The role of capital requirements in macroprudential policy
Javier Suarez
CEMFI
Conference on Financial Stability and Macroprudential Policy
Banco de Portugal, 10 February 2015
1
Introduction
• Macroprudential policy is a reality (authorities+tools)
• The goals are clear
• We are in a hurry to complete the institutional architecture
2
• Pressure to respond to prior weaknesses has produced an overly complex architecture
• There has been no time to fully understand foundations, implications, degree of substitutability, and the most suitable calibration of
the candidate tools
• It is unclear questions on their “expected effects” and “when to
activate them” can be properly answered at the moment
3
• We understand what the macroprudential approach is meant to be,
but I am not sure we know which tools should be truly assigned to
macroprudential policy
• Is it all about touching specific tools? Or about fine-tuning structural
regulations taking the macroprudential trade-offs in mind?
• We now face a long learning-by-doing period in the implementation
of macroprudential policy
4
• In this setup, analytical frameworks constitute the other big alternative to advance in the process
— They can help explore the logical connections between candidate
tools and the moving parts of the system
— They can assist in the design and communication of the new
policies and improve their accountability
• The development of these frameworks is still at its infancy but has
already yielded some valuable fruit
5
• I am going to devote the rest of my talk to comment on papers that
I know first hand
• They deal with capital requirements (CRs) and the convenience or
not of cyclically adjusting them
• Some of the unexpected results of these papers constitute a call-forcaution
• I will conclude with a critical assessment of the results and a brief
thought on the debate about rules vs. discretion in macroprudential
policy
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Paper 1 (“The Procyclical Effects of Bank Capital Regulation” with
R. Repullo, Review of Financial Studies, 2013)
• Analyzes the procyclicality induced by capital requirements in a
model of relationship banking with a simple time structure
— Borrowers need loans for two consecutive periods and become
dependent on their initial lenders (banks)
— These lenders cannot issue equity in between the two periods and
may lose the capital needed to extend the 2nd period loans
• As a precaution, banks may start holding voluntary buffers of capital
on top of the regulatory minimum (γ s)
• The credit cycle is captured as 2-state Markov chain for the PDs of
the loans (s=l: low PD; s=h: high PD)
⇒ the IRB approach implies γ h > γ l
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• Basel II produces larger expected credit rationing than Basel I (esp.
after s=h) but, importantly, it also reduces the probability of bank
failure (esp. in s=h)
• Net impact on welfare depends on the social cost of bank failure (c)
W 0.0975
0.0925
0.0875
0.0825
0.00
0.10
0.20
0.30
Basel I
Laissez-faire
0.40
0.50
Basel II
Optimal requirements
0.60
c
— Basel 1 Â Basel II for very low c
— Basel II requirements ' socially optimal γs for c ' 0.25
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Optimal γ s vs social cost of bank failure c
8%
γs
7%
6%
5%
4%
3%
2%
1%
0%
0.00
0.10
0.20
0.30
0.40
0.50
0.60
c
Basel II, s=l
Optimal, s=l
Basel II, s=h
Optimal, s=h
[Basel III seems a good idea for c > 0.30:
optimal γ s are higher but less cyclically varying]
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Paper 2 (“Banks’ Endogenous Systemic Risk Taking” with D. MartinezMiera, 2014)
• Simple macroeconomic model where some investments fail when a
rare event occurs
• Systemic risk results from banks’ voluntary exposure to these investments, which are attractive to them due to standard risk-shifting
incentives of levered firms [“Heads we win, tails you lose”]
• Although systemic risk taking is unobservable ex ante, a capital requirement (γ) helps ameliorating banks’ gambling incentives through:
— Standard leverage-reduction effect
— A last bank standing effect (Perotti-Suarez 2002): bankers’ greater
incentive to preserve wealth when other bankers are losing it
[Bankers’ wealth e is needed for banks to comply with CRs]
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Equilibrium dynamics with low and optimal γ
Equilibrium dynamics (CR=7%)
Equilibrium dynamics (CR=14%)
3
3
2.5
Dynamics if shock realizes
Dynamics if shock realizes
Aggregate bank capital at t+1
Aggregate bank capital at t+1
Dynamics if no shock realizes
Dynamics if no shock realizes
2.5
45-degree line
2
1.5
1
0.5
45-degree line
2
1.5
1
0.5
0
0
0
0.5
1
1.5
Aggregate bank capital at t
2
2.5
0
(γ =7%)
0.5
1
1.5
Aggregate bank capital at t
2
2.5
(γ =14%)
• With higher CRs bankers gamble less and a shock implies a lower
loss of bankers’ wealth e (aggregate bank capital)...
• But levels of economic activity are lower ⇒ interior optimal γ
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What happens if γ is cyclically adjusted?
[higher when e is high, lower when e is low]
• The partial equilibrium logic points to a decline in the credit crunch
that follows a systemic event
• However, the adjustment weakens the last bank standing effect and
banks, in anticipation of this, gamble more
⇒ The partial equilibrium prediction gets off-set or even reversed
∴ Countercyclical adjustments may be destabilizing!
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Paper 3 (“Capital Regulation in a Macroeconomic Model with Three
Layers of Default” MaRs Model Team∗, 2014)
[∗Clerc, Derviz, Mendicino, Moyen, Nikolov, Stracca, Suarez, Vardoulakis]
• Model in DSGE tradition with microfounded intermediaries
— All external financing is based on debt subject to default risk
— Default produces deadweight losses; final borrowers borrow an
endogenous multiple of their net worth
• Banks enjoy deposit insurance and neglect their contribution to deposit insurance costs as well as to the residual pricing of their failure
risk by depositors...
— underprice default risk, potentially leading agents to overborrow
— their leverage is controlled by the regulatory CRs
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• Banks satisfy CRs with equity funding provided by bankers using
endogenously accumulated wealth
— Negative shocks increase bank failure rates and get amplified by
a channel connected to banks’ financial vulnerability
— CRs are effective in shutting down bank-related amplification channels, but at a cost in terms of the level of economic activity
⇒ interior optimal CRs (levels)
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Are countercyclical capital buffers a good idea?
D e p r e c ia tio n S h o c k
G D P (8 % C a p ita l R e q u ire m e n t)
G D P (1 0 .5 % C a p ita l R e q u ire m e n t)
0.2
0.2
0
0
-0 . 2
-0 . 2
-0 . 4
-0 . 6
-0 . 6
-0 . 8
-0 . 8
-1
per cent
per cent
-0 . 4
CCB
R e le a s e
NO CCB
R e le a s e
-1
-1 . 2
-1 . 2
-1 . 4
-1 . 4
-1 . 6
-1 . 6
-1 . 8
-1 . 8
-2
5
10
15
q u a rt e rs
20
25
-2
30
CCB
R e le a s e
NO CCB
R e le a s e
5
10
15
q u a rt e rs
20
25
30
Underlying trade-off: (+) potentially smaller fall in credit supply; (-) higher bank default rate
• With HIGH baseline CRs, overall margin for improvement!
• With LOW baseline CRs, (+) short-run effect is off-set by destabilizing long-run effect
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This question is further addressed (under a proper calibration and an
explicit “stochastic welfare” calculation) in a new paper
(“Designing Capital Regulation in a Quantitative Macroeconomic Model”
with C. Medicino, K. Nikolov and D. Supera, 2015)
• Key qualitative result is confirmed: CCB is a good idea only when
CRs are high enough to start with
• When overall desirable, its impact on the welfare of borrowers (↑)
and lenders (↓) is asymmetric
• Its total contribution to the gains associated with optimally designed
CRs (level+risk weights+CCB) is modest
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Conclusions
• Some of the existing analytical frameworks offer good rationales for
prudential tools and allow for a model-based assessment of the contribution coming from adding some explicit macroprudential ingredient to the basic tool
• The reviewed papers identify advantages & disadvantages associated
with the cyclical adjustment of capital requirements:
— If excessive or applied to CRs that are too low to start with, the
effects can be counterproductive
— From this perspective, the Basel III approach (CCB as a releasable
add-on) seems a good compromise
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• The reviewed papers abstract from asset price bubbles and bank
panics, potentially understating the role of macroprudential policy,
esp. regarding the detection and fight against unsustainable developments
• At the current state of knowledge, simple and recurrently revised
rules (which operate like “automatic stabilizers”) can & should be
seen as complementary to the continuous surveillance of the system
and the willingness to act on a discretionary basis
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