act as a countervailing forces to natural decline in measured risks in a boom & the subsequent rise in measured risks in the subsequent bust

14. Scope & uses… • Limiting system wide financial risk • Prevent disruption to key financial services & economy

15. Features • Holistic & Forward looking approach • Balance & Coordination with other Sectors • Real sector of economy observance • Join up the dots • Arrangement with institutional set up • Toolkits used for monitoring

16. Work needed for MPP framework • Design and collection of better information and data to support systemic risk identification and modelling; • Design of techniques to identify and measure systemic risk that utilise this information and help inform the design of policies; • Design of an effective MP toolkit of powers and instruments, including the criteria for the choice and calibration of the instruments and methods to assess their effectiveness, as well as the respective merits of rules versus discretion; and • Design of appropriate governance arrangements for the exercise of the MPP powers.

17. Unique advantage of Central Bank to implement MPP • Ensuring FS is central bank’s traditional responsibility • CB has advantage in MP analysis, it possess much of the expertise & institutional capacity required to conduct systemic risk monitoring • In addition to MP, CB organizes & supervises the payment system, which play a key role of the modern financial system

18. Key Issues in systemic risk monitoring • Systematically important financial institutions(SIFIs) identification & assessment of systemic importance • Strengthen the intensify & effectiveness of supervision • Establish effective resolution regimes

19. Best Efforts • Numerous Research, articles and models come out • FSB, BIS & IMF, BCBS, CGFS working together at the request of G-20 • G-30 established its working Group on MPP • ECB & other Central Bank in the process of Implementation

20. BCBS proposals for MPP • Increasing & improving bank capital quality • Raising capital base • Cap on leverage ratio • Creating counter cyclical capital buffer

21. Two dimensions of MPP aims • Time dimension evolution of system-wide risk over time • Cross sectional dimension the distribution of risk in the financial system at a given point in time

22. Policy tools: time dimension • International level: • Basel lll • Margins and haircuts on securities used as collateral • Expected loss provisioning • National level: • Addressing excessive credit or asset price increases • Other instruments

23. Policy tools: cross sectional dimension • International level: • Basel lll • SIFI framework • OTC derivatives infrastructure • National level: • Other instruments

24. Policy tools • Distance to default measuring credit risk by expressing net worth as proportion of asset price volatility – mainly institution level • Value at risk – flawed due to assumptions such as normality, correlations • Stress tests at institution, banking system and economy wide level • Bubble detection

25. Policy tools… • Early warning systems • Multinomial logit using macro, structural and financial variables for binary variable of banking crisis – samples generally dominated by EMEs • Signal extraction EWS using relation of individual time series to banking crises – can use country specific data • Binary recursive tree - “which non-linear variable interactions make an economy more vulnerable to crisis than others?” liquidity, credit and market risks potentially non-linear – seeks key discriminator between crisis and non crisis

26. Instruments by vulnerability and financial system component • Leverage • capital ratio/risk weights/Provisioning • profit distribution restrictions • credit growth cap • Liquidity or market risk • liquidity / reserve requirements • FX lending restriction/currency mismatch limit /open FX position limit • Interconnectedness • concentration limits /systemic capital surcharge/subsidiarisation

27. MPP policy rational for emerging market economies • Risk of spill over and contagion from international markets • Domestic credit & market risks from credit growth & booms in asset prices • Risks of domestic contagion/spillovers arising from common exposures & network links

28. Rationale • FS of containing systemic risks rather than individual FIs • Interaction between macroeconomic conditions & the financial system • The possibility of dampening procyclicality in the financial systyem • MPP regulation needs to complement micro prudential regulation

29. Four forms of intervention in EME • Measures to control capital inflows • Foreign exchange market intervention and foreign reserve accumulation • Measures to strengthen bank balance sheets and capital • Measures to maintain the quality of credit or to influence credit growth or allocation.

30. Macro Prudential Regulatory Tools • Time-varying capital requirements • Higher-quality capital • PCA: Target Amount of capital, not capital ratios only • Contingent capital • Regulation of debt maturity and asset liquidity • Regulating the shadow banking system • others

31. Customizations needed for implementation • Should customize as per country specific need • Should access the in/out flow of funds • Should access the impact of various exchange rate regime/capital account convertibility • Thee essentials: liquidity buffer capital buffer rule based supervision

32. Way forward • Need of Country specific comprehensive study • Coordination mechanism within regulators/other stakeholders • Develop system wide RM framework • Focus on Liquidity monitoring • Find roadmap for Basel III implementation

33. conclusion • Build buffer in good time • Supplement the micro prudential policy through MPP for FS • Proactive & Independent CB role is inevitable • Macroeconomic stability with FS, prevents crisis • Correction needed if financial imbalance occurred • Focus on liquidity management

34. References • Policymaking from a “macroprudential” perspective in emerging market economies by Ramon Moreno, 2011(BIS working paper) • Macroprudential policy – a literature review by Gabriele Galati and Richhild Moessner, 2011 (BIS Working Papers) • Building resilient financial systems – macroprudential regimes and securities market regulation, 2011, Paul Tucker, Dy governor, Bank of England • MACROPRUDENTIAL REGULATION, Jesús Saurina,Director. Financial Stability Department, Banco de España, 2011 • MACROPRUDENTIAL REGULATION – THE MISSING POLICY PILLAR by E Philip Davis NIESR and Brunel University, West London, 2009 • Macroprudential policy tools and frameworks, document generated by FS/BIS/IMF, 2011 • The role of macroprudential policy(discussion Paper), Bank of England, 2009 • A Possible Macro-prudential Approach, british Bankers Association, 2010