A Survey of Macroprudential Policy Issues

1. A Survey of Macroprudential Policy Issues By David Longworth John Weatherall Distinguished Fellow, Sept. 2011-May 2012 Former Deputy Governor, Bank of Canada 9 June 2011

2. Introduction What do we know about financial crises? • They are costly economically • They are predictable (but not perfectly!) • They are associated with the procyclicality of the financial system • They are exacerbated by features of the cross-section of financial firms (connections) • They are related to “market failures” • Therefore, regulation should focus on system, not on individual institutions

3. Outline of Presentation • Introduction to Macroprudential Policy • Market Failures in the Financial System • Regulations to deal with Market Failures • A typology • Governance

4. 1. Introduction to Macroprudential Policy • Macroprudential policy: • Aimed at mitigating systemic risk: • “risk of disruption to financial services that is caused by an impairment of all or part of the financial system and has the potential to have serious negative consequences for the real economy” (IMF, ‘09) • Has a “macro” or system-wide element • Has a “prudential” element (for “safety and soundness”) • Hence not all financial stability policies are macroprudential • Has a time series or procyclical aspect • Has a cross-section aspect • Interrelationships among banks; common exposures

5. Time series aspect: • Cycles in financial variables, particularly credit • Antecedents: studies of credit cycle; Minsky (‘82) • Financial crises typically preceded by rapid credit growth, and often asset price bubbles as well • Subsequent statistical work predicting crises • Borio and Lowe (2002) • Borio and Drehmann (2009a, 2009b) • Studies of leverage-margin-liquidity cycle • Leverage: ratio of assets to capital • Margin: ratio of equity(downpayment) to loan • Optimism leads to rising prices and liquidity, falling margins, rising leverage; Pessimism to reverse

6. Cross-sectional aspect • Models of contagion • Banks interrelated because hold each other’s deposits, bonds, shares, repos, derivatives • When there is a liquidity shock, if don’t have enough liquid assets may be forced to initiate fire sales (Shleifer and Vishny, 2011) • Reduced valuations of assets for competitors • Losses reduce capital and in extremis lead to a credit crunch

7. Macroeconomic consequences • Stem from credit crunches, decline in wealth (value of banking sector) and effects of fire sales on the prices of assets • New Keynesian models predict declines in output and inflation • Estimated real effects can be extremely significant • Reinhart and Reinhart (2010) study of recent episodes • Output growth 1 percentage point lower in ten years after crisis then in ten years before • Unemployment much higher in ten years after the crisis than in the ten years before • Yet, before crisis, typically no macroprudential authority

8. 2. Market Failures • Nature of overall market failure described by Shin (2010a) as: “Risk is being ‘under-priced.’ Banks take account of their own short-term objectives without taking account of the spillover effects of their actions on other banks and on the economy as a whole.” • Need to examine particular market failures

9. Brunnermeier et al. (2009) describe 6 major negative externalities: • Banks are special as institutions • Loss of funding access for failed bank’s customers • When a bank is in difficulty (liquidity, capital), it may restrict new credit extension (“credit crunch”) • Banks are special in their interconnections • “Pure informational contagion” • Interbank connections mean uncertainty about consequences of failure of one bank • With banks in difficulty there will be fire sales, liquidity spirals, and deleveraging • In the boom, excessive credit expansion and investment in bubble assets will be associated with resource misallocations

10. 3. Regulations to deal with market failures • A typology of macroprudential instruments • Policies have largely fallen into three categories: • Capital requirements (“risk-weighted” or simple) • Pigovian taxes (and subsidies) • Maximums or minimums (quantities; or elements of credit conditions) • Policies have dealt with three proximate concerns: • Excessive credit creation (in aggregate, or sectoral) • Insufficient liquidity (including maturity mismatch) • Continuation of a bank where little common equity is left

11. Typical bank balance sheet

13. 1: Informational contagion2: Loss of access3. Interconnection/failure4. Fire sales/cycles5. Restriction of new credit expansion (everything in column)6. Resource misallocations in booms

14. 1: Informational contagion2: Loss of access3. Interconnection/failure4. Fire sales/cycles5. Restriction of new credit expansion (everything in column)6. Resource misallocations in booms

16. 1: Informational contagion2: Loss of access3. Interconnection/failure4. Fire sales/cycles5. Restriction of new credit expansion (everything in column)6. Resource misallocations in booms

17. 4. Fire sales/cycles5. Restriction of new credit expansion (everything in column)6. Resource misallocations in booms

18. 1: Informational contagion3. Interconnection/failure4. Fire sales/cycles5. Restriction of new credit expansion (everything in column)

19. 1: Informational contagion2: Loss of access3. Interconnection/failure4. Fire sales/cycles5. Restriction of new credit expansion (everything in column)6. Resource misallocations in booms

20. Which macroprudential instruments and how many? What are the unresolved issues? • Can ask the question in a theoretical world without constraints • But can also ask about a world in which taxes would have to be approved by legislatures, and one in which there is already risk-weighted capital regulation • Geneva Report 11 appears to be asking it in the second context—emphasize capital regime • Policymakers have generally decided to focus on the time-series dimension (excessive credit growth) through capital • Still a lot of differences on the approach to the cross-section dimension as it applies to liquidity (a concept which has many different dimensions)

21. Strain of the literature (Shin, Korea) in which the connection between the growth in assets and growth in liabilities is essential to results • Especially true when the acceleration in credit is financed by an acceleration in “short-term” or “non-core” liabilities • If this is a general feature of financial cycle, the dimensionality of the policy problem may be much reduced (i.e., negative externalities not all independent) • All this argues for a closer study across time and across countries of the association of accelerations in credit with the acceleration in various types of liabilities

22. The focus on the health of lenders suggests an examination of how the health of specific types of borrowers (and their loans) might feed back on the health of lenders that rely heavily on collateral • Special focus on mortgages and on repos in this regard • Close examination of whether separate regulation is needed for loan-to-value ratios and haircuts, as opposed to relying on capital to cover all credit risks • Housing price bubbles in many crises, but is dealing with negative externalities associated with behaviour of total credit sufficient?

23. Liquidity is the “column” where much of the work, both theoretically and in practice is less compelling than in the other columns • In part, because of multidimensional nature of liquidity mentioned already • In part, because of multidimensional nature of negative externalities • Basel III liquidity regulation needs to spell out what happens when system under stress (relax constraints) • Since most academic work treats negative externalities one by one (for tractability?) results are more difficult to use directly in policy

24. 4.Governance • Emphasis on governance for achieving results • A framework for achieving a desired objective • Specific governance practices to aid in effectiveness • Legitimacy, relationships, structure of decision-making

25. Framework Objective: Avoiding significant financial instability Goals: Dampening procyclicality and reducing potential effects of contagion Policy Instruments: Macroprudential instruments, Advice on policies, Warnings Activities: Data Collection, Surveillance, Analysis, Stress Testing, Risk Assessment Powers

26. Does macroprudential authority set macroprudential instruments or just require “comply or explain” by microprudential regulator? • Not independent of who the authority should be

27. Governance

28. Committees have advantages in the elements that come together to enhance achieving objectives: • Legitimacy that comes from a variety of experience • Significant ties to important international bodies: • G20, FSB, BCBS, IOSCP, CPSS, CGFS, BIS Governors • Blinder and Morgan (2005): “group decisions on average better than individual decisions” • EU and US vs. UK in terms of structure • Need effective framework, leadership, and motivation • Given market failures, what are structures and practices more likely to achieve a financial stability objective? • Canada: FISC agencies, NSR, CMHC

29. Conclusion • Macroprudential approach has old roots: • Systemic risk, negative externalities, bank runs • Traditional microprudential instruments • Procyclicality (historical episodes, credit cycle) • Automatic stabilizers • Networks and contagion • Behavioural finance, macroeconomics of financial frictions

30. Much has been accomplished in the last four years, but much remains (Ph.D. theses and articles; international standards, policies) • Two sides of same balance sheet but multiple assets and liabilities • Collateralized credit and leverage • Role for monetary policy? • Trend in financial health of household sector • Governance of macroprudential policy