Economic Policies for Financial Stability

1. Economic Policies for Financial Stability Dr. Gopal Prasad Bhatta Director PDMD, NRB

2. Outline • Understanding the Crises • Risk Identification and Management • Micro and Macro-prudential Policy Issues

3. Course Content • Overview: Financial Risk Cycles and Financial Stability • The Financial Crisis 2007-201? • Banking Crises in Theory and Practices • Balance of Payment and Sovereign Debt Crises • Systemic Risk and Financial Contagion • Linkages between financial and Macro Economic Stability • Financial Innovations and Leverage • Stress Testing of Financial Systems • Detecting Financial Fragilities I: Balance Sheet Approach and Contingent Claims Analysis • Financial Risk Management • Detecting Financial Fragilities II: Early Warning Exercises • Macro-Prudential Policy: Singapore Experience • Assessment of Financial Stability in Asia: A Private Sector Perspective • Micro-Prudential Regulation and Supervision • Macro-Prudential Regulation and surveillance

4. UNDERSTANDING THE CRISES

5. Financial Stability and Crises • Transformation of Finance • Financial market have undergone rapid transformations and expansions in recent years driven by: • Deregulation • Innovation and leverage • Globalization • Frequent Financial disruptions • Nordic Banking Crises in early 1990s • Currency crisis in Mexico (1994) • Asian Financial crisis (1997) • LTCM collapse (1998) • Argentina crisis (2000) • GFC (2007-2011) • European debt crisis (2010-0ngoing)

6. Financial Stability and Crises(2) • Functions of Financial System • Payment system • Credit intermediation • Liquidity creation for non financial sector • Deals with problems of asymmetric information • Providing means of hedging risk

7. What is financial Stability? A financial stability is a situation in which the financial system is satisfactorily performing its three functions: • The financial system is efficiently and smoothly facilitating the inter temporal allocation of resourses from savers to investors and the allocation of economic resources generally. • Forward looking financial risks are being assessed and priced reasonably, accurately and are being relatively well managed. • The financial system can comfortably, if not smoothly absorb financial and real economic surprises and shocks

8. A Definition of Financial Instability Financial instability is a situation characterized by three basic criteria: • Important financial asset prices seem to have diverged sharply from fundamentals; and/or • Market functioning and credit availability have been significantly distorted, with the result that • Aggregate spending deviates (or is likely to deviate) significantly, either above or below, from the economy’s ability to produce Source: Ferguson, Roger, 2002, Should Financial Stability be an Explicit Central Bank Objective? (Washington: Federal reserve Board)

9. Policy Challenge • Maintaining • The smooth functioning of the financial system and • Its ability to facilitate and support efficient performance of the economy • Safeguarding • Resilience to adverse shocks and unraveling of imbalances • Preventing • Accumulation of large vulnerabilities and excessive risk taking

10. Policy Challenge • It is not practical to expect • That a dynamic and effective financial system can always avoid instances of market volatility and turbulence, or • That all financial institutions would be capable of perfectly managing the uncertainties and risk involved in providing financial services A certain amount of instability may have to be tolerated from time to time because it may encourage long-term financial system efficiency (bank failures should be seen as creative destruction) It is undesirable to create and impose mechanisms that are overly constraining of risk taking .

11. Financial Stability and Market Discipline • Market mechanisms failed (based on Crockett, 2011) • Limited liability (downside of a return distribution is curtailed, leverage can augment the upside) • Agency problems: Difficult to align the incentives of agents with those of principals particularly in finance where long-term horizons are needed to judge the effectiveness of a risk taking strategy • Risk perceptions warped by “disaster myopia” (tendency to discount low probability events that have not occurred for many decades) • Competition (maintaining market share) • Incentives to high quality information provision too weak to overcome conflicts of interest (mortgage origination in US)

12. The Micro and Macro Prudential Approach • The objective of the micro-prudential approach is to limit distress of individual institutions. • The micro-prudential approach is bottom-up: correlations and common exposures across institutions are of secondary importance • The micro prudential perspective assumes that risk is exogenous-a partial equilibrium view • The objective of macro-prudential approach is to limit risk of financial distress with significant losses for the economy as a whole. • The macro-prudential approach is top-down: common exposures among institutions and correlations are important.

13. Efficiency Versus Stability • An implicit or explicit judgment has to be made: • How much potential for financial instability is acceptable to support economic and financial efficiency?

14. Promoting Financial Satbility • What kind of economic policies would be desirable to bolster financial stability? • Regulatory and supervisory policies (micro-and macro prudential), • Monetary policy • Exchange rate policy • Other types of policies (fiscal policy, capital control etc.)

15. Promoting Financial Stability • A Key question in deciding on appropriate policies: • What are the incentive effects of various policies? • Do these effects strengthen the desirable results? • Or do they create significant unintended consequences? Providing a framework to address these questions is the focus of this presentation.

16. Current Issues Raised by the Financial Crisis of 2007-201? • Originate and Distribute Banking • Incentive structure • Regulation of originators and brokers • Transparency and provision of information • Risk assessment of ABS and structured products • Credit ratings • Rating agencies • Monolines, Credit Insurance • Fair value accounting

17. Current Issues Raised by the Financial Crisis of 2007-201? • Central banking • Money market operations • Lender of the last resort facilities • Shadow banking • Bank non bank nexus • Market and funding liquidity • Regulation of financial institutions • Capital adequacy • Liquidity management • Leverage • Off balance sheet activities • Procyclicality • Volcker rules • Risk management and stress testing • Living wills

18. Current Issues Raised by the Financial Crisis of 2007-201? • Macro prudential regulation • Systemic risk charges • Deposit insurance • Bank insolvency regime • Prompt and corrective action • Too-big-to-fail concerns • Supporting troubled banks and non-bank financial intermediaries • Implicit and explicit government guarantees • Regulation of capital and derivative markets • Consumer protection • Governance and compensation structure of financial institutions • Design of regulatory structures • International regulatory coordination • Crisis management and exit strategies • Fiscal policies, sovereign debt, and financial system fragility

19. Banking, Balance of Payment and Sovereign Debt Crisis The major three types of financial crises are: • Banking crisis: bank fail to redeem deposits in currency or become insolvent • Currency crisis: government abandons a fixed or quasi-fixed exchange rate • Debt crisis: Borrowers (including sovereigns) fail to repay lenders in full The systemic banking crises include the loss of confidence in substantial portion of banking system serious enough to generate significant negative effects on the real economy. It also makes disruption to the payment system, credit flows, and fire sales spirals with asset values. In systemic banking crisis, government forced to intervene to prevent bank runs by providing bank with large scale financial support.

20. Why Study banking Crises? • Because they are very costly: • Fiscal costs: which often lead to debt crises • Output costs: which results in severe recessions • Capital outflows: which often lead to balance of payment crises • Macroeconomic Disruptions: • Depositors lose access to their funds, • Good borrowers can lose access to credit and be forced into bankruptcy • Sound banks may be driven out of busisness

21. Why Study Banking Crises? (Laeven and Valencia (2008))

22. What Goes Wrong with Banks? • Credit risk: making bad loans • Liquidity risk: drying up of funds • Market risk: the impact of falling asset prices • Unauthorized ‘rogue’ trading/ major frauds

23. Banks and Balance Sheet Mismatches • Maturity Mismatch: borrow short, lend long • Maturity transformation is an essential task of banks: • People need short assets (demand deposits) and long debts (mortgages). Banks take reverse positions. • But can become excessive. Pre-crisis: very short wholesale bank borrowing to fund risky mortgages. • Currency Mismatches: borrow in foreign currency and lend in domestic currency

24. The “Standard Model” of Crisis Management Phase 1-Containing the Crisis Phase 2- Bank Restructuring Phase 3- Management of Impaired Assets Phase 4- Reintermediation

25. The “Standard Model” of Crisis Management • Containing the crisis • Protect depositors (possibly with a blanket gurantee) • Credible macroeconomic policies • Close unviable institutions • Announce a medium-term restructuring program • Be transparent in policies to regain confidence • If all this fails: resort to administrative measures (like deposit freeze) as a very last resort • The central banks should provide sufficient liquidity • To protect the payment system and • Give authorities time to identify root problems and design a response • The types of support includes: • Reductions in reserve requirements • Access to overdraft facilities and discount windows • Open market operations

26. The “Standard Model” of Crisis Management • Bank Restructuring • Strategy entails: • Improving the operating environment for banks • Strengthening viable banks • Resolving banks that are insolvent or nonviable • Strategy should aim at the following economic objectives • Restore the viability of financial system • Provide an appropriate incentive structure (including avoiding moral hazard) • Minimize the cost to the government • Diagnosing banks and valuing bank assets is complicated because there are no market prices for NPLs or toxic assets • Explicit decisions about burden sharing to be made in designing restructuring. How to share costs among: shareholders, depositors, other creditors and tax payers? • These are political, as well as technical, decisions.

27. The “Standard Model” of Crisis Management • Option 1: Create central agency for bad assets. “Bad Bank” like in Swedish case • Option 2: Buy up some bad assets, but without full centralization. TARP in US • Difficult issues in both cases: • Pricing of assets: usually illiquid • Making banks sell: may prefer keeping markets in dark about extent of exposure, to retain funding

28. The “Standard Model” of Crisis Management • Re-intermediation • Once banking system stabilized, turn to strengthening the financial system and fostering re-intermediation • Liability side: attracting deposits/funding • Asset side: restoring adequate level of bank credit • Also requires: macro/debt/currency stability • Easier to achieve when: • More state control over the banking sector (China, various countries post crisis) • Mostly domestic banks rather than foreign

29. Currency and BOP Crisis • Currency and BOP crisis occur when a speculative attack on a country’s currency results in: • A devaluation or sharp depreciation • Or forces the central bank to defend the currency by selling large amounts of reserves • Or by significantly raising interest rates • And, currency and BOP crises do not necessarily occur together: • Example: speculative attacks that fail to trigger devaluations-successfully resisted by the central bank-cause BOP crises but not currency crises. • Theoretical models explain joint currency and BOP crises • Empirical studies usually define them as separate events

30. Sovereign Debt Crisis • A debt crisis occurs either when a borrower defaults or when lenders believe default is likely and therefore withhold new loans and try to liquidate existing ones.

31. Sovereign Debt Crisis • Debt crises can be associated with either commercial (private) or sovereign (public) debt. • Failure to meet a principal or interest payment on the due date (or with the specified grace period) • Restructuring of debt into less favorable to the lender than those in the original contract • Fiscal policy and performance often appear to be contributing factors to crises • Overly expansionary fiscal stance leading to a credit and/or consumption boom • Concerns about sustainability triggered by “bad news” about contingent liabilities or by a shift in expectations about the government’s commitment to fiscal adjustment • Shocks can never be eliminated, but important for policy makers: • Reduce vulnerabilities (balance sheet, fiscal, debt) • Choose appropriate economic policies: macro (FX) and micro (prudential)

32. Risk Identification and Management

33. Linkages between Financial and Macroeconomic Stability • Recent issues of macro-financial linkages: • Rapid credit growth (Korea, 2003) • Foreign capital inflows and sudden stops (Iceland, 2006) • Financing of domestic credit expansion through current account deficits (CEE Europe, 2008) • Asset price inflation in housing (US, 2007-present) • Complex structured derivatives (US, 2007-present) • Euro sovereign debt crisis and banking system stress (ongoing) • Macro-financial linkages highlights the issue of booms and bubbles via financial accelerator model, impact of leverage, balance sheet effects, correlation of exposures etc. • Policies to lean against the financial cycle as well as to counter act the feedback mechanisms that amplify financial and business cycle risks are critical • Monetary policy aimed at containing financial imbalances may be too blunt • Effective macro prudential policy instruments are an important ingredient for the currency policy making toolkit • Addressing systemic risk through macro prudential approach continues to evolve

34. Financial Innovations and Leverage • Repos: • Financial institutions significantly increased their leverage in the run-up to the crisis. One of the key transactions with which financial institutions build up leverage are repurchase agreements. Holder of the securities sells them to another party while agreeing to buy back the securities on a specified future date as a specified price. Thus, a repo is collateralized loan. • Risk in Repo Transactions: • Counter party risk: is addressed by posting securities as collateral • Market risk: arises from the volatility of collateral values, • Initial margin (haircut) ensures over collateralization • The haircut should reflect the market risk of the collateral • Daily margin depending on market price of collateral • Operational risk: relate to the transfer and management of the collateral.

35. Financial Leverage • Investment banks raised their leverage through very short term repo transactions. Commercial bank increased their leverage by booking more assets in their trading books, where capital requirements were much lower (however, US banks are subject to an overall leverage ratio constraint). • In addition to “on-balance-sheet” leverage, institutions increased their “off-balance-sheet” leverage through embedded leverage in derivatives, and by using off-balance-sheet funding vehicles.

36. Stress Testing of Financial Systems • Stress testing is a range of techniques to assess vulnerability of financial system to exceptional but plausible shocks. It imposes a coherent structure to discuss risks and can add to rigor to systemic analyses. Stress test originally developed for use at the level of –portfolios and for individual institutions. • Macro Stress Testing • Combine • Forward looking macro economic perspectives • Assessment of banks’ sensitivity to major shocks • System-wide nature • Avoid one-size-fits-all approach. Tailor to: • Country specific circumstances • Complexity of the financial system • Data availability • In less complex financial systems, sources of risk on bank balance sheets more readily measured at aggregate level

37. Stress Testing of Financial Systems • The steps of stress tests: • Identify the major risks and exposures in the system • Define the coverage of the tests • Calibrate the shocks and scenarios • Implement the methodology and run the tests • Interpret the results • Public dissemination • Three types of stress testing • Single factor sensitivity analysis: identify how portfolios respond to changes in economic variables, like interest rates, exchange rates and equity prices • Scenario analysis: to assess resilience of banks and the financial system to exceptional events • Contagion analysis: Transmission of shocks from individual institutions to system as a whole, including inter bank contagion.

38. Stress Testing of Financial Systems • Limitations of stress tests • Are we capturing the right thing? • Amplifying effects • Financial system behavior difficult to model, particularly under stressed conditions • Correlation ands and linear assumptions don’t hold • Treatment of key financial interactions and feedback effects is often rudimentary • Second round effects • Interpretation of stress tests

39. Detecting Financial Fragilities and Financial Risk Management • Risk Identification: • Traditional analysis: • - Focus on flows and prices (current account, fiscal deficit) • After the Asian Financial Crisis • Focus on stock variables and balance sheets (types of debt, illiquid assets, etc) • Capital account crises stem from portfolio adjustments • Balance sheet weaknesses can drive vulnerability • Drop in demand for assets may spill over into other sectors, including public sector • Adjustment in stocks drives flows

40. Balance Sheet Approach • Important source of vulnerability is composition and size of liabilities and assets • Balance sheet Approach: • It focuses on detecting sectoral vulnerabilities, particularly vulnerability to changes in key financial variables. • Balance sheet mismatches • Maturity mismatches • Currency mismatches • Capital structure problems • Solvency problems

41. Risk Management • Risk management is the process of measuring risk and adjusting both risk of large losses and the institutions’ vulnerability to them. • The vulnerability depends on: • The portfolio of positions • The liquidity of its positions • The amount of capital • The quality of the firm’s risk management

42. Risk Management Models • Market risk models • Value at risk (VaR) • Credit risk models • Credit VaR • Contingent claims approach/ KMV approach

43. Value at Risk • VaR summarizes the expected maximum loss over a time horizon within a given confidence interval. It tries to estimate the level of losses that will be exceeded over a given time period only with a certain (small) probability.

44. Micro and Macro Prudential Policy Issues

45. Macro Prudential Regulation and Supervision • The macro prudential policy limits risk by: • Dampening the build-up of financial imbalances • Building defenses that contain the speed and sharpness of downswings and their effects • Identifying and addressing common exposures, risk concentrations, linkages, and connections that are sources of contagion and spill over risks • Focusing on all banks, non banks, instruments, markets, financial structures

46. Micro Versus Macro Prudential Measures

47. Macro Prudential Policy • Macro prudential policy is become an over arching public policy in the wake of the global financial crisis. It involves the authority and tools of prudential, monetary, fiscal and competition policies (including capital controls). Central bank plays central role, but conduct of macro prudential policy is a consensus process with multiple agencies involved

48. Lessons for Nepal • Nepal should introduce sound risk management system so that systemic financial crises can be reduced. • Better to identify systemically important financial institution (domestic) and have supervision standards different from other institutions • Gradually shifts towards Basel III • Emphasize on macro prudential regulation • Preparation of financial stability report- a better technique for identifying fragilities • Deeply monitor the leverage of the financial institutions and conduct stress tests