A Doctrine for Macro-Prudential Regulators

Jean-Charles Rochet(Professor of Banking, UZH and SFI)

12th OEC ALUMNI UZH, FORUM 2012FINANCIAL SYSTEM STABILITY

January 24th 2012, UZH

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Introduction

The subprime crisis has shown the need for implementing a new form of financial regulation, called macro-prudential.

In Switzerland it will be implemented by FINMA and the SNB.

However there is still a discussion about the respective roles that will be played by these two institutions.

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Introduction(2)

In other regions, new institutions have been set up:• European Systemic Risk Board in the EU, • Financial Services Oversight Council in the US,… The precise mandate of these institutions is not

clear, nor are the instruments they will use. This presentation proposes some preliminary

thoughts on what could be done on this front.

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PUNCHLINE • Macro-prudential regulation/supervision should

be taken seriously, otherwise systemic crises will occur again in the future.

• Macro-prudential supervisors should be strong and independent, for resisting lobbying from the financial industry and short termist political pressures.

• These supervisors should also be accountable to society.

• This requires a clear doctrine and transparent operating procedures.

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PLAN OF THIS PRESENTATION

1. Some Economics of Regulation2. Micro-prudential Regulation of Banks3. Need for Macro-prudential Regulation4. What Mandate? What Architecture?5. Which Instruments?6. A Proposed Doctrine7. Conclusion

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1.Some Economics of Regulation (1)

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Economists identify several causes of market failures:

• Excessive market power (e.g. monopolies).

• Externalities (e.g. pollution, networks).

• Public goods (e.g. infrastructure).

• Asymmetric information, implying the need for consumer or worker protection (e.g., approval of new drug, , safety regulations for hazardous jobs).

1.Some Economics of Regulation (2)

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To correct market failures, several modes of intervention are possible:

• Establish an independent agency (e.g. Competition Authority) in charge of preventing distortive behaviours (e.g. cartels and anti-competitive agreements).

•Allow the government to control directly some private activities (e.g., access price regulation of infrastructure).

• Allow the government to use indirect incentives (e.g. carbon tax, subsidies for R&D).

1.Some Economics of Regulation(3)

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A cost-benefit analysis is needed before any intervention.

On the benefit side: clarify precise reasons for intervention, mode of intervention and instruments chosen.

On the cost side: assess possible distortions of competition created by regulation but also risk of capture of regulators by the industry or by politicians.

As an illustration: micro-prudential regulation of banks.

2. Micro-prudential regulation of banks

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Reasons for intervention: •Commercial banks are largely financed by small depositors, who do not have the expertise to monitor bank managers, and who can withdraw their money easily.

•Bank-runs can only be avoided if these retail deposits are completely and credibly insured.

•But this insurance may create a moral hazard problem: bankers must be prevented from taking excessive risks with their depositors’ money.

2.Micro-prudential regulation(2)

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Mode of intervention: •design prudential regulations aimed at limiting banks’ risk taking (Basel Committee recommendations, national legislations).

•establish a banking supervisor (or a financial service authority) in charge of representing the interests of small depositors (or investors, or insurance policy holders).

•supervisor can be an independent agency (like FINMA in Switzerland) or remain under the control of the government (like the FSA in Sweden).

2.Micro-prudential regulation(3)

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Objective of regulation should be focused on the precise reason for intervention, i.e. minimize expected cost of individual bank failures.

Instruments: minimum capital ratios, on site supervision, transparency requirement, liquidity ratios, as well as special resolution procedures.

2.Micro-prudential regulation(4)

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Potential problems: •Risk of regulatory capture by the industry (e.g. adoption of Value at Risk criterion by Basel Committee).

•Risk of supervisory forbearance under political pressure (e.g. unjustified bail-outs paid by tax-payers)

•Possibilities of distortions of competition (e.g. inadequate risk weights for capital ratios).

3.Need for Macro-Prudential Regulation

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Consensus: micro-prudential regulation is insufficient!

Several reasons for this:

1.Banking crises: •banks’ assets are strongly correlated, •banks’ liabilities are interdependent,•hence bank failures are clustered (banking crises).

Banking crises have a huge social cost (not only fiscal cost, but more importantly persistent output loss).

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Bank failures are clustered

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4.Need for Macro-Prudential Regulation(2)

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2.Financial cycles: •banks lend too much in good times (credit booms)•banks lend too little in bad times (credit crunches) •this generates excessive volatility of credit (pro-cyclicality) and asset prices (bubbles and fire sales spirals)

3. Systemically Important Financial Institutions (SIFIs): • some financial institutions (including non-banks) are major players in vital parts of financial system, or are just too big for the country; • governments prefer to bail out these SIFIs even if they incur large losses (Too Big To Fail).• but sometimes there are just Too Big To Be Bailed Out (Iceland)!

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Credit Cycles in the USA

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3.Need for Macro-Prudential Regulation (3)

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Three questions: what should be done (objectives) , who should do it (allocation of tasks) and how (instruments)?

Ideally: one objective, one institution, one instrument. Clearly not feasible:

• Maintaining financial stability has several dimensions.

• Several institutions share financial stability responsibilities.

• Several instruments can be envisaged.

4. Which Mandate?

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Swedish Riksbank: « ensuring that financial system can maintain its basic functions and has resilience to disruptions that can threaten these functions »

•Financial System: financial markets and intermediaries, infrastructure (payment systems, clearing and settlement platforms).

•Basic functions: mediating payments and securities trading; converting savings into funding; managing risks. •Disruptions: payments « gridlock »; serious perturbations to money markets or exchanges (bubbles, fire-sales spirals); credit crunch.

4.Which mandate? (2)

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Two possible mandates for the systemic risk authority:

1.Narrow: limiting the frequency and cost of financial crises. But crises are (hopefully) rare events, difficult to forecast. Hard for an independent authority to take impopular decisions based on hypothetical risk of a crisis, that may never materialize.

2.Broad: dampening financial cycles: seems more practical. But fiscal authorities and monetary authorities can also stabilitize business cycle fluctuations. How to share responsibilities and to manage potential conflicts of interest (i.e. take restrictive measures on the eve of a general election)?

5.What Instruments?

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A first category concern the instruments that specifically target SIFIs (which can be non-banks):

• capital add-ons,

• systemic taxes, • control of managers’ and traders’ compensation.

• special resolution regimes (« living-wills »)

5. What Instruments?(2)

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Second category of instruments: conditional on macroeconomic events:

• countercyclical capital requirements: require banks to have more capital when things go well and less when things go badly.

• restrictions on lending (Loan To Value or loan to income ratios).

5. What Instruments? (3)

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Not clear how these instruments should be used (if at all):

• systemic taxes: taxation is under the control of Ministry of Finance, no simple measure on which these taxes could be based. • control of managers’ and traders’ compensation: politically very difficult to delegate to an independent regulator.

• countercyclical capital requirements or maximum LTV ratios:

impossible to find automatic rules, dangerous to leave it to the control of government.

6.A Proposed Doctrine

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Reasons for intervention: 1.A well functioning financial system is necessary to a modern economy. Its basic functions (payments, transformation of savings into funding, management of risks) can be threatened by some institutions.2.Excessive fluctuations of the volume of credit are costly to the economy. Without regulation, banks lend too much during booms and too little during recessions.

6.A Proposed Doctrine (2)

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Mode of intervention: The Systemic Risk Authority (either a new institution, the Central Bank or the FSA) receives a double mandate:• ensure the continuity of the vital parts of the financial system• limit excessive fluctuations of aggregate credit. Decisions are made by a Financial Stability Committee (FSC), comprising representatives of the Central Bank, the micro-prudential supervisor and the Ministry of Finance, as well as independent members.

6. A Proposed Doctrine (3)

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Instruments: The Financial Stability Committee decides on:

• Which institutions are deemed systemic (SIFIs) and what special measures are applicable to them (capital add-ons, additional liquidity requirements,…), based on financial stability models and stress tests.

• Whenever quantitative restrictions on credit (CAR, leverage ratio, maximum LTV ratio,…) should be the adjusted, based on forecasts of future macroeconomic conditions, and assessments of risks build-ups.

6. A Proposed Doctrine (4)

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• Transparency and accountability: The FSC is accountable to the Parliament, Deliberations disclosed (ex-post) to the press, so that they can be assessed by the financial industry and the general public, as well as the models used to forecast economic and financial conditions.

• Coordination with other agencies: It is simplified by the fact that the FSC comprises representatives of the Central Bank, the micro-prudential supervisor and Ministry of Finance.

If a conflict arises, it can be arbitrated by Parliament.

7. CONCLUSION

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• Financial stability is equally important as price stability

• Macro-prudential supervision should be organized in a similar way as monetary policy (FSC).

•Thus the need for a clear doctrine (mandate, instruments, objectives) and transparent operating procedures.

• Other important aspects have not been addressed here: international cooperation, crisis management,…