Post-Crisis Monetary Policy Challenges in 'New Europe'

1. 17th Dubrovnik Economic Conference Post-Crisis Monetary Policy Challenges in 'New Europe‘ Financial Stability Issues Lubomír Lízal, PhD. Dubrovnik, June 30, 2011

2. Emergence of the financial stability goal • The Czech Republic came through a period of major financial instability during 2nd half of 1990s. • The natural response was to set financial stability as important goal of CNB’s policies. • Up to 2004, the goal was pursued as rather informal one in a historical memory-based manner. • With the amendment of the Act as of April 2006 (integration of financial supervisors into the CNB), the financial stability task of the CNB became more explicit • Article 2 (2d): CNB shall… contribute to stability of the (Czech Republic’s) financial system as a whole.

3. Organization of financial stability in the CNB • Several options considered in 2004: independent division, part of existing department (banking supervision, economic research, monetary) • Financial Stability Unit (FSU) established in July 2004 as a new “independent” financial stability unit of the Economic Research Department • small - 6 economists (but also occasionally people from other parts of CNB participate in financial stability analyses and writing the Report), • financial stability analyses at the cross-section of macro, real economy and financial sector analyses, but slightly different focus: thus FSU independent of both monetary and financial supervision department(s) • relative independence: strategic, legal and communication reasons • 2007 – Economic Research and Financial Stability Department • individual management of both activities that share joint administrative infrastructure • department became fully responsible for ESCB Banking Supervision Committee agenda • 2010 – Financial Stability Department

4. CNB’s (working) definition of financial stability • Under financial stability we understand a situation in which • financial system fulfils its functions without disturbances and negative effects on current and future development of the economy, • and at the same time shows a high degree of resilience towards adverse shocks.

5. Sound financial system Yes: resilience No: vulnerability Financial stability Financial vulnerability Shocks No Financial volatility Financial instability (crisis) Yes Potential sources of financial instability • The CNB’s approach to financial stability has historically been strongly macroprudential and close to the relatively narrow BIS interpretation focusing primarily on risks associated with the financial cycle. • Its objective is to ensure that the financial system does not become so vulnerable that unexpected shocks ultimately cause financial instability in the form of a crisis. • Focus on whether weak spots are forming in the financial system and whether conditions are being created in which the interaction of macroeconomic factors and policies, excessive debt, and financial market volatility could cause a financial crisis.

6. Two dimensions of macroprudential policy • The object of macroprudential policy is systemic risk in two dimensions: • The time dimension reflects the build-up of systemic risk over time. • The source of this dimension is pro-cyclical behaviour of financial institutions contributing to the formation of unbalanced financial trends. • Systemic risk of this type manifests itself primarily as common exposures to macroeconomic factors across financial institutions. • The second dimension is cross-sectional and reflects the existence and distribution of systemic risk at any given moment in time. • The source of this dimension is common exposures across financial institutions. • Systemic risk models based on the cross-sectional dimension of the interaction between financial institutions, which can result in collective failure of the system due to the susceptibility of interconnected institutions to a common source of risks.

7. Macroprudential policy and financial stability • The CNB considers macroprudential policy to be an element of financial stability policy. • The main distinguishing feature of macroprudential policy is that unlike traditional microprudential regulation and supervision (focused on the resilience of individual financial institutions to mostly exogenous events): • it focuses on the stability of the system as a whole; • it primarily monitors endogenous processes in which financial institutions that may seem individually sound can get into a situation of systemic instability through common behaviour and mutual interaction; • the task of financial stability analysts is therefore to avoid risks arising from the fallacy of composition, which arises when the whole is wrongly assessed only as the sum of mutually independent parts.

8. Supervision and its integration • Up to 2006 the CNB was in charge of banking supervision only, insurance sector was supervised by the Ministry of Finance, capital market by securities commission and credit unions by other independent authority. • Currently CNB the sole supervisor of the whole financial system. • The main goals of financial supervision integration: • Better monitoring of financial sector from one point (important from financial stability point of view) • More efficient supervision of financial groups and conglomerates • Reduction of cost of supervision and realization of synergies • Securing similar or same conditions for the all participants in the sector (reduced room for regulatory arbitrage, similar approach to similar risks across the market) • Clear responsibility for supervision, removal of duplicities as well as gray zones without any supervision

9. The framework for financial stability analysis • Operational internal relations among business areas in the CNB are important. • The build-up of financial imbalances creating risks for financial stability is usually identified rather early. • Without working internal relations it is rather difficult to make institutions react in a cooperative way and in due time. • The studies of relations between monetary policy and financial sector supervision are often ending in a recommendation to align more closely monetary policy analysis with financial stability analysis. • There is no easy way to do so if these analyses are being done at different geographical locations.

10. Cooperation needed to fulfill the financial stability objective • CNB’s solution was based on the “independent” interaction of the conduct of financial stability agenda, monetary policy and regulation/supervision. • If financial stability concludes that there are growing risks for financial stability, the governing body (i.e. bank board) has to consider measures to limit the risks. • In one institution, the governing body can directly and immediately address departments responsible for monetary policy and supervision. If the whole structure involved more institutions, it would be rather difficult. • After the outset of crisis a multi-department monitoring team established in 2008 • Since May 2009 new macrofinancial panel organized: • one day before quarterly monetary meeting with new forecast presentations and discussions with the Board • simulations of various crisis scenarios prepared by the financial stability department and the monetary policy department • departments: financial stability, research, monetary policy department, supervision, regulation, financial market operations, risk management

11. Monetary policy rates since the start of the financial turbulence The koruna exchange rate and its volatility (%) 38 30 6 36 25 34 5 32 20 30 4 15 28 26 10 3 24 5 2 22 20 0 1 2000 2002 2004 2006 2008 2010 0 CZK/EUR Implied 1M volatility (right-hand scale, %) 03/07 09/07 03/08 09/08 03/09 09/09 03/10 09/10 03/11 Euro area US CZ Source: CNB calculation based on CNB data Note: The dotted line shows the long-term trend. Source: Thomson Datastream Stress tests • Macro-stress tests (top-down): • since 2003 banking sector, since 2007 insurance companies and pension funds, since 2008 liquidity stress tests of banks • Bottom-up stress tests: • since 2009 with selected banks, since 2010 with selected insurance companies • Recent alternative scenarios: • Baseline = official CNB forecast from May 2011 • Renewed Recession = extreme GDP decline of around -5 %, market turmoil with depreciation of CZK and increase in both short-term rates and bond yields • Asymmetric Developments = volatile environment with first appreciation and then depreciation of CZK, economic decline, cost-push inflation, high interest rates

12. Alternative scenarios: real GDP growth Alternative scenarios: 3M PRIBOR (%) (%) 7 7 5 6 3 5 1 4 3 -1 2 -3 1 -5 0 -7 03/09 09/09 03/10 09/10 03/11 09/11 03/12 09/12 03/13 03/09 09/09 03/10 09/10 03/11 09/11 03/12 09/12 03/13 Baseline Scenario Asymmetric Developments Baseline Scenario Asymmetric Developments Renewed Recession Renewed Recession Alternative scenarios: inflation Alternative scenarios: exchange rate (%) (CZK/EUR) 5 29 28 4 27 3 26 2 25 Inflation target 1 24 0 23 22 -1 03/09 09/09 03/10 09/10 03/11 09/11 03/12 09/12 03/13 03/09 09/09 03/10 09/10 03/11 09/11 03/12 09/12 03/13 Baseline Scenario Asymmetric Developments Baseline Scenario Asymmetric Developments Renewed Recession Renewed Recession Source: CNB Alternative scenarios for the stress tests

13. Capital adequacy ratios in each scenario (%) 18 16 14 12 10 8 6 4 03/09 09/09 03/10 09/10 03/11 09/11 03/12 09/12 03/13 Baseline Asymmetric Developments Renewed Recession Capital adequacy ratios in each scenario in the event of extraordinary dividend payments (%) 18 16 14 12 10 8 6 4 03/09 09/09 03/10 09/10 03/11 09/11 03/12 09/12 03/13 Baseline (extraordinary dividends) Asymmetric Developments (extraordinary dividends) Renewed Recession (extraordinary dividends) Source: CNB, CNB calculation Stress test results • Despite increase in risk costs and decrease in profitability, capital adequacy always above regulatory minimum of 8 % • Example of an ad-hoc sensitivity test: extraordinary dividend payments • Banks, expecting favorable future developments, will decide to downsize their existing capital buffers to the level prevailing in the pre-crisis period (2004-2007) and will pay out extraordinary dividends.

14. Reform of the European Supervisory Framework • Integration of supervision is essential. • Information sharing much better with national integrated supervision than through a supranational supervisory authority. • As a consequence, CNB does not support: • Further radical or gradual steps leading to the transfer of powers from national supervisory authorities to EU institutions or even global supranational ones. • Separation of national powers from national responsibilities for decisions. • Regulation based on populist (and not expert) arguments (e.g. “fight against speculators”). • Adoption of new regulations without trying to fix the already existing but malfunctioning ones first. • Baseless “micromanagement” of areas that shall be left up to the free market (e.g. remuneration). • Risk of regulatory overreach (“overkill”)

15. EU framework for crisis management in the financial sector • CNB is strictly against: • Scope of the EU framework for crisis management in the financial sector (shall be limited only to cross-border systemic institutions according to CNB). • Separation of proposed resolution authorities from supervisory authorities (setting-up of new colleges for resolution; obligation to justify decisions to authorities in other EU Member States or EU institutions; future potential integration of crisis management on the EU level). • Possibility to transfer assets within a financial group without prior approval from both home and host supervisory authorities, as well as against the possibility to overrule the decision through a (mandatory) mediation process.

16. Concluding remarks • Positive role of the Hungarian presidency – Deposit Guarantee Schemes Directive compromises • Monetary policy cannot afford to ignore financial stability due to strong feedback effects. • In case of emergence of serious financial instability, the central bank may be forced to turn to quasi-fiscal policy (such as direct purchases of government bonds) which may be very risky for its reputation, independence, etc. • As a consequence, each central bank should have strong incentive to be concerned with fiscal stability. If anything goes seriously wrong, it has to face the consequences and bear the costs. • EU and other supranational authorities do not bear the costs, national authorities do…

17. Thank you for your attention www.cnb.cz Lubomír Lízal, PhD. member of the CNB Board lubomir.lizal@cnb.cz