Macroprudential policy and its instruments Jan Frait Executive Director

1. Macroprudential policy and its instruments Jan Frait Executive Director Financial Stability Department

2. „ … in tracking systemic risk … we should avoid a false sense of precision … it is better to be approximately right than precisely wrong“ Claudio Borio, BIS (2010) 2

3. Macroprudential Policy Framework

4. What is „macroprudential“? • Following the global financial crisis, on the EU level as well as on the national levels the ways how to establish the additional pillar for financial stability – macroprudential policy framework – is being discussed. • Until the crisis, the concept of macroprudential policy was discussed primarily within the central banking community under the leadership of the Bank for International Settlements (BIS henceforth). • After the crisis, the term “macroprudential” has become a buzzword (Clement, 2010) and the establishment of effective macroprudential policy framework has become one of the prime objectives of the G20, EU, IMF and other structures. • In the EU, such a desire has already been reflected in the decision to create the European Systemic Risk Board as the EU-wide authority of macroprudential supervision and by number of iniciatives focusing on defining the EU-wide framework for macroprudential regulation.

5. What is a macroprudential policy? • The term “macroprudential” is now too embracive and it is often used outside of the scope of its original meaning. • The CNB looks at the concept of macroprudential policies from relatively narrow perspective of the original BIS approach (e.g. Borio, 2003, Borio and White, 2004). • The objective of a macroprudential approach in the BIS tradition falls within the macroeconomic concept and implicitly involves monetary and fiscal policies (Borio and Shim, 2007, and White, 2009). • In the BIS tradition, the phenomenon of financial market procyclicality (mainly the procyclical behaviour of credit provision) stands centrally (Borio and Lowe, 2001, or Borio, Furnine and Lowe, 2001).

6. What is a macroprudential policy? • The other stream is modelling of systemic risk associated with individual institutions. By comparison with canonical models of systemic risk like Diamond and Dybvig (1983) emphasining interlinkages and common exposures among institutions, in the BIS logic, systemic risk arises primarily through common exposures to macroeconomic risk factors across institutions. • The cross-section dimension of systemic risk (common exposures among institutions, network risks, infrastructure risks, contagion ...) has been intensively studied by the IMF (see special chapters on systemic risks in the last few Global Financial Stability Reports).

7. The CNB’s historical interpretation of financial stability The CNB’s approach to financial stability has historically been strongly macroprudential and close to the relatively narrow BIS interpretation focusing primarily on risks associated with the financial cycle. Its objective is to ensure that the financial system does not become so vulnerable that unexpected shocks ultimately cause financial instability in the form of a crisis. Sound financial system Yes: resilience No: vulnerability Financial stability Financial vulnerability Shocks No Financial volatility Financial instability (crisis) Yes 7

8. The CNB’s interpretation of financial stability II Robustness is the key to avoiding vulnerability. For a bank-based system, robustness can be achieved via high loss absorbency, strong liquidity, barriers to credit boom and plenty of luck. Loss-absorbency: expected losses – sufficient provisions (Frait and Komárková, 2009) unexpected losses – capital cushions countercyclical component (Frait, Geršl and Seidler, 2011; Geršl and Seidler, 2011) cross-section SIFI component (Komárková, Hausenblas and Frait, forthcoming 2012) Strong liquidity (buffers and stable funding) is essential way for limiting fragility of liabilites (Komárková, Geršl and Komárek, 2011). Some macroprudential tools for creating barriers to credit booms, excessive leverage are needed too. 8

9. Financial stability vs. macroprudential policy – the CNB view The CNB considers macroprudential policy to be an element of financial stability policy (Frait and Komárková, 2011). The main distinguishing feature of macroprudential policy is that unlike traditional microprudential regulation and supervision (focused on the resilience of individual financial institutions to mostly exogenous events): it focuses on the stability of the system as a whole; it primarily monitors endogenous processes in which financial institutions that may seem individually sound can get into a situation of systemic instability through common behaviour and mutual interaction, the objective of financial stability analysts is therefore avoid the risk of the fallacy of composition – wrong assumption that the state of the whole is the sum of the state of seemingly independent parts. 9

10. Macroprudential policy and systemic risk - objectives The macroprudential policy objective is to prevent systemic risk from forming and spreading in the financial system. Systemic risk has two different dimensions: The time dimension reflects the build-up of systemic risk over time due to the pro-cyclical behaviour of financial institutions contributing to the formation of unbalanced financial trends. The second dimension is cross-sectional and reflects the existence of common exposures and interconnectedness in the financial system. The two dimensions of systemic risk cannot be strictly separated, as they largely evolve jointly over the financial cycle. The experience commands that the time dimension of systemic risk has to be regarded as more important. Cross-sector dimension cannot be ignored especially due to the risk of contagion from domestic as well as foreign environment. 10

11. Macroprudential policy and systemic risk - definition • Macroprudential policy can be defined as the application of a set of instruments that have the potential to • increase preventively the resilience of the system, in the accumulation phase, against the risks of emergence of financial instability in the futureby • creating capital and liquidity buffers, • limiting procyclicality in the behaviour of the financial system • containing risks that individual financial institutions may create for the system as a whole. • mitigate the impacts, in the materialization phase, of previously accumulated risks if prevention fails.

12. Prevention vs. reaction in micro- and macro-approaches • Microprudential approach (for example banking supervision): • Prevention through enforcement of compliance rules and regulations of prudential behaviour. • Reation when breaching of the rules/regulations is identified and when prudential indicators got worse. • Microprudential approach: • Prevention not based on rules and regulations, but on analyses and indicators of systemic risk (as with monetary policy). • Prevention can work only through timely and forward-looking action. • Paradox of financial (in)stability – most serious risk emerge in good times when prudential indicators look well (they are getting better). • Correction action must therefore occur in good times (as with monetary policy).

13. Conseptual approach of the CNB‘s macroprudential policy • The key source of systemic risk is financial cycle and one of the key concerns of macroprudential policy has to be containment of procyclicality. • In periods of fast economic growth the financial institutions and their clients may start mispricing the risks associated with their decisions or may even be incentivized to increase the extent of risk taken. • In such periods, access to external sources of financing improves significantly - such access is more dependent on current risk perceptions on the side of both banks and their clients, which, in turn, are strongly dependent on current economic activity. • If economic agents start to misconstrue a temporary cyclical improvement in the economy as a long-term increase in productivity, virtuous cycle can start to develop, supported by an increased willingness of households, firms and government to accept a higher level of debt and use it to buy risky assets. • This sets off a spiral (positive feedback loop) manifesting itself as a decreasing ability to recognize risk, trend growth in asset prices, weakened external financial constraints and high investment activity supported by output growth, increased revenue growth and improved profitability. In the background of this cycle, financial imbalances grow and systemic risk builds up unobserved.

14. Conseptual approach of the CNB‘s macroprudential policy • The key concept describing the time dimension of systemic risk over financial cycle is leverage (the indebtedness of economic agents, stocks of loans, the ease of obtaining of external financing, the size of interest rate margins and credit spreads, etc..). • The leverage can be approximated by credit-to-GDP ratio: • increases until the financial cycle turns over, sometimes the turn is disorderly and presents itself as the eruption of financial crisis. • then starts to decline, although in the early phase of the crisis remains high (given falling nominal GDP it can even rise in the initial post-crisis years). • The deleveraging phase can therefore last several years, and in the event of a deep crisis the leverage ratio can, after a time, fall below its long-term normal value. • Consequently, the leverage ratio adjusts to economic conditions after a considerable lag, so stock measures have only a limited information value as a guide for the macroprudential policy response during the financial cycle. • For this reason, forward-looking variables are needed that can be used to identify situations where the tolerable limit for systemic risk has been exceeded.

15. Leverage over credit cycle – a slow motion process Conduct of macroprudential policy changes throughout financial cycle. leverage turning point (start of crisis) Good times (systemic risk accumulation): leverage phase with excess optimism Bad times (systemic risk materialization): deleveraging phase with excess pessimism time Normal level of leverage Discontinuity in marginal risk of financial instability: e.g.financial markets indicators (credit spreads, CDS spreads) or market liquidity indicators Signal for termination of supportive policies: contemporaneous indicators (default rates, provision rates, NPL rates, lending conditions) and financial markets indicators Signal for macroprudential tools activation: forward-looking or leading indicators (credit-to-GDP gap, real estate prices gap …) 15

16. Credit cycle and systemic risk – two phases In a credit cycle, systemic risk evolves differently in two phases:accumulation (build-up) and materialization (manifestation). Note the financial stability paradox: a system is most vulnerable when it looks most robust. Build-up of systemic risk Materialisation of systemic risk period of financial exuberance period of financial distress period of low current risk period of high current risk time time normal conditions degree to which risks materialise as defaults, NPLs and credit losses marginal risk of financial instability 16

17. Systémové riziko a finanční cyklus • Systémové riziko vzniká v průběhu finančního cyklu, kdy finanční instituce vytvářejí rostoucí a vzájemně korelované expozice (typicky hypoteční úvěry) citlivé na shodné makroekonomické faktory. • Špatné úvěry vznikají obvykle v dobrých časech, což se ukáže v následující recesi.

18. Operational framework of macroprudential policy 18

19. Prevention and forward-looking indicators The main task of financial stability analysis as regards prevention is timely identification of the risk of financial instability – the marginal contribution of the current financial environment to the build-up of risks of a future financial crisis. In this phase, macro-prudential analysis must be focused primarily on the identification of hidden risks to financial stability being generated in the balance sheets of financial intermediaries and their clients. Analytical attention, however, must also be paid to the quality of cash flows, as financial institutions with structural problems in their balance sheets, weak balance-sheet liquidity and long maturity transformations are naturally far more prone to cash-flow problems. Authorities need a set of forward-looking indicators providing information on the possibility of materialisation of systemic risk in the future as a result of currently emerging financial imbalances. This refers mainly to “gap” indicators based on the assessment of deviations of factors determining the degree of leverage from their equilibrium values. As regards the possibility of using forward-looking indicators to construct early-warning systems, we feel that their information value and practical applicability remain limited. Analytically, it is also possible to use the FS paradox – extremely good values of parallel indicators tell us that something strange is going on in the system. 19

20. Being forward-looking over the financial cycle? Rember the financial (in)stability paradox: a system is most vulnerable when it looks mostrobust! 20

21. Mitigation and identification of discontinuities In the systemic risk materialisation phase, the macrofinancial policy focus must be shifted to mitigating the impact of the crisis. In this phase it is vital to assess the scale of the risk materialisation problem and the resilience of the financial system. Stress tests of the financial system’s resilience are a suitable analytical instrument for performing this task. Macroprudential analyses must take into account the high degree of discontinuity in the evolution of systemic risk – the potentially sharp transition from good to bad times. To this end it is necessary to construct indicators characterising the start and end of the materialisation of financial instability. In a small open economy, financial or informational contagion resulting from the links between an economy and its institutions and the external environment can be a major source of materialisation of systemic risk and of discontinuity in the evolution of such risk. The analytical approach will differ significantly from country to country (share of foreign ownership of financial institutions, dominance of subsidiaries or branches of foreign banks, share of foreign currency loans, net external and foreign exchange position of the banking sector and entire economy...). 21

22. How to Tell Normal Times from the Not So Normal Ones • Financial exuberance period - in addition to the availability of cheap credit, the emergence of overly optimistic expectations about future income and asset prices required. • Financial distress period - in addition to the limiting the availability of credit, economic agents become over-pessimistic. • To identify the onset of or exit from not so normal times - the gaps based on the indicators‘ level relative to their long-term average or trend reveal the story: • credit growth, credit-to-GDP; • debt-to-income, debt-to-assets dynamics; • money market risk premia, credit spreads and CDS spreads; • financial investors’ lever length; • length of maturity transformation by banks; • lending standards, credit risk gauges, ... • Bad news: the framework is still more philosophical than operational!

23. II. Instruments of Macroprudential Policy

24. Macroprudential policy and systemic risk - tools • True (genuine) macroprudential tools are those which can be applied in the form of rules and can therefore take the form of built-in stabilisers. • They should automatically limit the procyclicality of the financial system or the risky behaviour of individual institutions. • They should be explicitly focusing on the financial system as a whole and endogenous processes within it. • In addition to true macroprudential tools, various microprudential regulatory and supervisory tools can be used for macroprudential purposes. • If these tools are applied not to individual institutions, but across the board to all institutions in the system, they can be regarded as macroprudential instruments. • Measures of this type, along with monetary policy tools, fiscal policy tools and tax measures, have been applied in many countries in the past in an effort to slow excess credit growth.

25. Macroprudential policy and systemic risk – tools I

26. Macroprudential policy and systemic risk – tools II

27. Makroobezřetnostní politika • Výsledek mezinárodní diskuse v letech 2009-2011: • Cíl finanční stability je důležitým cílem centrálních bank, • Měl by být prosazován prostřednictvím makroobezřetnostní politiky jako samostatné kategorie hospodářské politiky spolu s tradičními nástroji a přístupy. • V rámci mandátu od G20 tento přístup prosazují společně Financial Stability Board (FSB), IMF a BIS • IMF má ambice stát se výkonnou složkou makroobezřetnostní politiky na globální úrovni. • Na úrovni EU začala v roce 2011 fungovat Evropská rada pro systémová rizika (ESRB, viz prezentace VG Tomšíka) jako evropská autorita pro makroobezřetnostní politiku • ESRB schválil doporučení pro členské země ohledně vytvoření mandátu pro makroobezřetnostní politiku na národní úrovni.

28. Makroobezřetnostní politika – nezbytné definice • Na nadnárodní úrovni došlo v loňském roce ke značné konvergenci představ o cílech a nástrojích makroobezřetnostní politiky. • Nyní je nutno výsledek diskuse přenést na národní úroveň. • Makroobezřetnostní politika představuje aplikaci makroobezřetnostní regulace a makroobezřetnostního dohledu k prosazování cíle finanční stability. • Makroobezřetnostní regulace – definování nástrojů pro ovlivňování systémových rizik. • Makroobezřetnostní dohled – makro-dohled „na dálku“ spočívající v monitoringu systémových rizik, vydávání varování nebo doporučení pro mikroobezřetností dohled či měnovou politiku a aplikaci makroobezřetnostních nástrojů.

29. References • BANK OF ENGLAND (2009): The Role of Macroprudential Policy. Discussion Paper, November 2009. • BORIO C., FURFINE C. AND LOWE, P. (2001): Procyclicality of the financial system and financial stability: issues and policy options”, in “Marrying the macro- and microprudential dimensions of financial stability”, BIS Papers, No. 1, March, pp. 1–57 • BORIO, C – SHIM, I. (2007): “What can (macro)-prudential policy do to support monetary policy. BIS Working Papers, no 242, December. • BORIO, C. - P. LOWE, P. (2001): To provision or not to provision. BIS Quarterly Review, September 2001, pp. 36-48. • BORIO, C. - WHITE, W. (2004): Whither monetary and financial stability? The implications of evolving policy regimes. BIS Working Paper, No. 147, February 2004. • BORIO, C. (2003): Towards a macroprudential framework for financial supervision and regulation? BIS Working Paper, No. 128, February 2003. http://www.bis.org/publ/work128.pdf. • BORIO, C. (2009), Implementing the macro-prudential approach to financial regulation and supervision, Banque de France Financial Stability Review, No. 13 — The Future of Financial Regulation, September 2009. • BORIO, C.-DREHMANN, M. (2009), Towards an operational framework for financial stability: fuzzy measurement and its consequences. BIS Working Paper, No. 284, June 2009. • CLEMENT, P. (2010): The term “macroprudential”: origins and evolution. BIS Quarterly Review, March 2010, pp. 59-67 • WHITE, W. (2006): Procyclicality in the financial system: do we need a new macrofinancial stabilisation framework?, BIS Working Papers, no 193, January.

30. References • Frait, J., Komárková, Z. (2009): Instruments for curbing fluctuations in lending over the business cycle. Financial Stability Report 2008/2009, Czech National Bank, pp. 72-81. • Frait, J., Komárek, L., Komárková, Z. (2011): Monetary Policy in a Small Economy after the Tsunami: A New Consensus on the Horizon? Czech Journal of Economics and Finance 61, No. 1, pp. 5-33. • Frait, J., Komárková, Z. (2011): Financial stability, systemic risk and macroprudential policy. Financial Stability Report 2010/2011, Czech National Bank, pp. 96-111. • Frait, J., Gersl, A., Seidler, J. (2011): Credit growth and financial stability in the Czech Republic. World Bank Policy Research Working Paper; no. WPS 5771 2011/08/01 August 2011 • Gersl, A., Seidler, J. (2011): Excessive credit growth as an indicator of financial (in)stability and its use in macroprudential policy.Financial Stability Report 2010/2011, Czech National Bank, pp. 112-122. • Gersl, A., Jakubík, P. (2010): Procyclicality of the financial system and simulation of the feedback effect. Financial Stability Report 2009/2010, Czech National Bank, CNB, pp. 110-119. • Komárková, Z., Geršl, A., Komárek, L. (2011): Models for Stress Testing Czech Banks’ Liquidity Risk. Czech National Bank Working Paper 11/2011.