developments in macroprudential policy: implications for macro stress testing in the comesa region...

Developments in macroprudential Policy: Implications for Macro Stress Testing in the COMESA Region

by

Charles Augustine Abuka, PhDDirector, Financial Stability Department

BANK OF UGANDA

CMI Course on Macro stress testing

August 23, 2013

KSMS, Nairobi, Kenya

Outline

I. IntroductionII. Types of Macroprudential InstrumentsIII. Challenges with Macroprudential Policy

ToolsIV. Conclusions: Implications for Macro Stress

Testing in the COMESA Region

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INTRODUCTION

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I. Introduction

– The global financial crisis has renewed policymakers’ interest in macroprudential supervision.

– Growing awareness that supervisory and regulatory approaches need a “macro” dimension.

– Pre-existing frameworks for prudential regulation and supervision had focused near-exclusively on the management of the risk of the individual financial institutions and too little on systemic risk.

– Recognition that soundness of financial institutions alone does not necessarily amount to financial stability.

– A holistic perspective on the financial sector pays consideration to interconnections between financial institutions, markets and infrastructure.

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I. Introduction

• Compared to monetary policy, research on macroprudential policy is still at infancy: – The role of macroprudential tools in policy discussions

is relatively recent.– Understanding of the interaction between the financial

system and the macro economy is also at infancy.– The global financial crisis prompted a reassessment of

policies towards financial regulation all over the globe.

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I. Introduction

• Like EMEs, COMESA countries also face a number of vulnerabilities that could arise from:– Spillovers and contagion from external financial shocks.– The pro-cyclical nature of financial intermediation with credit

growth linked to the economic cycle. – The contagion due to common exposures to risky sectors such as

the housing market. – The spillovers from Network externalities linking financial

institutions via the interbank market or payments system. – Distress from the SIFIs.

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I. Introduction

• Macroprudential policy: What it is and why it matters– The global financial crisis showed that policymakers had

lacked the tools to prevent problems in one part of the financial system from spiralling out of control.

– System-wide risks cannot be addressed through the traditional mix of macroeconomic policies and “microprudential” measures aimed at individual financial institutions.

– By focusing on the health of the financial system as a whole, macroprudential policy can improve the authorities’ grasp of the web of connections between financial institutions, markets, and the macro-economy.

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I. Introduction

– The new tools enhance policy makers’ ability to cope with two, interrelated drivers of systemic risk:• The risks associated with swings in credit and

liquidity cycles, driven by procyclical forces such as leverage and herding behaviour by financial institutions, non-financial firms, and households.• The concentration of risk in certain financial

institutions and markets that are highly interconnected within, and across, national borders.

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TYPES OF MACROPRUDENTIAL POLICY INSTRUMENTS

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II. Types of Macroprudential Policies

– Macroprudential supervision seeks to mitigate the two dimensions of systemic risk

– Cross Sectional dimension: modern era financial systems are sustained by a complex web of interconnections between financial institutions, financial markets and financial infrastructure, double functioning as contagion channels in times of financial distress

– Preventing the emergence of too big to fail (TBTF) institutions; containing interconnectedness• E.g. extra capital surcharges for SIFIs (Systemically Important

Financial Institutions); restrictions on investment banking activities• Strengthening resolution tools for failing financial institutions

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• Time Series dimension: inherent bipolar tendencies of financial systems, i.e. overexposure to risk in the upturn of the financial cycle, excessive risk-aversion in downturns; financial system acts as an amplifier of economic shocks– Countercyclical financial regulation to moderate the financial

cycle; using the upturn of the cycle more effectively to create buffers• E.g. countercyclical provisioning and time-varying capital buffers

(Basel III)• Time-varying Loan-To-Value requirements for real estate• Ad-hoc increases in risk weights for specific categories of loans (e.g.

foreign-denominated loans); anti-cyclical use of reserve requirements

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• Progress has been made in developing measures and institutional frameworks aimed at containing risks in the financial system as a whole. For example: – The new bank capital framework under Basel III includes a

countercyclical capital buffer aimed at addressing the pro-cyclicality of financial systems.

– To limit the risks associated with interconnectedness, a systemic capital surcharge and a systemic liquidity surcharge based on a financial firm’s marginal contribution to systemic risk.

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• Many countries have been experimenting with macroprudential policies:– Europe, has launched the European Systemic Risk Board – Various national institutional arrangements e.g.:

• The Financial Policy Committee in the UK, • The Financial Regulation and Systemic Risk Council in

France. • The US has established the Financial Stability Oversight

Council; • There are similar institutional changes in COMESA region.

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II. Types of Macroprudential Policies– Some countries have sought to address risks in real estate markets by :

• Limits on Loan-to-Value ratios (Hong Kong, Singapore, South Korea, and China).

• Loan-To-Income ratios (Serbia), • Debt-to-Income ratios (South Korea).

– Some countries have used direct monetary policy instruments to constrain credit supply during booms.

• These instruments include limits on the level, or growth rate, of aggregate credit or specific exposures (Serbia and Malaysia),

• Changes in reserve requirements (Brazil, Bulgaria, Colombia, China, India, and Saudi Arabia).

– Fiscal policy measures such as stamp duties on property holdings to tame speculation in real estate markets (China, Hong Kong).

– Structural measures including the “Volcker-rule”, which creates a ban on proprietary trading for U.S. SIFIs.

– The EU, has structural policy proposals to limit the use of certain derivatives in the event of a serious threat to financial stability.

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CHALLENGES WITH MACROPRUDENTIAL TOOLS

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III. Challenges With Macroprudential Tools

• A clear understanding of what constitutes macroprudential policy is required– We need to lay out a clear understanding of what macroprudential policy

is, and what it is not; and what it can and cannot do. – Macroprudential policy seeks to limit systemic financial risks by using

(primarily) prudential tools. These prudential tools are designed to prevent financial instability and the associated social and economic costs.

– This system-wide perspective is very important, because of the so-called “fallacy of composition” of traditional prudential policy—that is, actions that are appropriate for individual firms may collectively lead to, or exacerbate, system-wide problems.

– The complexity of processes that can generate systemic risk, and the ease with which risk can migrate across the financial system, call for a focus on the whole range of financial institutions (banks and non-banks alike), instruments, markets, and infrastructures.

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– Macroprudential policy is no substitute for robust microprudential and sound macroeconomic policy.

– Effective supervision and regulation of individual financial institutions are necessary preconditions for effective macroprudential policies.

– Monetary and fiscal policies should remain the first line of defence against macroeconomic distortions and imbalances. Macroprudential policy innovation should not be used as an excuse to avoid difficult, but necessary, macroeconomic choices.

– Equally important, independence in other policy areas—including monetary and microprudential policy—should not be undermined in the name of macroprudential policy.

– Macroprudential and other policies should be coordinated in a manner that is compatible with the achievement of each policy’s objectives. This will require appropriate separate mandates, and suitable governance and accountability structures.

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III. Challenges With Macroprudential Tools• Financial stability is a shared responsibility.

– No matter how different policy mandates are structured, ensuring financial stability is a shared responsibility..

– An especially prominent role is played by microprudential policy and monetary policy, both of which affect the amount of risk the financial system is bears. • The larger the buffers created by microprudential policy, the smaller the need

for macroprudential policy to step in. – Macroprudential and other policies interact in complex ways that are not yet fully

understood. Policy conflicts may arise: • If monetary policy is loosened for a long period, macroprudential policy may

want to become tighter to avoid excessive risk-taking. • If macroprudential policy encourages drawing down bank capital buffers in a

downturn to sustain the flow of credit, microprudential policy may be inclined to keep buffers unchanged to guard against the heightened risks.

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III. Challenges With Macroprudential Tools– Mechanisms for coordination across policies is required:

• Institutional reforms. • Respect the independence of monetary policy.

– But know that at some point, addressing systemic risks will also require policy action.

• Coordination will be particularly important if the operational control over the instruments of macroprudential policy may, or may not, rest with the macroprudential body itself. – The European Systemic Risk Board, for example, does not

have direct control over policy instruments.

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• One size does not fit all – The tools to identify and monitor systemic risk, the operational toolkit, and

the chosen institutional set-up will vary from country to country, depending on the level of development, financial structure, policy regime, and other historical and political factors.

– The central banks should play a prominent role. • Their expertise in monitoring macroeconomic and financial market

developments could help shape policies aimed at containing the build-up of systemic risks.

• Their existing roles in monetary policy and payment systems, implies they are well placed to analyze systemic risks and the impact of bank failure.

• They bring in much-needed reputation and independence. • They have strong institutional incentives to ensure that

macroprudential policies are effective—because if they are not, central banks will have to take costly corrective measures.

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III. Challenges With Macroprudential Tools• The other regulatory and supervisory agencies need to be involved in

to activate macroprudential policy tools such tools are not under the operational control of the macroprudential body.

• The involvement of finance ministries comes with its pros and cons. – It is valuable because of the importance of taking into account fiscal

policy and some of its instruments. – Platform for discussion of legislative changes that may be required

to mitigate systemic risks. – However, there is one important risk: because of election cycles

and other political considerations, they may be reluctant to take the punch bowl away when the party gets going. • Leading to crucial delays in the application of macroprudential

measures.

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• More understanding of the operation of the broad toolkit is required

• Macroprudential policy uses primarily prudential tools to address systemic risk. – Because there are different dimensions of systemic risk

and different aspects within them, the range of tools is potentially large.

• The key question is - how should these tools be used?

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• Macroprudential policy is necessary—but it is not a magic bullet– Macroprudential policy is in its infancy. Many issues remain

unresolved. For example:• The measurement of systemic risk, • Evidence that macroprudential policies can, in fact, prevent or

contain credit or asset price bubbles, • The transmission mechanism of macroprudential policy, the policy

conflicts, and how can they be resolved, • How micro- and macroprudential policies should relate to each other • Addressing the trade-off between stability and efficiency in

macroprudential policy making.

Resolving these issues is still a daunting task.

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• To illustrate the challenge of developing a macroprudential policy framework, it is useful to draw some parallels to monetary policy.– Monetary policy has a precisely defined objective—price

stability. For macroprudential policy, systemic risk is multidimensional, difficult to measure and monitor.

– Monetary policy includes a well-defined set of policy tools. Macroprudential policy has multiple possible macroprudential instruments,

– Monetary policy transmission mechanisms are better understood. We are yet to fully understand the equivalent mechanisms in macroprudential policy.

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Systemic risk surveillance: The Role of Macro Stress testing

• We must be aware of the limitations of stress tests– Data limitations – Staff analytical skills in some countries– Most economic models are linear, but extreme shocks tend to be non-

linear– Economic relationships that were estimated during normal times may

change during stressed times– The treatment of key financial interactions and feedback effects is still

rudimentary. – Financial system behaviour under stressed conditions is difficult to

model (networks; contagion)

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• Macro Stress testing has a role in Systemic risk surveillance: – Analytical tools for macro stress testing, the methodologies and data

quality must be improved. Why?• To support early detection of risks,• To support robust risk assessments.

– Macro stress testing must link risk assessments and policy response. Why?• To ensure right timing for introduction and release of policy tools,• To ensure appropriate tool selection.

– Macro Stress testing must be linked to communication of risk assessments. Why? • To better our ability to influence market participants’ behaviour:

perceived potential for activation of macroprudential policy, • To improve our ability to inform decisions on policy intervention.

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Conclusions: Implications for Macro Stress Testing in the COMESA Region

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IV. Conclusions and Implications for EAC Countries

• All this suggests that we need to recognize the limits of what can be achieved, at least in the near term. Some of the main challenges facing policymakers include the following: – Creating a comprehensive analytical framework and a consistent

set of policy tools, including through rigorous back-testing. - Which tool is best to achieve the prime objective? - How good is the understanding of transmission channels?- Methodologies and data needs to calibrate the tool

– Establishing macroprudential authorities, where they are not already in place, with clear mandates to enhance their accountability and reduce the risk of political pressures.

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– Ensuring that risks are appropriately identified and measured through better stress testing processes.

– Assuring that all systemic risks are addressed and all potential policy conflicts managed through cooperation among national authorities.

– Increasing international cooperation to ensure the consistent application of national macroprudential policies->>>EAC, SADC, COMESA?• Cooperation in macroprudential policies reduces the scope for

international regulatory arbitrage that may undermine the effectiveness of national policies.

• International cooperation is also needed to contain the risks associated with systemically important institutions that operate across borders. The new supervisory and resolution colleges for cross-border firms will play an important role.

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• COMESA Member States need to improve the stress testing frame work by:– Forming Stress Testing Working Groups,– Formalizing the involvement of high level management of the central

banks, – Gathering more data and having regular meetings with primary sources of

information,– Reviewing the existing stress testing methodologies, incorporate so far

unobserved feedback effects, – Management in member state central banks must define potential lists of

macroprudential policy tools which are to be applied once stress tests reveal vulnerabilities in the financial system;

– Communication policy needs to be designed in order to inform what goes into the Financial Stability Reports of member state central banks

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The macroprudential Oversight process (ECB)

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“We hope we made a small contribution”

THANK YOU FOR LISTENING

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REFERENCES

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References

Acharya, V (2009) “A Theory of Systemic Risk and Design of Prudential Bank Regulation” CEPR Discussion Papers No. 7164.Bank of England (2009) “The Role of Macroprudential Policy” A Discussion Paper.Basel Committee on Banking Supervision (2009) “Strengthening the resilience of the banking sector” Consultative Document, Bank for International Settlements.Borio, C and Drehmann (2009) “Towards an Operational Framework for Financial Stability: fuzzy measurement and its Consequences”, BIS Working Papers, No. 284, June.Caruana, J. (2010), Macroprudential Policy: Working towards a new Consensus, Remarks at the High-level meeting on “The Emerging Framework for Financial Regulation and Monetary Policy. IMF Institute, Washington DC.

Ghosh R. Swati (2010) Dealing with the Challenges of Capital Inflows in the Context of Macro financial Links, Economic Premise, The World Bank, Washington DC.Moreno, R. (2011) Policy Making from a “macroprudential” perspective in emerging market economies. BIS Working Papers No. 336.

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