Safeguarding financial stability: framework, tools and challenges
Guest contribution published in the December 2012 Monthly report of the Federal Ministry of Finance
- 1 Macroprudential oversight as a response to the financial crisis
- 2 The institutional framework
- 3 Definition and classification of macroprudential policy
- 4 The macroprudential toolkit
- 5 Outlook: use of macroprudential intervention instruments
1 Macroprudential oversight as a response to the financial crisis
The need to introduce a macroprudential oversight framework is one of the key lessons we have learned from the recent financial crisis. But unlike many other areas of economic policy such as microprudential supervision, in this case there is no existing regulatory regime that can be expanded and no existing structure that can be reformed and refined. Instead, a completely new set of institutions, concepts and instruments is being created.
This innovation ultimately equates to a paradigm shift. There is now a consensus that policymakers need to proactively tackle macrofinancial imbalances and systemic risks before they build up. However, this new approach demands answers to the old diagnostic problem of how exaggerations, imbalances or bubbles that jeopardise financial stability in the medium and long term can be identified early on – ie before erratic fluctuations appear, a bubble bursts or dislocations occur in the financial system. What is more, new instruments are needed to resolve the therapeutic challenge of addressing potential risks to financial stability with surgical precision so as to ensure that no major harmful side-effects jeopardise other economic policy objectives.
A stronger emphasis on the prevention of financial crises calls for a macroprudential strategy that focuses on countering systemic risk. Such an approach involves important overlaps both with the traditional microprudential supervision of institutions and with monetary policy. On the one hand, macroprudential policy encourages a wide-angled monitoring of the financial system as a whole. Experience has taught us that it is not enough for regulation and supervision to be aimed exclusively at maintaining stability at the microprudential level of individual financial institutions. Instead, close cooperation between macroprudential oversight and microprudential supervision is an essential prerequisite for rigorous crisis prevention. On the other hand, successful macroprudential regulation gives monetary policymakers greater room for manoeuvre, allowing them to concentrate on their primary objective of safeguarding price stability. Financial stability is a crucial requirement for ensuring that the monetary policy transmission mechanism operates smoothly. This is why – particularly in a monetary union that combines a single interest rate and exchange rate policy and the free movement of capital with diverging national economic developments – macroprudential oversight is central to adequately addressing undesirable developments at the national level.
2 The institutional framework
Considerable progress has been made in the meantime in establishing an institutional framework for macroprudential oversight.
At the international level, the International Monetary Fund (IMF) and the Financial Stability Board (FSB) have been entrusted with monitoring the risk situation and potential risk developments in the international financial system. At the behest of the G20, they have intensified their collaboration. The IMF focuses on identifying macrofinancial risks, notably on the interaction between the real economy and the financial sector. As an extension of the Financial Stability Forum (FSF) set up by the G7 finance ministers and central bank governors in February 1999, the FSB was re-established, with a broadened mandate and membership, at the G20 summit in April 2009. Supported by national institutions, the FSB focuses on vulnerabilities within the financial system. The FSB’s tasks include identifying weaknesses in the international financial system and proposing and monitoring the implementation of remedial action. Moreover, the FSB seeks to coordinate regulatory and supervisory policy in financial sector issues at an international level and promote cooperation and the exchange of information among the institutions responsible for these areas.
The FSB has drawn up a compendium of overriding standards for a stable financial system. These include defined core standards, which are deemed to be particularly important for financial stability and are therefore accorded priority implementation. The member countries of the FSB1 have pledged to observe these international standards and to maintain the stability, transparency and openness of their financial systems. Furthermore, they have agreed to subject their national financial sectors to periodic peer reviews and to undergo examinations by the IMF and the World Bank in the context of the Financial Sector Assessment Program (FSAP).
Within the European Union, the establishment of the European Systemic Risk Board (ESRB) has closed a gap in the European financial supervision framework. The ESRB began its work in January 2011. This body unites the expertise of central banks and supervisors in Europe with a view to identifying and assessing systemic risks and, if need be, issuing warnings and recommendations for appropriate measures to avert threats to financial stability. To date, the ESRB has made three public recommendations, one of which was to set up national macroprudential authorities. According to this recommendation on the macroprudential mandate of national authorities, which was published on 16 January 2012 (ESRB/2011/3), an effective national macroprudential policy needs a well-defined policy framework. For this purpose the ESRB recommends a legal framework that would prescribe macroprudential policy objectives, designate the competent authority (with several authorities collaborating, if appropriate) and set forth transparency and accountability requirements. A leading role is assigned to central banks, in particular regarding macroprudential analysis. Furthermore, macroprudential authorities should be equipped with the instruments needed to achieve the defined objectives, and should publish the basic tenets of their policy, the decisions they have made and the reasons for those decisions, unless such publication poses a potential risk to stability. The recommended measures are to enter into force by 1 July 2013.
Germany is implementing this recommendation of the ESRB with the Act on Overseeing Financial Stability (Gesetz zur Überwachung der Finanzstabilität), also known as the Financial Stability Act. The main focus of the draft Act is on strengthening cooperation between the Bundesbank, the Federal Financial Supervisory Authority (BaFin) and the Federal Ministry of Finance in the field of financial stability. Above all, it aims to better synthesise microprudential supervision and macroprudential oversight. To this end, the draft Act envisages the creation of a German Financial Stability Commission, on which these three institutions will each have three representatives. The Bundesbank expressly welcomes the fact that this Act will introduce a macroprudential oversight framework in Germany, enabling Germany to live up to its international responsibilities that follow from the importance of the German financial system.
3 Definition and classification of macroprudential policy
The objective of macroprudential policy is to ensure financial stability. The Bundesbank defines financial stability as the financial system's ability to fulfil smoothly its key macroeconomic functions – in particular, the efficient allocation of financial resources and risks along with the provision of a well-functioning financial infrastructure – at all times, including in situations of stress and periods of structural upheaval.2
A number of policy areas impinge upon the goal of financial stability. For instance, it is clear from the current European sovereign debt crisis that the state of public finances has a considerable effect on financial stability. But taxation policy, for example, may likewise create incentives which encourage excessive developments in specific financial market segments. However, neither budgetary nor tax policy decisions constitute macroprudential policy measures, since they are not usually taken primarily in order to influence financial stability. Therefore, macroprudential policy is defined, first, by its objective, and, second, by its toolkit, which is made up essentially of regulatory and supervisory instruments.
As a branch of economic policy, macroprudential policy includes both intervention in the sectoral structure of the financial system (structural policy) and direct state intervention in market processes (process policy) and interactions with other economic agents.
Macroprudential policy can typically be said to be structural policy when it is focused on the cross-sectional dimension of systemic risk. This dimension encompasses the risks arising from contagion, particularly through systemically important institutions and infrastructures, as well as from herd behaviour. The primary aim of such structural policy is to ensure that the basic framework is right. Market exit has to be a credible threat for large, interconnected financial institutions, to ensure that shareholders and creditors bear liability for any losses resulting from the risks incurred and that they perform their control function. This means that, for systemically important financial institutions (SIFIs) in particular, recovery and resolution plans are required, as well as a suitable insolvency procedure which also takes due account of the international dimension. Equally, market entry has to be possible for financial institutions in order to ensure the substitutability of financial institutions. Furthermore, enhanced transparency of financial markets and financial agents helps reduce the uncertainties and thus the systemic risks which derive, for instance, from their interconnectedness via the derivatives and interbank markets. In all of this, macroprudential policy should have a broad area of application which covers financial market segments and participants that have hitherto been less closely regulated, in order to prevent evasive manoeuvres and regulatory arbitrage.
Macroprudential policy can typically be said to be process policy when it is focused on the temporal dimension of systemic risk. This dimension describes the procyclical behaviour inherent in the financial system. It fosters an alternating sequence comprising exuberant phases, in which market participants are prepared to incur very high levels of risk, followed by periods characterised by a flight to safety, in which market participants mainly seek to avoid risk.
4 The macroprudential toolkit
Macroprudential policy needs an effective toolkit that can be updated and adjusted if and when necessary. In particular, this toolkit should take account of all the main risk drivers and, besides fiscal policy measures, primarily make use of supervisory instruments such as capital, liquidity and leverage rules. The range of instruments needs to cover the whole financial system – not just the banking sector, but also notably the insurance industry and the financial markets.
Macroprudential instruments can be graded by the degree of intervention that they entail. They can be “soft” tools (communication, eg financial stability reviews), “intermediate” tools (warnings and recommendations) or “hard” tools (intervention instruments such as the countercyclical capital buffer). It is important, in particular, to distinguish between communication tools and intervention tools.
Public communication has long played an essential role in the standard monetary policy toolkit of central banks. It will feature as prominently or even more so in the case of financial stability policy. On the one hand, public communication, as a “soft” macroprudential instrument, does not impinge directly on the business activities of financial institutions and can thus have only an indirect influence. It should therefore be deployed in the early stages of a risk build-up. On the other hand, it entails little danger of undesirable side-effects or legal consequences. Furthermore, public communication does not need to be based on a specific legal foundation. It nonetheless constitutes an effective tool in the influence it can exercise on market players’ expectations and policymakers’ opinions. The Bundesbank publishes its analyses and evaluations of financial stability in the form of reports, in particular its Financial Stability Review and research papers.
4.2 Warnings and recommendations
If the build-up of risk continues, public communication tools will no longer be sufficient. Macroprudential oversight therefore also requires additional formal communication tools, in the shape of warnings and recommendations. These “intermediate” instruments are the key tools both for Germany’s future Financial Stability Commission and for the ESRB at EU level. In Germany, warnings and recommendations may be addressed to BaFin, the Federal Government or other domestic public authorities.
Recommendations provide specific guidance on policy measures that need to be instigated. They may relate to making full use of existing policy options (eg setting the countercyclical capital buffer), but can also be flexibly deployed to highlight regulatory deficiencies or the need for a new intervention tool, something which usually requires action by the legislator. Recommendations are not legally binding, but the addressees are obliged to issue an explanation of how they intend to implement the recommendation or why they do not intend to implement it (“comply or explain” requirement). The effectiveness of warnings and recommendations should not be underestimated: any attempt to ignore them will put the addressee under considerable pressure to justify this inaction.
4.3 Macroprudential intervention instruments
Intervention instruments, such as capital buffers or higher risk weights for certain credit exposures, are the third set of macroprudential tools. They require a legislative framework, and their use must be subject to democratic control. The banking sector is the initial focus of regulation owing to its key macroeconomic importance. Macroprudential instruments are designed to internalise negative externalities that arise when market participants only factor the private costs of their actions, not the social costs, into their decisions.
In principle, the toolkit should be designed to be as simple as possible but as comprehensive as necessary. Risks need to be carefully targeted in order to avoid unintended side-effects. Furthermore, potential interactions have to be taken into account if several macroprudential tools are deployed concurrently.
Possible measures under discussion at the international level for reducing the cyclical components of systemic risk include not only time-varying capital and liquidity requirements but also the introduction of an upper borrowing limit (leverage ratio), options for raising risk weights for specific asset classes, the adjustment of loan collateral standards, dynamic credit risk provisioning and the revision of international accounting standards. Additional capital charges for SIFIs, liquidity ratios to encourage stable funding sources as well as market infrastructure measures (eg the obligation to clear OTC derivatives via central counterparties) are notably being discussed as instruments to counter cross-sectional systemic risk.
The macroprudential intervention instruments described above are an initial selection of potential tools for containing systemic risk. This selection is based on the lessons learned from the financial crisis and the international debate on the structure of macroprudential regulation and is by no means exhaustive. Economic analyses on the functioning of the instruments, their transmission mechanisms as well as their side-effects and interactions are still in their infancy. Furthermore, the complexity of the financial markets means that systemic risks can arise in diverse forms that are very difficult to predict. That is why the available toolkit has to be constantly reviewed and amended or supplemented if necessary. The criteria used for assessing and selecting instruments are based on the principles of effectiveness, efficiency and feasibility.
5 Outlook: use of macroprudential intervention instruments
When it comes to using macroprudential instruments, it is essential to weigh up the pros and cons of deploying a discretionary versus a rules-based approach. Each new financial cycle exhibits both generic and unique characteristics, the assessment of which always requires qualitative information alongside empirical indicators. The timing and intensity of macroprudential measures will thus need to be gauged with some discretion. At the same time, it must be assured that macroprudential policy is predictable for market participants and that its instruments are deployed in a transparent fashion. Experience with monetary policy confirms that policymaking works best when it is predictable, transparent and consistent. Thus, a rules-based approach can set out guidelines for the use of instruments, thereby reducing uncertainty for financial market participants. This also makes it easier for macroprudential policy to counter possible resistance from vested interests, particularly where unpopular measures are concerned.
Given the existence of the single European market, it makes sense to harmonise the conditions and criteria for macroprudential instruments at the European level in order to avoid jeopardising the efficiency of the single European financial market and to prevent national protectionism. The use of macroprudential instruments is thus being regulated by the EU in the planned Capital Requirements Directive IV (CRD IV) and Capital Requirements Regulation (CRR), which are currently the subject of trilogue negotiations between the European Parliament, the EU Council and the European Commission. The legislative initiatives give scope for national macroprudential authorities to set inter alia the counter-cyclical capital buffer and sectoral risk weights at their discretion. Giving national macroprudential authorities these powers to avert threats to the financial system is essential. For one thing, national authorities have the greatest expertise when it comes to analysing national macroprudential conditions. For another, the costs of a financial crisis are mainly borne at the national level.
Yet given the integrated nature of the financial systems, macroprudential policy cannot be viewed solely as a purely national matter. Systemic risks and macroprudential measures within a given country often have cross-border effects, which also need to be taken into account. Positive externalities, in the form of avoiding financial crises and the associated costs, ensue from macroprudential policy for both the country taking action and for countries that have trading and financial ties with that country. Likewise, negative externalities, or spillover effects, that can have an unintended effect on the credit supply, on capital and liquidity shifts or on the increase in systemic risk, can arise in connection with the credit cycle and divergent national macroprudential policies. A degree of coordination within the European Union is therefore necessary.
Effective macroprudential oversight that is dedicated to safeguarding the stability of the financial system is a key component of a stable monetary and economic union in Europe. Germany has actively responded to this lesson from the financial crisis and has put in place appropriate statutory and institutional foundations. The institutions involved in financial system oversight – the Federal Ministry of Finance, BaFin and the Bundesbank – will now flesh out this framework and make it a practical reality.
- The FSB's members are central banks, finance ministries and supervisory authorities from the G20 countries as well as Hong Kong, the Netherlands, Spain, Singapore and Switzerland; the European Central Bank, the European Commission and representatives of international organisations and standard-setting bodies. Non-members are involved in the FSB’s work through regional consultative groups (regional outreach).
- See Deutsche Bundesbank, Financial Stability Review 2010, p 7.