Robert N McCauley*, Senior Adviser Monetary and Economic Department

1. Rethinking regulation for financialsystem stability and growthPresentation at the Central Bank of Nigeria‘s50th Anniversary International Conference on "Central banking, financial system stability and growth“, Abuja, 4-9 May 2009 Robert N McCauley*, Senior Adviser Monetary and Economic Department * Views expressed are those of the author and not necessarily those of the BIS

2. Where do we want to go? • “We will amend our regulatory systems to ensure authorities are able to identify and take account of macro-prudential risks across the financial system” -- G20 declaration on strengthening the financial system, 2 April 2009

3. Agenda • Macroprudential regulation—what is it? • Macroprudential perspective on the current financial crisis. • Macroprudential policy: what has been done? What is under discussion?

4. Macroprudential regulationWhere are we coming from? • Macroprudential regulation • Term used at the BIS since late 1970s more precisely since early 2000 • Distinguish macro- and microprudential • Two distinguishing features of macroprudential • Focus on the financial system as a whole with the objective to contain likelihood and cost of financial system distress and thus to limit costs to the economy • Treat aggregate risk as endogenous: manias and leverage increase financial fragility

6. Why do we need a macroprudential approach? • Could a microprudential approach be sufficient? • Yes - if bank failures were independent and if welfare losses exhausted by losses to equity holders and depositors • But: • Banks play crucial role in the intermediation from saving to investment → Real costs of financial crises can be substantial • Bank failures are correlated • Common exposures and direct and indirect interlinkages • Endogenous risk is crucial to financial instability • Endogenous feedback effects during crises • Procyclicality of the financial system

7. Procyclicality: The key mechanisms-1 • Limitations in measuring risk (and values) • expectations are not well grounded • bouts of optimism/pessimism; hard to tell cycle/trend • measures of risk are highly procyclical • Up markets tend to have low volatility, suggesting low risk, while down markets tend to have high volatility, suggesting high risk. • Thus measured risk spikes when risk “materialises” but may be quite low as risk/vulnerabilities build up

9. Procyclicality: The key mechanisms-2 • Limitations in incentives • how imperfect information/conflicts of interest are addressed in financial contracts • eg credit availability depends on value of collateral which waxes and wanes over cycle • Compensation arrangements • leaves wedge between individually rational and socially desirable actions (private/public interest) • “coordination failures”, “prisoner’s dilemma”, herding • eg lending booms, self-defeating retrenchment Importance of short horizons

10. II. Macroprudential perspective on the current financial crisis • What is new: System-wide threats arising from pseudo-dissemination of risk and in fact concentrations of risk in big banks. • What is not new: • Crisis as turn in an outsized credit cycle • overextension in balance sheets in good times masked by strong economy • build-up of “financial imbalances” that at some point reverse • Evidence • unusually low volatility and risk premia • unusually rapid growth in credit and asset prices • BIS leading indicators help in real time

15. III. Macroprudential policy: What has been done? What is under discussionThe policy problem in the upswing • Asset inflation amid rapid growth of credit • Inflation may be well-behaved • What is to be done?

16. Possible policy interventions • Force disclosure of exposure to inflated assets • Regulate the terms of credit • Selectively increase capital requirement • Impose reserves against (ie tax) credit or excess credit • Generally increase capital ratios. • …but do not expect such policies to be popular!

17. Force disclosure of exposure to inflated assets • “Sunshine is the best disinfectant” • Disclose credit (or equity) concentrations—sounds easy! • But “common exposure” may need to be invented. • For example, US regulatory authorities had defined “Highly leveraged transactions” by 1988, well before collapse of the leveraged buyout mania in late 1989 • Could be in tobacco, utilities or airlines • Cut across supervisory categories • No equivalent move in 2000s: • Define and publicise exposure to off-balance sheet structures like “structured investment vehicles” (SIVs)

18. Regulate the terms of credit-1 • Limit credit in relation to a “stock” • Minimum margin on equity purchase • Security “haircuts” in repo funding. • Maximum loan-to-value ratios in real estate. • Minimum down payment in purchases of consumer durables • Restrict debt service in relation to income (flow policy) • Mortgage payments in relation to income. • Credit card monthly payments (Bank of Thailand)

19. Regulate the terms of credit-2 • Effective? • Natural tendency of market is to raise loan to value ratio as asset prices rise, sometimes to over 100%, as next year’s price serves as collateral value • So merely holding the line would be an achievement • Hong Kong authorities reduced loan-to-value ratios through February 1997; apartment prices peaked in September 1997; subsequent 50% fall did not lead to banking crisis.

20. Ratcheting down the loan-to-value ratio in HK

21. Selectively increase capital requirement • Attach higher risk weight to class of loans/assets associated with/subject to asset inflation • Examples: • Proposal to attach 200% weight to highly leverage transactions in late 1980s. • US proposal to deduct venture capital investments of banks from own capital in late 1980s (=2,500% weight). • Reserve Bank of India’s higher capital weight on claims on households, given rapid growth of lending to same several years ago (Borio and Shim (2007)). • Could have put on high LTV or low documentation mortgages. • Effect is to raise overall capital ratio.

22. Impose reserve requirements on credit growth • On credit growth above a threshold (Finland in late 1980s-30%) • In effect a tax if required reserves remunerated at yields below those in the market. • Problem of uneven incidence: firms with access to securities markets or foreign bank loans can avoid paying • Uneven incidence may not be a problem if selects non-traded goods, e.g. real estate borrowing

23. Raise overall capital requirements • Subject of active research. • Building on Basel II, apply multiplicative or additive factor based on some measure of the aggregate risk in the economy • eg Goodhart and Persaud (2008) • Any rule has two components: • Measure of risk • How increase/decrease in required capital depends on this measure • The rub: Measure of aggregate risk in the economy can be problematic

25. Raise overall capital requirements—does it work? • Question effectiveness: Adoption of Basel 1 rules in late 1980s did not prevent Japanese asset prices and Japanese bank lending from rising into 1990. • But Japanese banks holdings of equities linked their market-value capital to bubble in equity and real estate. • Thus no general conclusion is justified that raising capital requirements is ineffective

26. Credit policies are not popular • Rapid credit growth and asset inflation generate “economic” justifications endogenously—eg professors at Tokyo University in the late 1980s rationalised the bubble with Q theory. • In Ibsen’s play, Enemy of the People, a doctor reveals that the water source on which a spa town’s prosperity based is tainted by poison: town rejects doctor.

27. Rules or discretion? • Rely as far as possible on rules rather than discretion… • can margin of error • measuring aggregate risk in real time with sufficient lead and confidence to take remedial action is very hard • rules act as pre-commitment devices •  pressure on supervisors not to take action during boom even if see risks building up • fear of going against view of markets • …But do not rule discretion out! • fool-proof rules may be hard to design • can be better tailored to features of financial institutions • need to discipline discretion (transparency and accountability)

28. Credit policies require stronger institutional set-up • Need to strengthen institutional setting for implementation • align objectives-instruments-know how • How? • strengthen cooperation between central banks and supervisory authorities • strengthen accountability • clarity of mandate, independence, transparency • monetary policy as a model?

29. Macroprudential policies, tried & proposed: recap Sectoral General Credit Equity req’s

30. Conclusions • Macroprudential regulation is on the agenda. • Current financial crisis combined asset inflation and excessive credit in source countries. • Central banks and authorities have tried sectoral credit policies to an extent not widely appreciated, and in some cases used sectoral bank capital policies as well. • Much work ongoing on rules that would build banks’ equity buffers during booms so that they can be run down in bad times.

31. References • Crockett, A (2000): “Marrying the micro- and macroprudential dimensions of financial stability”, BIS Speeches, 21 September. • Borio C (2003): “Towards a macroprudential framework for financial supervision and regulation?”, CESifo Economic Studies, vol 49, no 2/2003, pp 181–216. Also available as BIS Working Papers, no 128, February. • Borio, C and M Drehmann (2008): “Towards an operational framework for financial stability: 'fuzzy' measurement and its consequences”, 12th Annual Conference of the Banco Central de Chile, Financial stability, monetary policy and central banking, Santiago, 6–7 November. http://www.bcentral.cl/eng/conferences-seminars/annual-conferences/2008/program.htm. • Borio, C and M Drehmann (2009): “Assessing the risk of banking crises – revisited”, BIS Quarterly Review, March, pp.29-46. • Borio and I Shim (2007): “What can (macro-)prudential policy do to support monetary policy?” BIS Working Papers no 242 • Goodhart, C and A Persaud (2008): “A party pooper’s guide to financial stability” Financial Times, 4 June. • McCauley, R, J Ruud and F Iacono (1999): Dodging Bullets: Changing US Corporate Capital Structures in the 1980s (Cambridge: MIT Press), chapter 10, “Policy and asset inflation”.