TWN Info Service on Finance and Development (May10/05)
measures and challenges for central banks
Furthermore, in developing macro-prudential policy frameworks further, the design choices open to authorities will depend on their economic and financial system structures, as well as prevailing law and market practices (implying perhaps that a one-size-fit-all, global framework may be difficult).
These were some of the observations made by the Committee on the Global Financial System (CGFS) in a report titled "Macro-prudential instruments and frameworks: A stocktaking of issues and experiences."
[The term "macro-prudential regulations" (as different from micro-prudential regulations, used more commonly for monetary policy) has come into vogue, and is often used by central bankers, legislators, regulators, and the financial media - without explaining what the term means.
[Even experts don't seem to agree. In a comment in the Financial Times on 19 May (on the British conservative-liberal coalition government and its financial regulatory policies), Howard Davies (director of the London School of Economics) and David Green, former head of international policy at the UK Financial Services Authority, have said: "No one is yet clear, nationally or internationally, quite what this term involves", but suggest it involves measures of counter-cyclical reserving or provisioning.
[In setting out at the end of the paper what it calls "open issues", the CGFS in effect makes clear that the current global discussions on macro-prudential measures and a framework really involve many areas that are not fully clear, much less developed and tested than monetary policy frameworks (where central banks have had considerable experience), nor is it easy to deduce them from experience, involving as they do systemic issues and failures.
[In a sense, it is
a reminder of former US Defence Secretary Donald Rumsfeld's (often erroneously
cited and derided) remarks on
The CGFS report analyses the issues facing central banks as macro-prudential policy frameworks are strengthened, and discusses macro-prudential policy objectives, different instrument types, and issues relating to policy conduct.
As part of its work, in late 2009, the CGFS surveyed central banks on their conceptions of macro-prudential policy and their use of macro-prudential instruments. It also held a workshop for central banks in February 2010 on the use of macro-prudential instruments relating to property lending markets, many of which have been applied in emerging economies.
CGFS Chairman Donald L Kohn said that the report would be a relevant and timely input to the national and international discussions about strengthening the financial system.
Among the tentative lessons that the report draws from practical experience are that as macro-prudential policy frameworks are much less developed and tested than monetary policy frameworks, they should not promise more than they can deliver.
To date, says the report, approaches have been pragmatic, based on judgmental and discretionary use of existing instruments that are already used for other, usually micro-prudential, purposes.
These include existing micro-prudential and system liquidity management tools such as LTV (loan-to-value) ratio caps, capital requirements, reserve requirements and dynamic provisioning systems. Such instruments have been deployed from within their current institutional settings, and with close supervisory involvement.
Macro-prudential interventions have generally taken place in response to specific sectoral developments rather than at a system-wide level.
Authorities who use macro-prudential instruments express some confidence that they have been successful in enhancing the resilience of their financial systems. There is some evidence that such measures have led to some, at least temporary, cooling of excesses in the particular markets to which they have been applied.
"It is too early to say whether the small number of explicit macro-prudential loosening measures undertaken so far will be effective in promoting credit expansion during a period of widespread retrenchment in lending."
The report however notes that many open issues remain in the development of a fully fledged macro-prudential framework that delivers the promise of more effective stabilisation policy. Some of the issues are empirical, while others relate to operationalisation.
"And, at this early stage in our experience with macro-prudential policy, it is quite possible that effective instruments beyond the current toolkit might be developed. Several initiatives at the national and international level are exploring new instruments."
The report also underscores that institutionalisation of the aim of leaning against the financial cycle is still some way off, as is the related task of operationalising instrument usage resolutely to that end. Some of the more difficult open issues relate to this aim in particular.
The empirical issues include the effectiveness of the instruments through the cycle. As noted, most experience is with adjustments during the boom phase. There are a few examples where macro-prudential instruments have been loosened in response to the crisis, but it is too early to tell how effective they have been in promoting, rather than constraining, lending and risk-taking.
It is uncertain whether a more activist approach to operating the instruments would actually be effective in moderating the financial cycle. The micro-based instruments and measures adopted to date have mostly not been used in a way that could seriously limit aggregate credit growth or dampen asset prices. Most interventions have so far focused on specific sectors, motivated largely by a desire to ensure the resilience of the financial system. If macro-prudential instruments were used more actively and ambitiously to moderate the financial cycle, questions would naturally arise whether and how far they were also stifling innovation and growth.
According to the report, another open question is how frequently instruments would need to be adjusted in an activist approach. Authorities have tended to vary macro-prudential instruments at intervals of a few years, but there appears to be a spectrum of activism in this respect.
The global financial crisis has prompted a careful review of a wide range of policy areas. In many cases, micro-prudential supervision failed to ensure that financial institutions had sufficient capital and liquidity to cope with the shock. The efficacy of monetary policy in responding to system-wide financial risk in an environment of stable inflation was, and still is, under debate.
The issue of how to define and develop the macro-prudential element of financial stability policy has attracted particular attention. Policymakers broadly agree that the purpose of macro-prudential policy is to reduce systemic risk, strengthening the financial system against shocks and helping it to continue functioning stably without emergency support on the scale that was extended in the crisis. Preventative in its orientation, macro-prudential policy is distinct from financial crisis management policy.
Views vary on how macro-prudential policy should be defined and implemented, says the report.
Central banks have a stake in macro-prudential policy. First, they are seen as bearing important responsibilities for financial stability, if sometimes only implicitly so. Second, the objectives, instruments and conduct of macro-prudential policy are part of an overall economic and financial stabilisation function that includes monetary policy. Successful macro-prudential policy and monetary policy can reinforce each other to stabilise the economy.
In articulating the practical objectives of macro-prudential policy, the report notes, two aims might be distinguished. The first is to strengthen the financial system's resilience to economic downturns and other adverse aggregate shocks. The second is to actively limit the build-up of financial risks. Such leaning against the financial cycle seeks to reduce the probability or magnitude of a financial bust.
These aims are not mutually exclusive, the report observes. They both go beyond the purpose of micro-prudential policy, which is to ensure that individual firms have sufficient capital and liquidity to absorb shocks to their loan portfolios and funding. Macro-prudential policy takes into account risk factors that extend further than the circumstances of individual firms. These include shock correlations and the interactions that arise when individual firms respond to shocks. Such factors determine the likelihood and consequences of the systemically important shocks that macro-prudential policy seeks to mitigate.
Another observation is that a key part of developing macro-prudential instruments is to adapt existing micro-prudential tools, such as strong prudential standards (for example, requirements to hold high capital and liquidity buffers) and limits on activities that increase systemic vulnerabilities and risks.
"Existing micro-prudential instruments could be used for promoting financial system resilience. They can be re-calibrated to limit the financial system's exposure or vulnerability to shocks. Instruments in this category include capital and liquidity requirements with a 'buffer' character, limits on leverage in particular types of lending contract, constraints on currency mismatches, or measures that strengthen financial infrastructure."
Leaning against the financial cycle requires instruments that can be varied actively and calibrated quantitatively. They might apply narrowly to sectors where systemically relevant imbalances are developing, or more broadly to intermediaries and markets across the financial system when financial excesses are more generalised. Ideally, the instruments should be effective in leaning against both the upswing and the downswing. In the latter phase, their task would be to avert a generalised fall-off in risk appetite and credit.
Few potential instruments appear to exist with these characteristics, but work is under way in international forums to develop them, says the report, noting that the Basel Committee on Banking Supervision is considering the introduction of measures to promote the build-up in good times of capital buffers that can be drawn down in periods of stress.
According to the report, by definition, macro-prudential risks can be diagnosed only by reference to measures of systemic vulnerability, even though sectoral developments may also form an important part of the information set. The measures might comprise system-wide counterparts of familiar financial risk measures such as leverage, maturity or currency mismatches, and the correlation of exposures across institutions and other measures of interconnectedness.
Also important are measures of system-wide financing conditions, such as aggregate or sectoral credit growth, the credit/GDP ratio and inflation in asset prices. For all such measures, the imbalances or excesses need to be identified, as distinct from fundamentals-driven cyclical fluctuations and longer-term trends.
Policymakers will be unable to lean against the cycle effectively unless they can first identify the build-up of financial risks. Even when excesses are evident, it might be difficult to assess the consequences for the real economy and weigh them against the effects of tighter macro-prudential policy. Moreover, the need to take timely policy action increases the risk of diagnostic error.
Evidence of financial imbalances and vulnerabilities will need to be sought at both the aggregate and dis-aggregated levels. Such evidence might be more apparent at the sectoral level, given that imbalances and exposures do not typically develop evenly across the financial system or sectors of the real economy. The difficulty of aggregating sector-specific measures into credible evidence of an overall macro-prudential problem might lead policymakers to take action mainly at a dis-aggregated level, even though the actions might be motivated primarily by macro-prudential concerns. The danger here is that the intent of macro-prudential policy might not be clear.
A further risk is that policy measures will not be applied uniformly and proportionately across sectors. Specific measures that might be taken to reduce these risks include supervisory guidance statements and other public communication devices, as well as "horizontal" reviews and stress tests.
Experience with monetary policy suggests that policymaking works best when it is fairly predictable and transparent. The same is likely to hold true for macro-prudential policy, says the report, suggesting that when leaning against the financial cycle, where timely policy action is particularly important, explicit guidelines or well-articulated principles for macro-prudential policy actions should help to counter political and institutional resistance.
"A crisis that is successfully averted by macro-prudential policy leaves no traces. This makes it difficult to judge how well policymakers might have strengthened the resilience of the financial system. The uncertainties surrounding macro-prudential assessment mean that policy will inevitably have to be conducted with a considerable degree of judgment and discretion."
Policymakers need to manage regulatory instruments in ways that counter avoidance and regulatory arbitrage, and they also have to keep up with innovation and structural change. These issues are especially pronounced for instruments that will be used in highly integrated and substitutable financial markets.
Macro-prudential policy will raise questions of fairness both at home and abroad. Within a single jurisdiction, the playing field can be kept level by applying macro-prudential interventions broadly across the financial system. This approach works less well across borders, however, given that financial cycles are not often synchronised between jurisdictions.
Furthermore, cross-border financial activity can undermine the effectiveness of national macro-prudential policy. Problematic financial activity in one jurisdiction might be caused by institutions domiciled in a different jurisdiction, where there is no concurrent macro-prudential problem and where the macro-prudential authority has no motive or legal capacity for taking action.
According to the report, there are limits to how far macro-prudential policy can be coordinated internationally. Close international cooperation to enhance domestic resilience is likely to prove more practicable than a coordinated approach to leaning against the cycle. Successful monetary policy and macro-prudential policy are likely generally to reinforce each other.
Measures to strengthen the resilience of the financial system reinforce monetary policy by shielding the economy from sharp financial disruptions. Conversely, macroeconomic stability reduces the financial system's vulnerability to pro-cyclical tendencies. Overall, official interest rates probably need not move as much as would be required in the absence of policy coordination.
"Of course, it is unrealistic to expect the combination of monetary and macro-prudential policies to completely eliminate the economic cycle. The objective would be to moderate the cycle and increase the resilience of the system."
In most economies, the report notes, macro-prudential policy frameworks are at an early stage of development.
They have been implemented using existing micro-prudential monetary policy and liquidity management mandates and institutions. And, macro-prudential interventions have taken the form of adjustments or add-ons to instruments already used for micro-prudential or liquidity management purposes.
To date, most experience with macro-prudential policy has focused on judgmental, rather than rules-based, use of instruments. The aims have mostly been to enhance financial system resilience rather than to moderate aggregate financial cycles, though there are examples where instruments have been used with a flavour of both aims.
The evidence for effectiveness is tentative. The independent effect of macro-prudential instruments is hard to isolate, given that they have come into use only recently in most cases, and often in conjunction with other stabilisation measures such as monetary policy responses. Authorities that have used them generally report that they helped to protect the financial system from downturns, but made a lesser contribution to moderating the financial cycle.
To date, macro-prudential
instruments have been used mainly to limit the amount of credit supplied
to specific sectors seen as prone to excessive credit growth, especially
property investment and development. In addition, some emerging market
economies have used reserve requirements to prevent the build-up of
domestic imbalances arising from volatile cross-border capital flows.
Measures targeting the size and structure of financial institution balance
sheets for macro-prudential purposes have been less common, with the
The report cites a survey undertaken by CGFS at the end of 2009 of central banks on the use of macro-prudential instruments in their economies. The survey covered the definition of macro-prudential instruments, their categorisation, and objectives for their use. Some 33 central banks responded to the survey.
According to the report, the CGFS survey showed that macro-prudential instruments or interventions had been widely applied. They had targeted a variety of problems arising from the financial system and financial behaviour, at both aggregated and highly sector-specific levels. Most respondents had a broad concept of what constitutes a macro-prudential instrument.
Survey responses indicated that conceptions of macro-prudential policy aims and objectives are fuzzy.
Respondents generally agreed that the objectives include strengthening the financial system's resilience and containing the build-up of risk within it. "However, there was no common, or widely shared, formal definition of macro-prudential policy objectives."
Comments on the relationship with other policy areas emphasised the complementarity with monetary policy. Macro-prudential instruments were viewed as more effective than monetary policy in addressing specific imbalances. Many emerging market economies viewed capital controls also as a means of gaining monetary policy flexibility in the context of an exchange rate band.
A broad range of instruments has been used to address system-wide financial risks, including many tools normally used for other purposes. These include micro-prudential instruments that have been applied to the system as a whole, fiscal measures such as financial transaction taxes, and central bank tools used for system liquidity management.
The most widely used instruments have been measures to limit credit supply to specific sectors that are seen as prone to excessive credit growth. These include various restrictions on mortgage lending (caps on LTV ratios or debt/income ratios) and credit card lending limits. Some emerging market economies have used reserve requirements to prevent the build-up of domestic imbalances arising from cross-border capital flows.
The survey suggested that there are grey areas in regard to what counts as a macro-prudential instrument. "This should not be surprising, given that all instruments contemplated to date are derived from other policy areas with their own distinct objectives. The intent of the policymaker appears to have strongly influenced whether an instrument is considered macro-prudential."
Most of the instruments in use or under consideration apply to banks or deposit-takers. This probably reflects a pragmatic focus by the authorities on institutions that sit at the core of the financial system and are already subject to both micro-prudential regulation and supervision, and liquidity management interventions by central banks.
Reflecting the relatively broad experience with measures relating to property lending, the CGFS hosted a workshop in February 2010 to discuss the practical experience with property-related measures across a number of economies. The workshop focused on the use of loan-to-value (LTV) caps, debt servicing/income ratios, capital requirements and other measures related to property lending.
Discussions underscored that macro-prudential policy and instrument choices depend on financial system structure, as well as on law and market practices regarding property lending. A heavy exposure of the financial system and economy to property market cycles and a marked tendency for property markets to respond to liquidity fluctuations were common features among economies that have used these measures.
Most, but not all, were emerging market economies in which property lending is dominated by banks that retain the loans on their balance sheets rather than securitising them.
Macro-prudential policy seems to be especially important for economies that are constrained by fixed or managed exchange rate regimes from using monetary policy for stabilisation purposes. Changes in (domestic currency) reserve requirements have commonly been seen as part of the toolkit for the implementation of monetary policy or exchange rate policy. Especially in emerging market economies in response to large ebbs and flows in foreign capital, more attention is being focused on the use of reserve requirements to moderate the financial cycle.
A number of economies have also imposed reserve requirements on foreign currency funding of financial institutions. Here, the macro-prudential concern is more directly related to currency mismatch and foreign currency liquidity vulnerabilities that may be generated in the banking system through such funding.
According to the report,
as an example of a macro-prudential instrument, statistical or dynamic
provisioning has been applied in
Banks are required to set aside provisions during phases of rapid credit expansion according to a formula. The measure anticipates the impairments that will arise when the economy turns down and credit retrenchment appears.
In brief, the report concludes, the instrument is seen as having successfully protected banks from the risk of under-provisioning during the boom phase. It was less effective, however, in moderating the financial cycle. +