G roup I nstitutional & R egulatory A ffairs

Group Institutional & Regulatory Affairs Macro-prudential policy and the ECB Comprehensive Assessment Zeno Rotondi May 2015

Index • Introduction: the financial crisis • Systemic risk surveillance and assessment • Central banking, monetary policy and the institutional set-up for macro-prudential policy • Macro-prudential policy instruments • Conceptual interactions between macro-prudential, micro-prudential and monetary policy • The ECB’s institutional setup • ECB's Comprehensive Assessment: the Asset Quality Review and the Stress Test 2

Introduction Causes of the great Financial Crisis • The great financial crisis in 2008 was generated by the financial sector and triggered: - the largest world recession since the 1930s - an increase in Fiscal deficits in all countries - a sovereign debt crisis in Europe • The crisis was preceded by: - excessive growth of credit and leverage; - expansion of a “shadow banking sector”. • The worldwide unprecedented increase in private (or inside) liquidity was facilitated by deregulation and financial innovations like securitisation and collateralised short-term borrowing (repos) • The crisis itself was triggered by a collapse of the short-term funding structures that had been developed, leading to a strongly negative liquidity spiral (Brunnermeier, 2009) 3 Source: Constâncio (2012)

Introduction Main views about the ultimate causes that created the conditions for the financial imbalances that led to the crisis The “savings glut” (and current account surplus) that developed in Asia and oil producing countries and the subsequent outflows to the developed economies (specially the US), would explain the low market interest rates and the credit expansion. The expansionary monetary policy (starting in the US), the accompanied deregulation (vg abolition of Glass-Steagall) and several financial innovations stimulated the financial excesses. Both views have merits but the second is more important to understand the crisis: As Borio (2011a) reminded us, interest rates are very much influenced by monetary policy and savings has to be distinguished from financing on which expenditures depend and that later originate income and ...savings. So, what is important, for instance, for the financing of the US external account deficits are the gross capital inflows. From this perspective, :..”By far the most important source was Europe, not emerging markets. Europe accounted for around one-half of total inflows in 2007. Of this, more than half came from the United Kingdom, a country running a current account deficit, and roughly one-third from the euro area, a region roughly in balance. This amount alone exceeded that from China 4 Source: Constâncio (2012)

Introduction The expansionary monetary policy fuelled leverage and search for yield. Financial innovation and changes in regulation allowed the lengthening of the intermediation chain which increased interconnectedness and contagion risk. Maturity transformation migrated to the shadow banking sector. Most of the new institutions and the new forms of funding them were not considered in any monetary or credit aggregate of MFIs that monetary policy considers. But all count for the total liquidity available for the economy... It was difficult to monitor this new environment, particularly in a framework of deregulation, trust in “efficient“ and self-correcting markets in the context of a dominant macroeconomic theory with no place for the financial sector as source of frictions and fluctuations in the economy. There was also a sort of “cognitive capture” of regulators that inhibited them even to fully use the available supervision tools. Systemic risk was rampant but a macroprudential view was missing and was no one's particular responsibility. Systemic risk as possibility of disruption of the whole financial system with material consequences for the economy, has precisely two types of endogenous sources: financial imbalances and contagion. Supervision in the new environment 5 Source: Constâncio (2012)

Introduction The lengthening of the intermediation chain and the creation of inside (or private) liquidity creation of inside (or private) liquidity 6 Source: Constâncio (2012)

Introduction Size of shadow banking in the US and EA 7 Source: Constâncio (2012)

Introduction Repos and M2 in the US 8 Source: Constâncio (2012)

Introduction MFI Interconnectedness • Higher debt levels within the financial sector were accompanied by increased interbank lending and cross-holdings of debt securities among banks • The banking sector had become more interconnected 9 Source: Constâncio (2012)

Introduction • Leverage in the banking sector had been building up before the financial crisis ( total assets/capital and reserves) Increased Banks' leverage 10 Source: Constâncio (2012)

Introduction • Indebtedness had been building up before the financial crisis • Higher debt levels both within and outside the financial sector • Increase as a share of GDP from 1999 to mid-2007: Financials = 35 %-points Non-financials = 25 %-points Households = 14 %-points Governments = -5 %-points Euro Area: Debt of the Financial Sector increased more than indebtness of other sectors 11 Source: Constâncio (2012)

Introduction In the US there was the same pattern of indebtness as in the EA 12 Source: Constâncio (2012)

Systemic risk surveillance and assessment • The two first tasks of Macroprudential Oversight are: • Surveillance: Aims to identify the building up of risks that can lead to systemic risk. Significant investment has been and continues to be made in developing analytical tools and models that can provide early warnings of the build-up of financial imbalances and possible sources of contagion risk • Assessment: Aims to assess the possible impact of identified risks in the financial sector and in the economy as a whole, thus testing the ability of the financial system to cope with identified risks. The major tool to perform such assessment is stress testing, primarily of the banking sector, including sensitivity and scenario analyses. Also, to take account of the channels through which risks can be propagated through the financial systems contagion and spillover models are used. Can we predict the financial cycle? 13 Source: Constâncio (2012)

Systemic risk surveillance and assessment Excessive leverage and credit boom indicators Asset price disequilibria indicators to identify bubbles (in financial and property markets) Indicators of financial market stress Financial market liquidity condition indicators Stress testing models Interconnectedness and institutions’ contribution to systemic risk indicators, as well as contagion and spillover models Analytical tools and indicators used in systemic risk surveillance and assessment 14 Source: Constâncio (2012)

Systemic risk surveillance and assessment In terms of performance there are three types of indicators: Early Warning Models with structural indicators would have predicted financial crisis like many other past crisis, but give rise to a significant number of false alarms Structural indicators e.g. leverage, house price valuation models: would have predicted crisis but it is difficult to decide on a threshold value. Market based indicators e.g. based on price, premia and volatilities are not very useful as early warning. They tend to be coincident indicators. This applies to various “financial stress” indices. Although, all in all, credit-gap growth models and property prices seem to be the best predictors of the financial cycle that is normally longer than the business or economic cycle. Some indicators did predict the last financial cycle 15 Source: Constâncio (2012)

Systemic risk surveillance and assessment Examples of credit boom indicators - Some early warning indicators currently used by the ECB identified growing imbalances before the crisis - Global credit gap rising from 2002 onwards and above threshold Q3 2005 - Q2 2009 - Real time performance since 1970: 82% correct warnings 32% false alarms 95% of costly asset price booms predicted in at least one of 6 preceding quarters 16 Source: Constâncio (2012)

Systemic risk surveillance and assessment Examples of asset price disequilibria indicators (1) 17 Source: Constâncio (2012)

Systemic risk surveillance and assessment Examples of asset price disequilibria indicators (2) 18 Source: Constâncio (2012)

Systemic risk surveillance and assessment Examples of indicators of financial market stress (1) 19 Source: Constâncio (2012)

Systemic risk surveillance and assessment Examples of indicators of financial market stress (2) 20 Source: Constâncio (2012)

Central banking • Monetary policy matters for financial stability; Affects asset prices; Affects liquidity conditions (Adrian and Shin (2010)); Affects bank risk taking (Borio and Zhu (2008), Adrian and Shin (2009) Maddaloniand Peydro(2010), Jimenez et al (2011)): low interest rates leads to increased leverage and riskier lending practices. • Beyond the traditional transmission channels, a new “risk-taking channel” has been theorized: short-term monetary rates => term spread => profitability => leverage and risk-taking => balance- sheet expansion funded by unstable, short-term instruments if the traditional stable ones (v.g. deposits ) are not enough. • As Adrian and Shin (2009) underline what is significant is that the short term interest rate has a direct effect on monetary- financial conditions not waiting for the indirect effect on medium term and expenditure decisions. There is a credit-supply friction that commands leverage and inside liquidity (Jean Tirole) not included in monetary policy aggregates Central banking, monetary policy and the institutional set-up for macro-prudential policy 21 Source: Constâncio (2012)

Central banking Traditionally monetary policy is only about price stability, particularly in the inflation targeting regime, even if central banking has since the XIX century cared for financial stability in the form of lender-of-last-resort for banks in times of liquidity distress. This asymmetric policy of only “mopping-up” with liquidity in financial market downturns but ignoring the risks of the upside booms creates moral hazard and provides a significant “liquidity subsidy” to the financial sector. The arguments against doing otherwise have been centred in the difficulty to “identify bubbles” or in the danger of “pricking bubbles”. The on-going change in macroeconomic theory and the development of macro models with financial sector frictions puts the question in different terms, as the result of the new models are optimal monetary policy rules that add financial conditions terms to the rule (v.g. banks and credit spreads in Christiano, Motto, Rostagno(2009), Curdia and Woodford (2010) or Gertler and Karadi (2011)) The new models are nevertheless not mature enough and do not include all relevant financial frictions. A pure “leaning against the wind” policy is possible but has limitations. Monetary policy must become less asymmetric after the crisis is overcome but cannot substitute an appropriate regulatory macro-prudential policy New view on monetary policy after the crisis 22 Source: Constâncio (2012)

Central banking • Synergies with other central bank tasks: • Financial stability analysis as reflected in Financial Stability Reviews/Reports • Oversight of market infrastructures • Prudential supervision • Strong independence • Key role of central banks reflected in ESRB Recommendation on macro-prudential mandate of national authorities • Yet macro-prudential oversight entails new elements for central banks • Extension of the surveillance to the whole financial sector • Focus on policy action • Safeguards not to affect the monetary policy mandate (e.g. separate committees) Central banks are well placed to play an important role in macro-prudential surveillance 23 Source: Constâncio (2012)

Central banking responsibility for macro-prudential policy has been attributed to a committee new agency or the central bank. Different set-ups for macro-prudential policy 24 Source: Constâncio (2012)

Central banking They appear in a period of crisis management, not imbalances prevention Most of the regulatory reform already well advanced and designed from a macro-prudential perspective. Overall difficulty in measuring the success and failure of macro-prudential policies and related accountability. Is the objective of the policy to increase the resilience of the system for crisis times or to smooth the financial cycle and mitigate boom-bust pattern? Shared instruments with other micro regulators In many cases, disposing only of warnings and recommendations Need to establish a macro-prudential policy toolkit and understand the impact of the instruments The new Macro-Prudential Authorities face several challenges 25 Source: Constâncio (2012)

Macro-prudential instruments Macro-prudential regulatory instruments 26 Source: Constâncio (2012)

Macro-prudential instruments To be implemented as part of the Basel III framework Main idea: CCB is to be activated in periods of excessive credit growth associated with the build-up of systemic risks and released in stress situations. It can substantially improve the resilience of the banking sector, thus contributing to the smooth provision of financial services throughout the business cycle. The ESRB and the EBA play important roles in ensuring consistent policymaking regarding the CCB across EU Member States (policy guidelines, regulatory standards). The CCB is the key macro-prudential instrument that has currently been internationally agreed upon. If the CCB had been in place in the last decade, the buffer requirements would, in most cases, have reached their peak during the recent financial crisis. On average, the CCB would have covered about half of the capital needs banks had to face in the recent crisis. Counter-cyclical capital buffer (CCB) (1) 27 Source: Constâncio (2012)

Macro-prudential instruments Counter-cyclical capital buffer (CCB) (2) 28 Source: Constâncio (2012)

Macro-prudential instruments • Main aim: build up provisions for potential expected losses (statistically estimated) over the cycle rather than on the basis of incurred losses. DP provides for an earlier recognition of inherent credit losses. • Motivation: • Increase bank resilience: reduce the need for a sharp rise in provisions during a period of rising defaults • Contributes to smoothing the credit cycle: provisions are built up in good times to be used in bad times • Impact: improved bank resilience to downturn but insufficient to prevent the build up of imbalances • By end-2007: increased bank reserves by 1.3% of total assets • Some success in smoothing credit supply fluctuations but overall lending impact small (Jimenez and Saurina (2006), Jimenez et al (2012)) • Spain house prices and household leverage still increased substantially Dynamic provisioning (DP): The Spanish Experience (began in 2000) 29 Source: Constâncio (2012)

Macro-prudential instruments • Motivation: • Enhance the resilience of households (as well as the banks lending to them) to negative shocks • Lean against building imbalances (especially in the housing market) • Cross country evidence (Duca et al (2010), Crowe et al (2011)): • LTV ratios affect house prices • 10pp increase in maximum LTVs increases house prices by 5-15% • The Korean experience (Crowe et al (2011), Igan and Kang (2011)): • LTV limits introduced in September 2002, DTI limits in August 2005) • LTV and DTI limits helped restrain the housing price boom (evidence from Iganand Kang (2011) and Crowe et al (2011)): • Led to a slowdown in housing price inflation • LTV limits somewhat more effective than DTI limits • Some evidence that the policy worked by dampening expectations of future house price appreciation Maximum loan-to-value (LTV) and debt-to-income (DTI) ratios 30 Source: Constâncio (2012)

Macro-prudential instruments Macro-prudential regulation: the potential role of accounting and the leverage cycles (1) 31 Source: Constâncio (2012)

Macro-prudential instruments • Lesson from the crisis: Pro-cyclical bias of present accounting standards, providing misleading signals to market participants • 2 main channels: Pervasive use of fair value accounting and delayed recognition of credit losses in the banking book • Possible remedies: Forward-looking provisioning (FLP), Economic cycle reserve (ECR) and prudential adjustments (PA) Macro-prudential regulation: the potential role of accounting and the leverage cycles (2) 32 Source: Constâncio (2012)

Interactions b/w macro-prudential, micro-prudential and monetary policy Conceptual interactions 33 Source: Lautenschläger(2014)

Interactions b/w macro-prudential, micro-prudential and monetary policy Macro-prudential and monetary policy (1) 34 Source: Lautenschläger(2014)

Interactions b/w macro-prudential, micro-prudential and monetary policy • Background: Legal basis in CRR/CRD IV • Instruments available for macro- and micro-prudential purposes • Capital requirements • Other instruments • Positive spillovers of having both under the same roof • Information exchange • Common understanding of mutual interactions • Negative spillovers • Different objectives, time dimension and overlap of instruments • The decision making mechanism should internalise potential spillovers between macro- and micro-prudential supervision. Macro-prudential and micro-prudential policy 37 Source: Lautenschläger(2014)

The ECB’s institutional setup General implementation • Governing Council is ultimate decision-making body for monetary, micro- and macro-prudential policy • Supervisory Board proposes micro- and macro-prudential measures • Potential conflict of interest between monetary and supervisory policy calls for organisational separation of monetary policy and micro-prudential supervision • Restricted information exchange for data, but separate analyses geared towards distinct objectives • Separate decision-making process with non-objection procedure reduces possible conflicts of interest between monetary policy and supervisory objectives The ECB's institutional setup 38 Source: Lautenschläger(2014)

The ECB’s institutional setup Detailed implementation 39 Source: Lautenschläger(2014)

The ECB’s institutional setup • Coordinating with national macro-prudential authorities • The concerned authority of Member States shall duly notify its intention to the ECB prior to taking a decision. • Where the ECB objects, it shall state its reasons in writing within five working days. • The concerned authority shall duly consider the ECB's reasons prior to proceeding with the decision as appropriate. • Taking macro-prudential actions • The ECB may apply (instead of national authorities of the participating Member State): • higher requirements for capital buffers • apply more stringent measures aimed at addressing systemic risks • Measures are subject to procedures set out in CRR/CRD IV and SSM Regulation Macro-prudential tasks and tools of the ECB 40 Source: Lautenschläger(2014)

The ECB’s institutional setup • Completing the macro-prudential toolkit • Bank-oriented instruments: setting exposure limits to non-bank financial intermediaries • Non-bank instruments: extending the regulatory perimeter to systemic non-bank institutions and activities • Market-based instruments: steering margin and haircut requirements in securities lending • Improving financial sector governance: aligning incentives and compensation to prudent risk-taking and long-term returns • Enhancing coherence between CRR/CRD IV and SSM Regulation • Recognizing new institutional setup of macro-prudential policy in CRR/CRD IV with the ECB becoming a key player in macro-prudential policy within the SSM • Clarifying and simplifying procedures between EU authorities and Member States Areas for improvement 41 Source: Lautenschläger(2014)

The ECB’s CA • The Comprehensive Assessment has unique features: • It combines an Asset Quality Review (AQR) with a macro Stress Test (ST); • It discloses very detailed methodological manuals for both components and the respective central quality control of banks reporting; • Its implementation involved many thousands of experts, including about 5000 from independent private firms; • More than 800 individual portfolios were in the scope of the exercise, implying the analysis of the quality of the credits of 119,000 borrowers; • It provides with unprecedented transparency a vast array of data from banks balance sheets and the final results. • The conclusion of the exercise was preceded by a significant amount of frontloaded measures taken by the banks. • The success of the exercise is based on excellent close cooperation between the network of national supervisors and the ECB. The Comprehensive Assessment was an exercise of unprecedented scope and depth 42 Source: ECB (2014)

The ECB’s CA Key findings • A total of €25 billion capital shortfall across 25 participant banks was jointly identified by the AQR and the ST. • The AQR resulted in a gross impact on asset values in need of adjustment by €48 billion, €37 billion of which did not generate a capital shortfall. • This means that the Comprehensive Assessment implies an overall impact on the banks of €62 billion. • An additional amount of €136 billion in non-performing exposures was identified in the AQR, with effect on the €48 billion of identified adjustments. • A measure of the strictness of the exercise is given by the fact that the combination of the AQR with the stress test results in: - A reduction of 4 percentage points in the CET1 median capital ratio of the 130 banks. - This reduction corresponds to €263 billion capital depletion over the three-year horizon of the exercise under the adverse scenario, of which €25 billion correspond to the actual capital shortfall in banks that fell below the 5.5% threshold. Overall results 43 Source: ECB (2014)

The ECB’s CA Banks have a €263 billion capital depletion in the adverse scenario 44 Source: ECB (2014)

The ECB’s CA Capital shortfall was observed at banks from 11 of the 19 countries in scope of the exercise 45 Source: ECB (2014)

The ECB’s CA The median bank’s CET1 ratio falls by 4% in the adverse scenario 46 Source: ECB (2014)

The ECB’s CA Capital shortfall of €24.6 billion across 25 banks 47 Source: ECB (2014)

The ECB’s CA Significant balance-sheet strengthening since July 2013 48 Source: ECB (2014)

The ECB’s CA Stress test scenarios more severe than in previous EU exercises 49 Source: ECB (2014)

The ECB’s CA Haircuts on sovereign bonds in the stress test conservative compared to market developments 50 Source: ECB (2014)

G roup I nstitutional & R egulatory A ffairs