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Frank Smets Directorate General - Research Macro Financial Modeling Group Conference, Chicago

Panel discussion on “Policy Perspectives on Systemic Risk Measurement”. Frank Smets Directorate General - Research Macro Financial Modeling Group Conference, Chicago 2-3 May 2013. New institutional set-up in the euro area. EU. ECB. European Systemic Risk Board (ESRB). Monetary Policy

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Frank Smets Directorate General - Research Macro Financial Modeling Group Conference, Chicago

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  1. Panel discussion on “Policy Perspectives on Systemic Risk Measurement” Frank Smets Directorate General - Research Macro Financial Modeling Group Conference, Chicago 2-3 May 2013

  2. New institutional set-up in the euro area EU ECB European Systemic Risk Board (ESRB) Monetary Policy Price Stability Macro-prudential policy Financial stability Systemic dimension Micro-prudential Soundness of individual banks Institution dimension European Financial Authorities (EBA, ESMA, EIOPA)

  3. Two perspectives • Time-series perspective: Smoothen the financial cycle • Finance is pro-cyclical: Why? Endogenous credit constraints and liquidity creation? Incentives? Expectations? • How to manage the financial cycle? • Need tools to analyse and interpret the build-up and unravelling of financial imbalances. • Cross-section perspective: Improve the resilience of the financial system • Finance is inherently fragile: Why? Leverage, liquidity/maturity/risk transformation, interconnectedness, complexity. • How to make the financial system more resilient? • Need tools to understand/predict spill-overs, contagion, negative feedback loops.

  4. Quantity versus price-based indicators • Quantity-based indicators have performed better in signalling the building up of financial imbalances • E.g. Credit-to-GDP ratio: Borio, Alessi-Detken, Schularick and Taylor; Non-core liabilities as fraction of M2, broker dealers’leverage: Adrian & Shin. • More useful for ex-ante leaning against the financial cycle? • Prices sent the wrong signals ex ante, partly due to what has been called the “volatility paradox”, but are better at capturing the unravelling of the imbalances: • E.g. Marginal Expected Shortfall, CoVar, Bank Stability Index; Network analysis; etc • More useful for ex-post interventions?

  5. Early warning signal models “Global” credit gap and optimal early warning threshold (Q1 1979 – Q4 2012; percentages) • ——De-trended private credit-to-GDP ratio (GDP-weighted average across countries) • –––––“Optimal” signal threshold

  6. Largest increase in leverage in OFIs

  7. ECB Systemic Risk Indicator Probability of two or more banks defaulting simultaneously within next 2 years Lucas, A., Schwaab, B., and X. Zhang (2012), ECB WP Source: ECB

  8. Negative feedback loop between banks and sovereigns • Exemplified by: Strong correlation between bank CDS and sovereign CDS in the euro area • Sovereign and bank CDS premia • United StatesEuro area Sources: Thomson Reuters and ECB calculations. In: ECB (2013): Report on Financial Integration in Europe.

  9. Challenge • Link time-series and cross-section perspectives: • Why and in what circumstances do credit booms go hand in hand with greater leverage, liquidity mismatch, interconnectedness and complexity? • Why and in what circumstances are credit booms associated with more risk-taking on the financial sector’s asset side? • Need better time series data and measurement of leverage, liquidity mismatch, interconnectedness and complexity • Need dynamic macro models that incorporate the building up of systemic risk and the non-linear feedback mechanisms that kick in in crises.

  10. MaRs: ESCB research network • Three work streams: • Macro-financial models linking financial stability and the performance of the economy • Early warning systems and systemic risk indicators • Assessing contagion risks • Interim report available on the ECB’s website.

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