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

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. TheIMF

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.