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The macroprudential approach to regulation and supervision: What? Why? How?. by Claudio Borio* Bank for International Settlements, Basel Banque de France and Toulouse School of Economics Conference on “The Future of Financial Regulation” Paris, 28 January 2009.
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The macroprudential approach to regulation and supervision: What? Why? How? by Claudio Borio*Bank for International Settlements, Basel Banque de France and Toulouse School of EconomicsConference on “The Future of Financial Regulation” Paris, 28 January 2009 * Claudio Borio, Head of Research and Policy Analysis at the BIS. The views expressed are those of the author and not necessarily those of the BIS.
Motivation, objective and structure • Term “macroprudential” (MaP) has become popular in policy circles yet remains unclear • how does it differ from “microprudential” (MiP)? • what is its relationship to procyclicality? • Understanding this is important for the future of the financial regulatory and supervisory (FR&S) frameworks • Thesis: need to strengthen MaP orientation of FR&S frameworks • Structure of remarks: • what? • why? • how?
I – What? • Intentionally stylised distinction between MaP and MiP • two souls coexist in current FR&S • Two distinguishing features of MaP • focus on the financial system (FS) as a whole rather than individual institutions • Objective: contain likelihood and cost of financial system distress to limit costs for the real economy • treat aggregate risk as endogenous w.r.t. collective behaviour of economic agents • sharp contrast to what individual financial institutions do
II – Why? Three reasons • Costs i.t.o. real economy is what matters most for welfare • Cannot assess the soundness of individual institutions on a stand-alone basis • common exposures across institutions to the same risk factors are key • direct and indirect (via interlinkages) • Endogenous risk is crucial to financial instability • procyclicality of the FS • self-reinforcing mechanisms within FS and between FS and the real economy that can exacerbate booms/busts • most prominent in downward phase • most insidious in expansion phase
II – Why? Recent experience reinforces need • Reinforced by what is new…. • need system-wide perspective to understand threat arising from “dissemination” of risk outside banks • And what is not new • crisis as turn in an outsized credit cycle • overextension in balance sheets in good times masked by veneer of strong economy • build-up of “financial imbalances” (FIs) that at some point unwind • evidence • unusually low volatility and risk premia (G II.2) • unusually rapid growth in credit and asset prices (G 3) • BIS leading indicators help in real time (G A.1)
II – Why? The key mechanisms • Limitations in measuring risk (and values) • expectations are not “correct/unbiased” • bouts of optimism/pessimism; hard to tell cycle/trend • measures of risk are highly procyclical • spike when risk “materialises” but may be quite low as risk/vulnerabilities build up • thermometers rather than barometers of financial distress • Limitations in incentives • how imperfect information/conflicts of interest are addressed in financial contracts • eg. direct link valuations-lending capacity via collateral • ie. wedge between individually rational and socially desirable actions (private/public interest) • “coordination failures”, “prisoner’s dilemma”, herding • eg. lending booms, self-defeating retrenchment Importance of short horizons
III – How? Two dimensions of a MaP approach • Cross-sectional dimension of aggregate risk • distribution of risk in FS at a point in time • systematic vs idiosyncratic risk • Time dimension of aggregate risk • evolution of system-wide risk over time • procyclicality
III – How? Cross-sectional dimension • Principle: calibration to weight on exposures to risks that are common across institutions rather than specific to them (systematic vs idiosyncratic risk) • at present no distinction: calibrate w.r.t. overall risk of an institution • How to implement? Tighter standards if: • many institutions have a common exposure • the impact of an institution’s failure on the system is greater • various ways this could be done
III – How? Time dimension • Principle: build-up buffers in good times so as to run them in a controlled way and within limits in bad times, as strains threaten to emerge • to cushion the blow to the system, need to allow buffers to be run down • otherwise not act as buffers! • regulatory minima from shock absorbers become shock amplifiers • build-up of buffers dragging anchor can restrain risk-taking • How to implement? • five general points
III – How? Point 1: holistic approach • Holistic approach is needed • degree of procyclicality depends on a broad range of policies • monetary policy; fiscal policy • accounting • deposit insurance and resolution procedures • capital is just one prudential tool • eg liquidity, underwriting, margining standards, including LTVs • eg, trend to FVA is increasing procyclicality • either adjust accounting, or adjust more elsewhere • eg, prudential filters
III – How? Point 2: build on Basel II • Building on Basel II is important • superior to Basel I • hard-wiring of credit culture • better at cross-sectional dimension of risk • reduce implementation costs • How? Simple and transparent adjustments to cyclical sensitivity of regulatory capital/have countercyclical elements (MaP “overlays”) • Pillar 1 or Pillar 2 • within each, several possibilities
III – How? Point 3: rules better than discretion • Rely as far as possible on rules rather than discretion… • margin of error • measuring aggregate risk in real time with sufficient lead and confidence to take remedial action is very hard • rules act as pre-commitment devices • pressure on supervisors not to take action during boom even if see risks building up • fear of going against view of markets • …But do not rule it out! • fool-proof rules may be hard to design • can be better tailored to features of FIs • need to discipline discretion (transparency and accountability)
III – How? Point 4: strengthen institutional set-up • Need to strengthen institutional setting for implementation • align objectives-instruments-know how • How? • strengthen cooperation between central banks and supervisory authorities • strengthen accountability • clarity of mandate, independence, transparency • monetary policy as a model?
III – How? Point 5: scope of regulation • Need to find a way of dealing effectively with the unregulated sector • major challenge • is indirect approach enough?
Conclusion • There is now a widespread recognition in the policy community of the need to strengthen the MaP orientation of FR&S frameworks • so far focus largely on procyclicality (time dimension) • expect greater attention to cross-sectional dimension in future • Task now is to examine concretely various policy options (desirability and feasibility) • BIS actively involved in this process