Macroprudential policy – a framework

Jan Frait

Executive DirectorFinancial Stability Department

22

„ … in tracking systemic risk … we should avoid a false sense of precision … it is better to be approximately

right than precisely wrong“

Claudio Borio, BIS (2010)

„ … dignity has never been photographed“

Bob Dylan, Dignity (1991)

3

I.

Concept of Macroprudential Policy

4

The birth of macroprudential“ policy

• Following the global financial crisis, on the global, the EU level as well as on the national levels the ways how to establish the additional pillar for financial stability – macroprudential policy framework – has been discussed.

• Until the crisis, the concept of macroprudential policy was discussed primarily within the central banking community under the leadership of the Bank for International Settlements (BIS henceforth).

• After the crisis, the term “macroprudential” has become a buzzword (Clement, 2010) and the establishment of effective macroprudential policy framework has become one of the prime objectives of the G20, EU, IMF and other structures.

• In the EU, such a desire has already been reflected in the decision to create the European Systemic Risk Board as the EU-wide authority of macroprudential supervision and by number of iniciatives focusing on defining the EU-wide framework for macroprudential regulation.

5

The birth of macroprudential policy

• The EU-wide framework for macroprudential regulation including the toolkit was created over 2012 and 2013.

• National competent or designated authorities in terms of macroprudential policy were constituted. • The CNB is the only institution responsible for macroprudential policy in

the Czech Republic. • There are different models in the EU (CB only, FSA only, multi-agency

committees, more institutions, minister of finance).

6

What is a macroprudential policy?

• The term “macroprudential” as applied now is too embracive and often used outside of the scope of its original meaning.

• The CNB looks at the concept of macroprudential policies from relatively narrow perspective of the original BIS approach (e.g. Borio, 2003, Borio and White, 2004). • The objective of a macroprudential approach in the BIS tradition

falls within the macroeconomic concept and implicitly involves monetary and fiscal policies (Borio and Shim, 2007, and White, 2009).

• In the BIS tradition, the phenomenon of financial market procyclicality (mainly the procyclical behaviour in credit provision) stands centrally (Borio and Lowe, 2001, or Borio, Furnine and Lowe, 2001).

• The CNB‘s analyses are focused mainly on risks associated with procyclicality, credit cycle in particular.

7

Two credit booms and one bust thus far in the CR

GDP growth and credit risk in the Czech Republic(1993-2012, in %)

Source: CNB

Note: % NPL is the share of non-performing loans on total bank credit.Data from the beginning of 1990s are based on authors' estimates.

0

5

10

15

20

25

30

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I/93 I/96 I/99 I/02 I/05 I/08 I/11

-8

-6

-4

-2

0

2

4

6

8

10

%NPL GDP growth (rhs)

Credit cycle in the Czech Republic(1993-2012, v %)

Source: CNB

Note: Credit growth is year-over-year increase in total bank credit.

% NPL is the share of nonperforming loans on total bank credit.

Data from the beginning of 1990s are based on authors' estimates.

30

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60

65

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-10

-5

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20

25

30

I/93 I/96 I/99 I/02 I/05 I/08 I/11

credit growth (MA) credit-to-GDP (rhs)

• Credit boom in early 1990s followed by sharp increase in credit losses and major financial crisis.

• Credit “boom” of 2005-2008 had benign consequences. • What made the difference?

8

What is a macroprudential policy?

• Financial market structures matter as well.• The other stream of macroprudential thinking is more micro-oriented and

focusing on individual institutions and their mutual interactions. • By comparison with the BIS logic, in this approach systemic risk arises

primarily through common exposures to risk factors across institutions, i.e canonical models of financial instability like Diamond and Dybvig (1983) emphasizing interlinkages and common exposures among institutions.

• The analyses of this sort (common exposures among institutions, network risks, infrastructure risks, contagion ...) has been intensively studied by the IMF (see special chapters in some Global Financial Stability Reports).

• The ESRB analytical work also puts more emphasis on structural issues than conjunctural ones.

• The reason is natural – financial cycles differ significantly within EU economies, the ESRB started to operate during financial crisis characterized by number of contagion risk channels.

99

The CNB’s historical interpretation of financial stability

• Consensus in the central bank community - the financial stability objective is to achieve continuously a level of stability in the provision of financial services which will support the economy in attaining maximum sustainable economic growth.

• The CNB adopted a definition consistent with this way of thinking about the financial stability objective back in 2004. • It has defined financial stability as a situation where the financial system operates

with no serious failures or undesirable impacts on the present and future development of the economy as a whole, while showing a high degree of resilience to shocks.

• Financial stability analysis as the study of potential sources of systemic risk arising from the links between vulnerabilities in the financial system and potential shocks coming from various sectors of the economy, the financial markets and macroeconomic developments. • The sources of systemic risks can be viewed as externalities associated with

behaviour of financial institutions (for details of such approach see Nicolò et al., 2012), and financial markets and their participants (short-termism, myopia, risk ignorance, herding).

1010

The CNB’s historical interpretation of financial stability

• The CNB’s approach to financial stability has historically been strongly macroprudential.

• Its objective is to ensure that the financial system does not become so vulnerable in the course of cycle that unexpected shocks ultimately cause financial instability in the form of a crisis.

Financial stability

Sound financial system

Yes: resilience No: vulnerability

Sh

oc

ks

Yes

No

Financialinstability

(crisis)

Financialvulnerability

Financialvolatility

1111

The CNB’s current interpretation of financial stability

• Robustness is the key to avoiding vulnerability. • For a bank-based system, robustness can be achieved via high loss

absorbency, strong liquidity, barriers to credit boom and plenty of luck. • Loss-absorbency:

• expected losses – sufficient provisions (Frait and Komárková, 2009),• unexpected losses – capital cushions,

• microprudential (Basel II) component,• countercyclical component (Frait, Geršl and Seidler, 2011; Geršl and Seidler,

2011),• cross-section SIFI component (Komárková, Hausenblas and Frait, 2012).

• Strong liquidity (buffers and stable funding) is essential way for limiting fragility of liabilites (Komárková, Geršl and Komárek, 2011).

• Some macroprudential tools for creating barriers to credit booms, excessive leverage are needed too.

1212

Financial stability vs. macroprudential policy

• The CNB considers macroprudential policy to be an element of financial stability policy (Frait and Komárková, 2011).

• the other part is microprudential oversight (regulation and supervision) • The main distinguishing feature of macroprudential policy is that unlike traditional

microprudential regulation and supervision (focused on the resilience of individual financial institutions to mostly exogenous events):• it focuses on the stability of the system as a whole; • it primarily monitors endogenous processes in which financial institutions that

may seem individually sound can get into a situation of systemic instability through common behaviour and mutual interaction,

• the objective of financial stability analysts is therefore avoid the risk of the fallacy of composition – wrong assumption that the state of the whole is the sum of the state of seemingly independent parts, for the trees the forest is not seen.

• Hanson et al. (2011) mark the microprudential approach as partial equilibrium conception while macroprudential approach as one in which general equilibrium effects are recognized.

13

Macroprudential policy components

• Macroprudential policy is comprised of application of macroprudential regulation and macroprudential supervision/surveillance for pursuing financial stability objective. • Macroprudential regulation – definition of rules and tools for their

enforcements for keeping systemic risk in reasonable level. • Macroprudential supervision/surveillance – macro-off-site

supervision consisting of monitoring of systemic risk, setting macroprudential instruments, issuing warnings and recommendations for microprudential regulation and supervision, or other policies.

1414

Macroprudential policy and systemic risk - objectives

• The macroprudential policy objective is to prevent systemic risk from forming and spreading in the financial system.

• Systemic risk has two different dimensions: • The time dimension (cyclical, conjunctural dimension) reflects the build-

up of systemic risk over time due to the pro-cyclical behaviour of financial institutions contributing to the formation of unbalanced financial trends.

• The second dimension is cross-sectional (structural dimension) and reflects the existence of common exposures and interconnectedness in the financial system.

• The experience commands that the time dimension of systemic risk has to be regarded as more important.

• Cross-sector dimension cannot be ignored especially due to the risk of contagion from domestic as well as foreign environment.

1515

Macroprudential policy and systemic risk - objectives

• The time and cross-sectional dimensions to a large extent evolve jointly and so cannot be strictly separated.

• Shin (2010) argues that increased systemic risk from interconnectedness of banks is a corollary of excessive asset growth and a macroprudential policy framework must therefore address excessive asset dynamics and fragility of bank liabilities. • In a growth phase of the financial cycle, rapid credit growth is accompanied by a

growing exposure of a large number of banks to the same sectors (usually the property market) and by increasing interconnectedness in meeting the growing need for balance-sheet liquidity.

• Financial institutions become exposed to the same concentration risk on both the asset and liability sides. This makes them vulnerable to the same types of shocks and makes the system as a whole fragile.

• When the shock comes, banks face problems with funding, their lending is tightened and all market participants try to sell their assets at the same time, which creates the downward spiral in both the financial and the real sectors.

• The time dimension shows up in degree of solvency, while the cross-sectional dimension manifests itself in the quality of financial institutions’ balance-sheet liquidity. However, solvency and liquidity are also interconnected, as liquidity problems often transform quite quickly into insolvency.

16

Macroprudential policy and systemic risk - definition

• The objective of macroprudential policy cannot be to secure financial stability at any point in time and prevent any stresses in financial system (make sure it never happens again), • pursuing such objective would lead to general elimination of risk-taking of

economic agents, innovations and economic dynamics. • Macroprudential policy can be defined as the application of a set of

instruments that have the potential to • increase preventively the resilience of the system, in the accumulation phase

of systemic risk, against the likelihood of emergence of financial instability in the future by

• creating capital and liquidity buffers, • limiting procyclicality in the behaviour of the financial system• containing risks that individual financial institutions may create for the

system as a whole.• mitigate the impacts, in the materialization phase of systemic risk, of

previously accumulated risks if prevention fails.

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II.Financial Cycle and Systemic Risk

18

Good times and virtuous cycle

• In good times the financial institutions and their clients may fail to price correctly the risks associated with their decisions or may even be incentivized to increase the extent of risk taken. • In such periods, access to external sources of financing improves

significantly - such access is more dependent on current risk perceptions on the side of both banks and their clients, which are strongly dependent on current economic activity.

• If economic agents start to misconstrue a temporary cyclical improvement in the economy as a long-term increase in productivity, virtuous cycle can start to develop, supported by an increased willingness of households, firms and government to take on a debt and use it to buy risky assets.

• This sets off a spiral (positive feedback loop) manifesting itself as a decreasing ability to recognise risk, trend growth in asset prices, weakened external financial constraints and high investment activity supported by output growth, increased revenue growth and improved profitability.

• In the background of this cycle, credit picks up, financial imbalances grow and systemic risk builds up unobserved.

19

Credit bust and vicious circle

• Systemic risk often shows up openly later on, when economic activity starts to weaken as a result of a negative stimulus.

• Recession subsequently sets in, opposite processes take place, and the spiral turns around. • Economic agents realise that their income has been rising at an

unsustainably high rate, they are burdened with too much debt, their assets have fallen in value and so they need to restructure their balance sheets.

• Both banks and their clients start to display excessive risk aversion and vicious circle gains momentum.

• To a large extent, the processes described above are as natural as the business cycle itself. • However, the financial imbalances can sometimes get too big and, as a

result, a dangerous vicious cycle can arise in the contraction phase. • If the desirable adjustment is combined with strong increase in general and

with fire-sales of overvalued assets, the downward movement can become extremely rapid and destabilising.

20

Conseptual approach to financial cycle

• The key concept describing the time dimension of systemic risk over financial cycle is leverage (the indebtedness of economic agents, stocks of loans, the ease of obtaining of external financing, the size of interest rate margins and credit spreads, etc..).

• The leverage (can be to some extent approximated by credit-to-GDP ratio):• increases until the financial cycle turns over, sometimes the turn is

disorderly and presents itself as the eruption of financial crisis. • then starts to decline, although in the early phase of the crisis remains high

(given falling nominal GDP it can even rise in the initial post-crisis years).• The deleveraging phase can therefore last several years, and in the event of

a deep crisis the leverage ratio can, after a time, fall below its long-term normal value. • Consequently, the leverage ratio adjusts to economic conditions after a

considerable lag, so stock measures have only a limited information value as a guide for the macroprudential policy response during the financial cycle.

• For this reason, forward-looking variables are needed that can be used to identify situations where the tolerable limit for systemic risk has been exceeded.

2121

Leverage over credit cycle – a slow motion process

• Conduct of macroprudential policy changes throughout financial cycle.

leverage

Good times (systemic risk accumulation): leverage phase with excess optimism

time

turning point (start of crisis)

Bad times (systemic risk materialization): deleveraging phase with excess pessimism

Normal level of leverage

Signal for macroprudential tools activation: forward-looking or leading indicators (credit-to-GDP gap, real estate prices gap …)

Discontinuity in marginal risk of financial instability: e.g.financial markets indicators (credit spreads, CDS spreads) or market liquidity indicators

Signal for termination of supportive policies: contemporaneous indicators (default rates, provision rates, NPL rates, lending conditions) and financial markets indicators

222222

Credit cycle and systemic risk – the case for forward-looking approaches

• In a credit cycle, systemic risk evolves differently in two stages: accumulation (build-up) and materialization (manifestation).

• Note the financial (in)stability paradox: a system is most vulnerable when it looks most robust.

period of financial exuberance

time

Build-up of systemic risk

marginal risk of financial instability

period of low current risk

time

degree to which risks materialise as defaults, NPLs and credit losses

Materialisation of systemic risk

period of financial distress

normal conditions

period of high current risk

2323

Good booms, bad booms and systemic risk

• It is difficult to convince people of the system heading into a big mess, after all a tranquil situation of this sort does not always mean that the financial system accumulates systemic risk dangerously. • A low level of risk indication can simply mean that a truly good and long-lasting boom is under way. • At any particular point in time it is likely that some indicators are giving contradictory results.• The financial instability paradox occurs only occasionally and irregularly.

• Still, the analysts have to keep in mind the risk of being trapped by the financial instability paradox, i.e. that unusually good values of current indicators signal a growing risk of financial instability. • One can be rather sure that if credit and some asset prices are going up quickly and moving away from historical norms, and both the quantitative and qualitative evidence indicates excessive optimism and mispricing of risk, there is a problem ahead, unless decision-making bodies take action.

Leading Indicators of Systemic Risk Accumulation in Ireland

Source: IMF.

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0

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60

I/00 I/02 I/04 I/06

credit-to-GDP gap (IE, %)real estate price gap (IE, %)

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Paradox in practice – the case of Irish boom and bustParadox in practice – the case of Irish boom and bust

• Remember Ireland – it looked so well in 2007:• real-estate-price gap and credit-to-GDP gap indicated exuberance,• sources of systemic risk may be increasing when banks and their clients consider their

business risks to be the lowest - non-performing loans ratio close to zero “indicated“ resilience.

Ireland (end 2007 vs. June 2010)(credit risk ratios in %)

Cove

rage

rati

o (p

rovi

sion

s to

NPL

s)

Non-performing loans ratio

Note: Size of the ring indicates relative volume of non-performing loansSource: Central Bank of Ireland

0%

20%

40%

60%

80%

0% 5% 10% 20% 25%

25

Paradox in practice – the case of Paradox in practice – the case of Czech credit Czech credit boomboom

• Bad loans are being created in good times.• „Good“ information about it comes in subsequent bad times.

Opravné položky a úvěry v selhání (v mld. Kč)(leden 2001-listopad 2011)

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opravné položky (mld. Kč) úvěry v selhání (mld. Kč)

Procyklické chování ekonomiky

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I/99 I/00 I/01 I/02 I/03 I/04 I/05 I/06 I/07 I/08 I/09 I/10

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tempo růstu úvěrů (mzr. v %)tempo růstu cen bytů (mzr. v %)tempo růstu HDP (mzr. v %)

26

III.Credit Risk and Cycle

27

Testing for credit risk determinants I

• The industry has a tendency to look at the credit risk level through the ratio of non-performing low to total loans (NPL ratio). • This itself provides a room for complacency in periods characterized by

increased economic activity and fast credit growth. • NPL ratio is a variable that may suffer from financial instability paradox.

• Empirical studies on credit risk determination (Hardy & Pazarbasioglu, (1998); Salas & Saurina (2002); Kalirai & Scheicher (2002), Delgado & Saurina (2004), Louzis et al. (2010); Vogiazas & Nikolaidou (2011), for example)), tend to confirm strong link between the phase of the business cycle, credit defaults and NPLs.

• We apply panel data methods to examine the determinants of non-performing loans (NPLs) in the Czech banking sector in order to investigate the effects of both macroeconomic and bank-specific variables on loan quality. • The exercise is not intended to identify the determinants of credit risk but to

demonstrate the how the NPL ratio evolves over a business cycle.

28

Variables:(i) macroeconomic: the growth rate of real GDP per capita (GDP), the

unemployment gap (difference between the unemployment rate and the long-term unemployment rate, UNEM); the spread between lending interest rate and three-month interbank interest rate (IR), exchange rate gap (difference between nominal rate and its Hodrick-Prescott trend, NER),

(ii) bank-specific: the ratio of non-performing loans to total loans (NPL), credit growth (LOANS),

(iii) other: „t“ denotes time and „i“ the individual banks (15).

Testing for credit risk determinants II

,,765431,2,1, ittitttttiiti LOANSNERIRUNEMGDPNPLNPL

• We focus on the determinants of NPLs in the Czech banking sector and use for estimation quarterly data for the period 1Q2001 – 1Q2014 including bank-by-bank supervisory data on NPLs and credit growth.

29

Testing for credit risk determinants III

Variable/Method FE1 GMM2

0.6997*** 0.7454***

(0.0773) (0.0677)

-0.0137 -0.0166**

(0.0088) (0.0075)

0.1000** 0.0963***

(0.0357) (0.0338)

-0.0014 -0.0011

(0.0011) (0.0009)

-0.0200 -0.0244

(0.0648) (0.0564)

0.0049* 0.0052**

(0.0024) (0.0025)

0.0466** 0.0422***

(0.0163) (0.0161)

R-squared 0.953400

No. of observation

No. of groups

Note: the first-differences used, ***, **, and * denote significance at 1 percent, 5 percent, and 10 percent, respectively. Standard errors are below coefficient

estimates in brackerts. 1We tested the panel data for non-stationarity using

the Hadri panel unit root test. 2Sargan test of overid. restrictions: chi2(6)=34.58, Prob>chi2=0.000, AR(1): z= -1.55, Pr>z=0.120, AR(2): z=1.26, Pr>z=0.207.

15.000000

780.000000

NPL (-1)

GDP

UNEM

LOANS

SIR

NER

CONS

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Testing for credit risk determinants IV

• Variables representing economic activity dominate while bank-specific variables do not appear significant.

• The macroeconomic variables have both expected signs (GDP negative and UNEM positive). • An increase in the real GDP growth leads to a decline in NPLs. • With respect to unemployment, the impact is also the one expected: an

increase in unemployment affects households’ ability to service their debts.

• Strong role of state of business cycle and its dynamics confirmed. • Once recession strikes, credit risk goes to the light.

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IV.Systemic Risk Indicators

3232

Prevention and forward-looking indicators

• The main task of financial stability analysis as regards prevention is timely identification of the risk of financial instability – the marginal contribution of the current financial environment to the build-up of risks of a future financial crisis. • In this phase, macro-prudential analysis must be focused primarily on the

identification of hidden risks to financial stability being generated in the balance sheets of financial intermediaries and their clients.

• Analytical attention, however, must also be paid to the quality of cash flows, as financial institutions with structural problems in their balance sheets, weak balance-sheet liquidity and long maturity transformations are naturally far more prone to cash-flow problems.

• Authorities need a set of forward-looking indicators providing information on the possibility of materialisation of systemic risk in the future as a result of currently emerging financial imbalances. • This refers mainly to “gap” indicators based on the assessment of deviations of

factors determining the degree of leverage from their equilibrium or normal values.• As regards the possibility of using forward-looking indicators to construct early-

warning systems, we feel that their information value and practical applicability remain limited.

• Beware of financial markets‘ data signals – IMF, ESRB ….. • Analytically, it is also possible to use the FS paradox – extremely good values of

parallel indicators tell us that something strange is going on in the system.

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Mitigation and identification of discontinuities

• In the systemic risk materialisation phase, the macroprudential policy focus must be shifted to mitigating the impact of the crisis. • In this phase it is vital to assess the scale of the risk materialisation problem and

the resilience of the financial system.• Stress tests of the financial system’s resilience are a suitable analytical instrument

for performing this task. • Macroprudential analyses must take into account the high degree of

discontinuity in the evolution of systemic risk – the potentially sharp transition from good to bad times. • To this end it is necessary to construct indicators characterising the start and end of

the materialisation of financial instability. • In a small open economy, financial or informational contagion resulting from the

links between an economy and its institutions and the external environment can be a major source of materialisation of systemic risk and of discontinuity in the evolution of such risk.• The analytical approach will differ significantly from country to country (share of

foreign ownership of financial institutions, dominance of subsidiaries or branches of foreign banks, share of foreign currency loans, net external and foreign exchange position of the banking sector and entire economy...).

3434

Countercyclical capital buffers – the example of policy

period of financial exuberance

time

Credit-to-GDP over financial cycle

turning point (start of crisis): credit-to-GDP still very high, but policy has to change sharply

period of financial distress

long-term „normal“ level of credit-to GDP

period of financial exuberance

time

Credit dynamics (e.g. y-o-y growth)

period of financial distress

turning point (start of crisis): credit growth falls, lending conditions tighten

CCB set to zero

CCB set to zero again

CCB set at maximum 2,5 %

• Policy of countercyclical capital buffers should follow the developments of leverage over financial cycle and associated risk for financial stability.

35

How to Tell Normal Times from the Not So Normal Ones

• The key feature of a financial exuberance period, in addition to the availability of cheap credit, is the emergence of overly optimistic expectations about future income and asset prices leading to extra risk appetite and excessive risk-taking.

• Financial distress period - in addition to the limiting the availability of credit, economic agents become over-pessimistic.

• To identify the onset of or exit from not so normal times - the gaps based on the indicators‘ level relative to their long-term average or trend reveal the story: • credit growth, credit-to-GDP;• debt-to-income, debt-to-assets dynamics; • money market risk premia, credit spreads and CDS spreads; • financial investors’ lever length; • length of maturity transformation by banks;• lending standards, credit risk gauges, ...

• Bad news: systemic risk cannot be measured/predicted precisely!

3636

Financial Stability Indicators Matrix

Phase Dimension

Time (cyclically induced risks) Risk accumulation

Cross-sectional time (structurally induced risks)

Time Risk materialisation

Cross-sectional

Note: The table contains a list of selected indicators. Many of these tools can be directed at both the time and cross-sectional component of systemic risk. The table gives the predominant target. Sector abbreviations: H – households, C – corporations, F – financial institutions, P – property market, M – financial markets, G – government. No abbreviations are shown next to indicators

that are valid for the economy as a whole. Underlined indicators are ones that we consider important for CNB analysis.

3737

Financial Stability Indicators

Indicators – Accumulation, Time credit-to-GDP (deviation from long-term trend or normal) rate of growth of loans and asset prices gaps in asset prices and yields (deviations from long-term trend or normal) leverage ratio (F) default rate, NPL rate (F) level and adequacy of provisions (loan-loss provision rate, coverage ratio, F) credit conditions and characteristics of new loans from BLS (F) credit spreads and risk premia (F) haircuts on collateralized lending (F) debt-to-assets ratio (H,C) debt-to-income ratio (H,C) interest-to-income ratio (H,C) price-to-income ratio (P) loan-to-value ratio (P) price-to-rent ratio (P) market liquidity in the form of market turnover (P) macro stress tests of markets and credit risks (F) early warning systems (F) composite indicators of financial stability or leverage level (F) macroeconomic imbalance indicators (government deficit and government debt,

current-account deficit and external debt, national investment position, foreign exchange reserves, external financing requirements, currency under- or over-valuation)

3838

Financial Stability Indicators

Indicators – Accumulation, Structural quality of liquidity structure (loans-to-deposits ratio, customer funding gap, ratio

of funds acquired on interbank market, F) ratio of non-core liabilities to total funding (F) maturity transformation ratio (maturity mismatch indicators, F) capital quality structure (F) liquidity stress tests (F) composite liquidity index (F) indicators of scale of activity within financial system, including network analyses

(e.g. flows between institutions, F) degree of asset and liability concentration (F) share of large exposures in balance sheet (F) share of riskier loans in within specific classes (interest-only mortgages, F) scale and structure of off-balance-sheet items (F) bank foreign debt to bank foreign asset ratio (net external assets of banks, F) currency mismatch indicators (open foreign exchange position, share of foreign

currency loans, F) composite volatility index (M) macroeconomic imbalance indicators (capacity for external contagion shock)

3939

Prevention and indicators

• When assessing systemic risk during the accumulation phase, the authorities have to build upon a comprehensive analysis of a set of indicators. • they must first of all reach a general consensus on the normal or sustainable

values of the relevant indicators (the ones deemed highly relevant for the CNB are underlined)

• and then continuously assess whether the deviations of the actual values from their normal levels are becoming critical.

• they also have to pay attention to recognition of the types of likely shocks, estimating their probabilities and potential impacts.

• The difficulties in reaching a consensus create a risk of delayed activation, leading to an insufficient and inefficient policy reaction. • imprecise timing of activation can result in overshooting or undershooting of

macroprudential objectives. • It is therefore crucial to assess, on a continuous basis, the position of the

economy in the financial cycle. • This is the crucial determinant in guiding the activation and release of

macroprudential tools in both stages of the cycle (preventive activation, deactivation of preventive tools if possible, release of buffers and other tools plus activation of anti-crisis measures, deactivation of anti-crisis measures).

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Scenarios for the Activation and Release of Macroprudential Instruments

Stage of financial cycle Bust

Boom With crisis Without crisis

Strong Tighten No change or release Other

macroeconomic conditions Weak

No change or tighten

Release (if possible) Tighten (only if

necessary)* Release

* The case of the euro area in 2011–12 demonstrated that if banks end up without capital buffers and markets lose confidence in their stability, the authorities may be forced to resort to requiring additional capital even though this would normally constitute unwelcome tightening of policy during a crisis.

Source: CGFS (2012, p. 5) The evolution of systemic risk and conduct of macroprudential policy over the financial cycle

Leverage

Good times (accumulation of systemic risk): phase of increasing leverage with excessive optimism

Time

Turning point (or outbreak of crisis)

Bad times (materialisation of systemic risk): phase of deleveraging with excessive pessimism

Normal leverage level

Signal to activate macroprudential policy: forward-looking indicators credit gap or property price gap…

Discontinuous change in marginal risk of financial stability: e.g. financial market indicators (credit spreads, CDS spreads) or market liquidity indicators

Signal to end support policies: current indicators (default rate, NPL ratio, provisioning rate, lending conditions) and financial market indicators

A case of cycle without a crisis

4141

Prevention and indicators

• It is undoubtedly quite difficult to distinguish normal cyclical fluctuations and long-term trends from a dangerous financial cycle in timely fashion. • At any particular point in time it is likely that some indicators are

giving contradictory results. • As to the build-up of systemic risk, one can be rather sure that if

credit and some asset prices are going up quickly and moving away from historical norms, and both the quantitative and qualitative evidence indicates excessive optimism and mispricing of risk, there is a need to send out a clear warning and recommend that decision-making bodies take action.

4242

Materialization and indicators

• If prevention is not sufficiently effective and a systemic risk materialisation phase occurs, the macroprudential policy focus must be shifted to mitigating the impact of the crisis. • The easiest job for financial stability analysts may be to identify a critical

point (outbreak of crisis) in a simultaneous economic and financial boom since the onset of a crisis tends to be clearly visible thanks to a sharp deterioration in market variables (e.g. credit spreads or CDS spreads).

• In the systemic risk materialisation phase, it is vital to assess the financial system’s ability to withstand the emerging risks. • The analyses will have to extend their focus to the short-term risks

associated with adverse economic developments.

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Financial Stability Indicators Matrix

Indicators – Materialization, Time dynamics of default rate and NPL ratio (F) dynamics of provisioning (coverage ratio, LLPR, F) decline in profitability (F) change in CAR (F) macro stress tests of markets and credit risks (F) credit spreads (H,C,G,M)

Indicators – Materialization, Structural stress tests of liquidity (F) changes in market liquidity measures (M) activity and spreads on interbank money market and government bond market (F) CDS spreads (F) interbank contagion tests (F) CoVaR (F) joint probability of distress (F) contingent claim analysis (F)

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V. Instruments of Macroprudential Policy

45

Macroprudential policy and systemic risk - tools

• True (genuine) macroprudential tools are those which can be applied in the form of rules and can therefore take the form of built-in stabilisers. • They should automatically limit the procyclicality of the financial

system or the risky behaviour of individual institutions.• They should be explicitly focusing on the financial system as a

whole and endogenous processes within it. • In addition to true macroprudential tools, various microprudential

regulatory and supervisory tools can be used for macroprudential purposes. • If these tools are applied not to individual institutions, but across the

board to all institutions in the system, they can be regarded as macroprudential instruments.

• Measures of this type, along with monetary policy tools, fiscal policy tools and tax measures, have been applied in many countries in the past in an effort to slow excess credit growth.

46

Prevention vs. reaction in micro- and macro-approaches

• Microprudential approach (for example banking supervision): • Prevention through enforcement of compliance rules and regulations

of prudential behaviour. • Reaction when breaching of the rules/regulations is identified and

when prudential indicators got worse. • Macroprudential approach:

• Prevention not based on rules and regulations, but on analyses and indicators of systemic risk (as with monetary policy).

• Prevention can work only through timely and forward-looking action. • Paradox of financial (in)stability - corrective action must therefore

occur in good times (as with monetary policy).

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• Flagship Report and Handbook on Macro-Prudential Policy in the Banking Sector published in March 2014 • Flagship Report provides overview of the new macro-prudential policy framework

in the EU. • Detailed handbook which is aimed at assisting macro-prudential authorities to

use the new instruments.

ESRB‘s key product of 2013 and 2014

Objective: Address Systemic Risk

Excessive credit growth & leverage

Indicators Credit-to-GDP gapHousing credit,housing prices

Key Instruments:Counter-cyclical Capital Buffer

Capital instruments:- by sector (realestate, intra-financial)- Systemic risk buffer- Leverage ratio

LTV / LTI caps

Broad Transmissionchannels:

Resilience of banks; contribute to curbing excessive (sectoral) credit

growth

Resilience households, mitigate pro-cyclicality

mortgage credit

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Instruments of macroprudential policy

Source of systemic risk (of vulnerability) Appropriate tool

Undue leverage Excessive credit growth accompanied by lenient

lending practices

Countercyclical capital buffer Through-the-cycle provisioning LTV and LTI (PTI) limits Leverage ratio Increased risk weights for specific sectors

Shortage of quick liquidity Maturity mismatches regarding asset and

liabilities Unstable structure of bank funding

LCR NSFR LTD ratio or core funding ratio

Excessive interconnectedness of financial institutions

Complexity and opacity of financial sector Reliance on bail-out of large and important

institutions

SIFI capital surcharges Systemic risk capital surcharges

Excessive concentration in assets or liabilities of financial institutions

Large exposure limits

• A consensus regarding the key sources of systemic risks and appropriate policy tools has emerged. • Reflected in the ESRB‘s Flagship Report and Handbook on Macro-

Prudential Policy in the Banking Sector published in March 2014.

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Macroprudential policy and systemic risk – tools I

50

Macroprudential policy and systemic risk – tools II

51

V.Conclusions

5252

The limits of macroprudential policy

• The preventive objective of macroprudential policy is not to sweep any risk out of financial system • it can only be to try to build barriers against the occasions when firms and

households take on risks that they are not able to identify or price correctly owing to wide-spread exuberance in the financial system;

• such barriers may limit the potential for mass of occurrence of wrong investment decisions leading to debt deflations etc.

• The central bankers may not be able to prevent from financial upswings and imbalances• but they can and set boundaries for prospective damages through applying

counter-cyclical tools. • At the same time central bankers should not try to assist the agents to

get from their wrong decisions too easily – this would just provide the incentive to excessive risk-taking in the next financial cycle.

• Paradox of financial instability thus sets clear limits for central bankers too – the push for undue stability may produce destabilizing effects in the long run.

5353

Proper analyses, courage and luck needed

• The importance of the analyses of risks associated with current policies and developments for future financial stability has been recognized.

• Owing to financial instability paradox, most indicators of actual credit and market risks are not much useful for detecting probability of systemic risk materialization in the future: they are not forward-looking.

• The analyses of financial stability risks must not be mechanical, relying too much on formal EWS, DSGE-like models, indicators from financial markets: deviations from equilibrium, non-linearities, discontinuities, failures of efficient market hypothesis have to be taken into account.

• All relevant pieces of information have to be assessed through fundamental analysis drawing upon economic theory and history: there is a role for judgment by experienced experts in telling good booms from the bad ones.

• The success in macroprudential policy-making will still require plenty of courage, communication skills and luck.

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References

• Frait, J., Komárková, Z. (2009): Instruments for curbing fluctuations in lending over the business cycle. Financial Stability Report 2008/2009, Czech National Bank, pp. 72-81.

• Frait, J., Komárek, L., Komárková, Z. (2011): Monetary Policy in a Small Economy after the Tsunami: A New Consensus on the Horizon? Czech Journal of Economics and Finance 61, No. 1, pp. 5-33.

• Frait, J., Komárková, Z. (2011): Financial stability, systemic risk and macroprudential policy. Financial Stability Report 2010/2011, Czech National Bank, pp. 96-111.

• Frait, J., Komárková, Z. (2012): Macroprudential Policy and Its Instruments in a Small EU Economy. Czech National Bank Research and Policy Note, 3/2012

• Frait, J., Gersl, A., Seidler, J. (2011): Credit growth and financial stability in the Czech Republic. World Bank Policy Research Working Paper; no. WPS 5771 2011/08/01 August 2011

• Gersl, A., Seidler, J. (2011): Excessive credit growth as an indicator of financial (in)stability and its use in macroprudential policy. Financial Stability Report 2010/2011, Czech National Bank, pp. 112-122.

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• Komárková, Z., Hausenblas, V., Frait, J. (2012): How to identify systemically important financial institutions, Financial Stability Report 2011/2012, Czech National Bank, pp. 100-111.

• Skořepa, M., Seidler, J. (2013): An Additional Capital Requirement Based on the Domestic Systemic Importance of a Bank, Financial Stability Report 2012/2013, Czech National Bank, pp. 96-102.

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