The macroprudential approach to regulation and supervision: What? Why? How?

1. 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.

2. 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?

3. 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

5. 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

6. 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)

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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)

17. 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?

18. 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?

19. 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