Presentation Transcript

1. What Can Financial Stability Reports Tell Us About Macroprudential Supervision

   Jon Christensson, Kenneth Spong, and Jim Wilkinson Banking Research Department Federal Reserve Bank of Kansas City Presentation to the Research Conference on “Government intervention and moral hazard in the financial sector” Norges Bank September 2, 2010 The views presented here do not necessarily represent the views of the Federal Reserve Bank of Kansas City or the Board of Governors of the Federal Reserve System
2. What Can Financial Stability Reports Tell Us About Macroprudential Supervision The financial crisis is spurring many reform ideas. One key idea is macroprudential supervision. Most central banks already perform a similar role through their financial stability reports (FSRs). Our paper looks at what FSRs can tell us about macroprudential supervision.
3. Outline of our Paper Overview of macroprudential supervision and FSRs Summary of the financial crisis Review of FSRs in five countries – UK, Sweden, the Netherlands, Spain, and Norway Evaluation of FSRs and their implications for macroprudential supervision
4. What is Macroprudential Supervision? Its goal is to ensure stability of financial system in its entirety – Crockett (2000) and Borio (2003) A systematic approach as opposed to an idiosyncratic one More attention to largest institutions, counterparty risk, and imbalances and shocks to economy New tool kit – indicators based on financial data, market prices, gaps, etc., and macro stress tests
5. Policy Steps under Macroprudential Supervision Countercyclical regulatory policy – build up more capital, reserves, and liquidity in prosperous times Control of contagion risk – stronger supervision of systemic firms, significant counterparty exposures, and financial infrastructure Discretionary policies – timely actions to address imbalances and large risk exposures developing in the financial system
6. What are Financial Stability Reports? Goal of FSRs is to promote financial stability by identifying risks, imbalances, and adverse trends that might threaten the financial system. Ideally, FSRs provide timely information that allows public authorities, financial institutions, and market participants to understand and respond to such risks and imbalances. In 2005, almost 50 central banks published FSRs (Čihák 2006).
7. What are Financial Stability Reports? Most FSRs look at three broad categories of risk: (1) macroeconomic conditions or sectoral imbalances, (2) financial sector risks, and (3) external or global risks. Among the approaches or tools FSRs use are financial indicators or ratios, market-based indicators, qualitative indicators and analysis, and scenario and stress testing.
8. Overview of the Financial Crisis Long period of prosperity led to a substantial underestimation of the inherent risks in many financial activities. Initial impetus was declining house prices in US and some other countries and collapse of subprime mortgage market. These events cast doubt on the value of many financial instruments and the condition of financial institutions.
9. Overview of the Financial Crisis Through a variety of channels, the crisis spread globally, creating liquidity, capital, and public confidence problems and leading to breakdowns in financial markets and bailouts of large institutions. The deterioration in financial markets further contributed to more general economic problems.
10. Table 1A - Effect of the Financial Crisis
11. Table 1 --What Risks Did the Countries Identify?
12. Table 2 -- What Did the Countries Use to Evaluate Risk?
13. Table 3 - What Stress Tests Were Used?
14. Evaluation of FSRs and the Implications for Macroprudential Supervision The FSRs for our five countries provide a systematic approach to tracking key economic and financial risks and are an important step in efforts to mitigate or respond to crises – which is the role we want macroprudential supervision to play. These FSRs did succeed in identifying many of the risks and unsustainable trends behind the financial crisis.
15. Evaluation of FSRs and the Implications for Macroprudential Supervision But some of these risks were regarded as low probability events and several identified risks did not play a direct role in the crisis. Identifying the timing and magnitude of these risks and their effects on the financial system proved to be a greater, if not impossible, challenge.
16. Evaluation of FSRs and the Implications for Macroprudential Supervision Several of the stress tests and other tests in the FSRs succeeded in capturing the capital needs of banks and the ensuing economic downturns. However, banks and public authorities may not have heeded these warnings because some were described as low probability tail events. A key benefit of the FSRs is that they may have given the central banks a better picture of financial markets and the type of assistance needed during the crisis.
17. Evaluation of FSRs and the Implications for Macroprudential Supervision “It is difficult to estimate the probability and price the risk of all possible outcomes in financial markets. This particularly applies to events that occur rarely and have not occurred for a long time…In the long term, public authorities have an important role to play in maintaining a collective memory of previous crises.” – Norges Bank’s May 2009 FSR
18. Evaluation of FSRs and the Implications for Macroprudential Supervision This experience with FSRs carries a number of implications for macroprudential supervision. First, it is unrealistic to expect macroprudential supervision to be the missing piece in our ability to prevent the next financial crisis – a role many politicians are now giving to it. There are dangers both from underestimating the treat of a crisis and from overestimating and overreacting to such threats.
19. Evaluation of FSRs and the Implications for Macroprudential Supervision Macroprudential supervisors will need strong evidence to overcome political, public, and industry pressures when attempting to curtail credit booms and asset bubbles. There must be a close linkage between those analyzing the macro risks and those supervising. It may be even more important to have macroprudential supervision focus on creating a financial system that is more resilient and less crisis-prone in the first place.
20. Concluding Comments Macroprudential supervision is of much interest now with such recent steps as the European Systemic Risk Board and the Financial Stability Oversight Council in the US. FSRs are a worthwhile exercise in identifying and monitoring important financial trends and emerging risks and understanding financial markets – which will also be essential elements in macroprudential supervision.