Rethinking regulation for financial system stability and growth Presentation at the Central Bank of Nigeria

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Rethinking regulation for financialsystem
stability and growthPresentation at the Central
Bank of Nigerias50th Anniversary International
Conference on "Central banking, financial system
stability and growth, Abuja, 4-9 May 2009

• Robert N McCauley, Senior Adviser
• Monetary and Economic Department
• Views expressed are those of the
  author and not necessarily those of the BIS

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Where do we want to go?

• We will amend our regulatory systems to ensure
  authorities are able to identify and take account
  of macro-prudential risks across the financial
  system
• -- G20 declaration on strengthening the
  
  financial system, 2 April 2009

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Agenda

• Macroprudential regulationwhat is it?
• Macroprudential perspective on the current
  financial crisis.
• Macroprudential policy what has been done? What
  is under discussion?

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Macroprudential regulationWhere are we coming
from?

• Macroprudential regulation
• Term used at the BIS since late 1970s more
  precisely since early 2000
• Distinguish macro- and microprudential
• Two distinguishing features of macroprudential
• Focus on the financial system as a whole with the
  objective to contain likelihood and cost of
  financial system distress and thus to limit costs
  to the economy
• Treat aggregate risk as endogenous manias and
  leverage increase financial fragility

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Why do we need a macroprudential approach?

• Could a microprudential approach be sufficient?
• Yes - if bank failures were independent and if
  welfare losses exhausted by losses to equity
  holders and depositors
• But
• Banks play crucial role in the intermediation
  from saving to investment ? Real costs of
  financial crises can be substantial
• Bank failures are correlated
• Common exposures and direct and indirect
  interlinkages
• Endogenous risk is crucial to financial
  instability
• Endogenous feedback effects during crises
• Procyclicality of the financial system

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Procyclicality The key mechanisms-1

• Limitations in measuring risk (and values)
• expectations are not well grounded
• bouts of optimism/pessimism hard to tell
  cycle/trend
• measures of risk are highly procyclical
• Up markets tend to have low volatility,
  suggesting low risk, while down markets tend to
  have high volatility, suggesting high risk.
• Thus measured risk spikes when risk
  materialises but may be quite low as
  risk/vulnerabilities build up

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Procyclicality The key mechanisms-2

• Limitations in incentives
• how imperfect information/conflicts of interest
  are addressed in financial contracts
• eg credit availability depends on value of
  collateral which waxes and wanes over cycle
• Compensation arrangements
• leaves wedge between individually rational and
  socially desirable actions (private/public
  interest)
• coordination failures, prisoners dilemma,
  herding
• eg lending booms, self-defeating retrenchment
• ? Importance of short horizons

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II. Macroprudential perspective on the current
financial crisis

• What is new System-wide threats arising from
  pseudo-dissemination of risk and in fact
  concentrations of risk in big banks.
• What is not new
• Crisis as turn in an outsized credit cycle
• overextension in balance sheets in good times
  masked by strong economy
• build-up of financial imbalances that at some
  point reverse
• Evidence
• unusually low volatility and risk premia
• unusually rapid growth in credit and asset prices
  
• BIS leading indicators help in real time

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III. Macroprudential policy What has been done?
What is under discussionThe policy problem in
the upswing

• Asset inflation amid rapid growth of credit
• Inflation may be well-behaved
• What is to be done?

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Possible policy interventions

• Force disclosure of exposure to inflated assets
• Regulate the terms of credit
• Selectively increase capital requirement
• Impose reserves against (ie tax) credit or excess
  credit
• Generally increase capital ratios.
• but do not expect such policies to be popular!

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Force disclosure of exposure to inflated assets

• Sunshine is the best disinfectant
• Disclose credit (or equity) concentrationssounds
  easy!
• But common exposure may need to be invented.
• For example, US regulatory authorities had
  defined Highly leveraged transactions by 1988,
  well before collapse of the leveraged buyout
  mania in late 1989
• Could be in tobacco, utilities or airlines
• Cut across supervisory categories
• No equivalent move in 2000s
• Define and publicise exposure to off-balance
  sheet structures like structured investment
  vehicles (SIVs)

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Regulate the terms of credit-1

• Limit credit in relation to a stock
• Minimum margin on equity purchase
• Security haircuts in repo funding.
• Maximum loan-to-value ratios in real estate.
• Minimum down payment in purchases of consumer
  durables
• Restrict debt service in relation to income (flow
  policy)
• Mortgage payments in relation to income.
• Credit card monthly payments (Bank of Thailand)

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Regulate the terms of credit-2

• Effective?
• Natural tendency of market is to raise loan to
  value ratio as asset prices rise, sometimes to
  over 100, as next years price serves as
  collateral value
• So merely holding the line would be an
  achievement
• Hong Kong authorities reduced loan-to-value
  ratios through February 1997 apartment prices
  peaked in September 1997 subsequent 50 fall did
  not lead to banking crisis.

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Ratcheting down the loan-to-value ratio in HK
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Selectively increase capital requirement

• Attach higher risk weight to class of
  loans/assets associated with/subject to asset
  inflation
• Examples
• Proposal to attach 200 weight to highly leverage
  transactions in late 1980s.
• US proposal to deduct venture capital investments
  of banks from own capital in late 1980s (2,500
  weight).
• Reserve Bank of Indias higher capital weight on
  claims on households, given rapid growth of
  lending to same several years ago (Borio and Shim
  (2007)).
• Could have put on high LTV or low documentation
  mortgages.
• Effect is to raise overall capital ratio.

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Impose reserve requirements on credit growth

• On credit growth above a threshold (Finland in
  late 1980s-30)
• In effect a tax if required reserves remunerated
  at yields below those in the market.
• Problem of uneven incidence firms with access to
  securities markets or foreign bank loans can
  avoid paying
• Uneven incidence may not be a problem if selects
  non-traded goods, e.g. real estate borrowing

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Raise overall capital requirements

• Subject of active research.
• Building on Basel II, apply multiplicative or
  additive factor based on some measure of the
  aggregate risk in the economy
• eg Goodhart and Persaud (2008)
• Any rule has two components
• Measure of risk
• How increase/decrease in required capital depends
  on this measure
• The rub Measure of aggregate risk in the economy
  can be problematic

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Raise overall capital requirementsdoes it work?

• Question effectiveness Adoption of Basel 1 rules
  in late 1980s did not prevent Japanese asset
  prices and Japanese bank lending from rising into
  1990.
• But Japanese banks holdings of equities linked
  their market-value capital to bubble in equity
  and real estate.
• Thus no general conclusion is justified that
  raising capital requirements is ineffective

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Credit policies are not popular

• Rapid credit growth and asset inflation generate
  economic justifications endogenouslyeg
  professors at Tokyo University in the late 1980s
  rationalised the bubble with Q theory.
• In Ibsens play, Enemy of the People, a doctor
  reveals that the water source on which a spa
  towns prosperity based is tainted by poison
  town rejects doctor.

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Rules or discretion?

• Rely as far as possible on rules rather than
  discretion
• can?? 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 discretion out!
• fool-proof rules may be hard to design
• can be better tailored to features of financial
  institutions
• need to discipline discretion (transparency and
  accountability)

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Credit policies require stronger 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?

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Macroprudential policies, tried proposed recap
Sectoral
General
Disclosure Loan-to-value ratio, etc Reserve requirements (tax) vs credit growth
Superweights, selective Build equity over cycle
Credit
Equity reqs
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Conclusions

• Macroprudential regulation is on the agenda.
• Current financial crisis combined asset inflation
  and excessive credit in source countries.
• Central banks and authorities have tried sectoral
  credit policies to an extent not widely
  appreciated, and in some cases used sectoral bank
  capital policies as well.
• Much work ongoing on rules that would build
  banks equity buffers during booms so that they
  can be run down in bad times.

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References

• Crockett, A (2000) Marrying the micro- and
  macroprudential dimensions of financial
  stability, BIS Speeches, 21 September.
• Borio C (2003) Towards a macroprudential
  framework for financial supervision and
  regulation?, CESifo Economic Studies, vol 49, no
  2/2003, pp 181216. Also available as BIS Working
  Papers, no 128, February.
• Borio, C and M Drehmann (2008) Towards an
  operational framework for financial stability
  'fuzzy' measurement and its consequences, 12th
  Annual Conference of the Banco Central de Chile,
  Financial stability, monetary policy and central
  banking, Santiago, 67 November.
  http//www.bcentral.cl/eng/conferences-seminars/an
  nual-conferences/2008/program.htm.
• Borio, C and M Drehmann (2009) Assessing the
  risk of banking crises revisited, BIS
  Quarterly Review, March, pp. 29-46.
• Borio and I Shim (2007) What can
  (macro-)prudential policy do to support monetary
  policy? BIS Working Papers no 242
• Goodhart, C and A Persaud (2008) A party
  poopers guide to financial stability Financial
  Times, 4 June.
• McCauley, R, J Ruud and F Iacono (1999) Dodging
  Bullets Changing US Corporate Capital Structures
  in the 1980s (Cambridge MIT Press), chapter 10,
  Policy and asset inflation.