Procyclicality and Macroprudential Policy
Framework
Jan Frait
Head of Financial Stability
I.
Macroprudential Policy Framework
What is a macroprudential policy framework?
• Following the global financial crisis, on the EU level as well as on the national
levels the ways how to establish the additional pillar for financial stability –
macroprudential policy framework – is being 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). The interest of the academic
community in the issue was rather limited.
• After the crisis, the term “macroprudential” has become a buzzword (Clement,
2010). 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.
What is a macroprudential policy framework?
• Various issues related to macroprudential considerations have become
in the centre of focus of researchers from multinational institutions,
central banking community, supervisory authorities and academia.
• One of the outcomes of the evolution described above is that the
meaning of the multi-facetated concept of macroprudential policy is
becoming more and more obscure. The term “macroprudential” is now
too embracive and it is often used outside of the scope of its original
meaning.
• This presentation is going to look at the concept of macroprudential
policies from relatively narrow perspective of the original BIS approach
(e.g. Borio, 2003, Borio and White, 2004).
What is a macroprudential policy framework?
• The objective of a macroprudential approach in the BIS tradition is to limit the
risk of episodes of financial distress with significant losses in terms of the real
output for the economy as a whole. The definition 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 of credit provision) stands centrally (Borio and Lowe,
2001, or Borio, Furnine and Lowe, 2001).
• The study of procyclicality has a strong time-series dimension and the gradual
build up of vulnerabilties over time has to be the subject of research (Borio,
2009, Brunnermeier et al., 2009, and Borio and Drehmann, 2009).
• Macroprudential policies are then defined the set of tools that have a capacity
to strenghten the resilience of the financial system as a whole through build up
of cushions or potentially reducing its vulnerability via decreasing the amplitude
of the financial cycle.
What is a macroprudential policy framework?
• The other stream is modelling of systemic risk associated with
individual institutions. By comparison with canonical models of
systemic risk like Diamond and Dybvig (1983) emphasining
interlinkages and common exposures among institutions, in the BIS
logic, systemic risk arises primarily through common exposures to
macroeconomic risk factors across institutions.
• The other stream focusing on the cross-section dimension of systemic
risk (common exposures among institutions, network risks,
infrastructure risks, contagion ...) has been intensively studied by the
IMF (see special chapters on systemic risks in the last few Global
Financial Stability Reports).
What is a macroprudential policy framework?
• The ongoing work on macroprudential tools is focusing mostly on the
design issues (e.g. Bank of England, 2009, and Drehmann et. al.,
2010).
• Major progress has been achieved in the design of countercyclical
capital buffers.
• More focus on the issues of efficiency and feasibility of
macroprudential tools should follow. Though there is some certainty
that the tools can help to provide the financial sectors with cushions,
there is a major uncertainty regarding the potential of the tools to limit
the effects of procyclical behaviour in good times.
• Should we really believe what the new GFSR says? “The model was
also used to investigate the impact of countercyclical capital
requirements, and found that a countercyclical rule linked to credit
growth might reduce output variability by around one third in the euro
area, and by around one-quarter in the United States.“
II.
Macrofinancial Framework and Monetary Policy?
Should monetary policy be part of macroprudential approach?
• Until recently a debate „how should central bank react to asset prices“
only, after the crisis the focus broader (credit and leverage)
• Central banks automatically has always been taking the asset price
developments into account when setting monetary policy:
• asset price movements impact on CPI inflation via demand for goods and
services used to create assets,
• asset price movements also feed into CPI inflation due to the "wealth“
effect,
• asset prices also feed through into spending via the effect of improved
balance sheets on borrowing capacity of firms and individuals and
willingness of lenders to lend.
• Normally asset and consumer prices move together, but
• sometimes speculative bubbles develop,
• bubbles will burst, potential damage may be huge.
CBs do not ignore asset prices
• Should central banks try to constrain asset price bubbles?
• The economists used to be divided into three groups (Bernanke‘s view)
• Group A philosophy:
• central bank should pay attention to asset markets’ developments, but
cannot and should not try to constrain asset price bubbles on their own.
• outspoken speaker - Ben Bernanke
• Group B approach:
• lean-against-the-bubble (BIS economists)
• Group C stance:
• aggressive bubble-popping
Ben Bernanke‘s view
• Bernanke (2002) rule for central bank policy regarding asset-market
instability:
• Use the right tool for the job!
• Fed has two sets of responsibilities:
• maximum sustainable employment, stable prices, and moderate long-term
interest rates,
• the stability of the financial system.
• Fed has two sets of policy tools:
• policy interest rates,
• range of powers with respect to financial institutions.
• Fed should focus its monetary policy instruments on achieving its
macro goals, while using its regulatory, supervisory, and lender-of-last
resort powers to help ensure financial stability.
Ben Bernanke‘s view
• Monetary policy:
• to the extent that a stock-market boom causes higher spending on
consumer goods and investments, it may indicate future inflationary
pressures, policy tightening might be an adequate reaction,
• goal of reaction should be to contain the incipient inflation, not the stockmarket boom.
• Financial sector policies:
• central bank should use its regulatory and supervisory powers to reduce
the incidence of bubbles and to protect the financial system.
Ben Bernanke‘s view
• Group B - leaning-against-the-bubble:
• not entirely without merit, the uncertainty regarding the
effectiveness.
• Group C - Aggressive bubble-popping:
• risky and dangerous approach,
• identical to Federal Reserve Policy in the 1920s - the Fed was
trying to prick the stock market bubble but succeeded only to
kill the economy.
The case against active stance
• General arguments against an activist approach:
• a central bank cannot reliably identify bubbles in asset prices,
• even if a central bank could identify bubbles, monetary policy
does not posses appropriate tools for effective use against
them,
• once a central bank becomes sure that a bubble has emerged,
it will probably be too late to act,
• pursuing a separate asset price objective could mean having to
compromise on normal inflation objective.
What Bernanke seemed to ignore?
• What if the bubble is emerging without any signs of inflationary
pressures?
• inflation measured in terms of consumer prices has not always signalled
that imbalances in the economy have been building up.
• prevailing monetary policy models used to forecast inflation pressures
derive demand pressures from current inflation pressures.
• A „dilemma“ scenario (small open economy case):
• higher economic growth  excessively optimist expectations  nominal
appreciation of domestic currency  a very low inflation can prevail
even under a rapid credit growth and asset price acceleration for rather a
long time  when the open inflation pressures finally appear, it may be
too late for monetary policy to react.
Note: these points were taken from CNB‘s 2005 presentation.
BIS economists disagreed
• BIS economists (mainly W. White) argued for a „leaning“ approach to the
monetary policy in treating the credit and asset prices boom.
• The summary of the approach is best covered by White‘s "post-BIS" paper
"Should Monetary Policy "Lean or Clean":
• It has been contended by many in the central banking community that monetary
policy would not be effective in “leaning” against the upswing of a credit cycle (the
boom) but that lower interest rates would be effective in “cleaning” up (the bust)
afterwards.
• These two propositions (can’t lean, but can clean) are examined and found
seriously deficient. In particular, it is contended that monetary policies designed
solely to deal with short term problems of insufficient demand could make medium
term problems worse by encouraging a buildup of debt that cannot be sustained
over time.
• .... monetary policy should be more focused on “preemptive tightening” to moderate
credit bubbles than on “preemptive easing” to deal with the after effects.
How to cope with a „dilemma“ scenario (CNB‘s experience)?
• BIS approach (to which the CNB subscribed a lot), untill recently the minority
one, was and still is was supportive of leanging-against-the-cycle.
• In this approach, if financial stability analyses identify the risk of emerging
bubble, central bank may act at an early stage when asset prices are starting
to accelerate and before the expansion in credit has become too sharp.
• By raising interest rates CB may help to avoid a subsequent collapse in asset
prices that could lead to considerably lower output and inflation in the longer
term.
• At least, central bank policies should be conducted in a way that does not
promote build-up of asset market bubbles.
• Central banks in small open economies must be ready to use monetary policy
steps as a kind of insurance against adverse effects of exchange rate bubbles.
• However, there might be a conflict created by the simultaneous impact of
monetary policy on both interest rates and exchange rate. The optimal policy
therefore may not be available and second-best policies have to be
considered.
Will BIS approach become a mainstream?
• M. Woodford (2010) in recent presentation in Prague (Inflation Targeting and
Monetary Policy) summarized growing consensus on the need of leaning:
• One needn't be able to predict exactly when crises will occur, only whether
the risk of a crisis increases under certain circumstances.
• Nor is the real issue whether assets are overvalued rather, the degree to
which the positions taken by leveraged investors pose a risk to financial
stability.
• Real issue not controlling mis-pricing of assets, but deterring extreme
leverage and maturity transformation - even modest changes in short-term
rates can affect incentives for highly leveraged investing, excessive shortterm funding.
• Really need to recognize financial stability as independent stabilization
objective.
Will BIS approach become a mainstream?
• M. Woodford (cont.):
• ... one can introduce a financial stability objective into a flexible IT
framework - financial stability considerations only affect the near-term
transition path to that invariant medium-run infation rate.
• The proposed procedure is related to calls for a target for credit growth,
but
• what matters for the target criterion is leverage of intermediaries, not credit as
such,
• not solely a leverage target: target criterion still involves price level, output
gap,
• what matters is marginal crisis risk, rather than leverage as such.
• Inflation should be allowed to undershoot normal target in a period of
elevated marginal crisis risk
• but there should be a commitment to make up the insufficient inflation later, so
that the long-run price level is unaffected,
• credible commitment of this kind would eliminate risk of deflationary spiral.
III.
Procyclicality and Provisioning
Procyclicality
• Financial system procyclicality means the ability of the financial system
to amplify fluctuations of economic activity over the business cycle via
procyclicality in financial institutions’ lending and other activities.
• The procyclical behaviour of financial markets transmits to the real
economy in amplified form through easy funding of expenditures and
investments in good times and financial restrictions leading to declining
demand in bad times.
• Procyclicality have increased over the last few years due to (i) the
greater use of leverage in the financial and real sectors, (ii) closer ties
between market and funding liquidity e.g. through increased use of
collateral in secured financing, (iii) increased contagion effects in
integrated markets as well as (iv) the (unintended) effects of some
regulations, including accounting standards. (EFC WG Report 2009)
To provision or not to provision
• Debate about the instruments that might reduce the potential procyclicality
of regulation is not a new one.
• Borio and Lowe (2001) – To provision or not provision
• paper written just prior to the setting and implementation of current
regulations,
• describes a conflict between the interests of supervisors and accountants,
• financial supervisors have tended to emphasise the role that provisions
can play in ensuring that banks maintain adequate buffers against future
deteriorations in credit quality,
• accounting authorities have stressed the importance of provisions in
generating fair and objective loan valuations.
• The accountants won the battle … but after a few years we seem to be
at the start back again.
To provision or not to provision, to buffer or not to buffer
• After the crisis - to provision or not to provision, to build capital buffers
or not to build capital buffers
• bank supervisors have always been more supportive of liberal general
provisioning regimes and reserves than have accounting and securities
authorities
• this time the supervisors may use the opportunity, but it is not so easy to
win a war …
• Procyclicality may be caused by broad spectrum of factors going much
beyond accounting and capital regulation framework of financial
institutions‘ regulation.
• The very idea that central bank will do its best by focusing its monetary
policy instruments on achieving its macro goals, while using its
regulatory, supervisory and lender-of-last resort powers to help ensure
financial stability should probably be reconsidered.
Procyclicality as a hot issue
• ECOFIN roadmap on financial supervision, stability and regulation takes
the issue of procyclicality rather seriously:
• Valuation and accounting standards: Refinement of the accounting
rules in respect of dynamic provisioning
• Pro-cyclicality:
• Follow-up to the report of the EFC-WG on Pro-cyclicality and the July
Ecofin Conclusions Possible measures to address pro-cyclicality of capital
requirements in the short term
• Identify policy tools to mitigate pro-cyclicality in the financial system and
financial regulation, including of capital requirements through countercyclical capital buffers in the CRD - dynamic provisioning, proccyclicality of CRD.
• Similar agenda set also by Financial Stability Board.
• Projects set by BCBS and IASB to propose what is required and expected.
To provision or not to provision
• In general principle, banks should set aside provisions to cover their
expected losses while their capital should primarily be used to cover
unexpected losses.
• There generally exist several provisioning systems differing in either
when the provisions are created and entered in the accounts or what event
triggers provisioning.
• Currently prevailing practice is “specific” provisioning.
• specific provisions are fixed against losses on predominantly individually
assessed loans and start at the moment an evident event occurs;
• specific provisioning is backward looking (i.e. it identifies risk ex post).
• General provisions
• are set against losses from portfolios of loans and can be forward looking
(i.e. they identify credit risk ex ante)
To provision or not to provision
• The key argument for forward-looking provisioning is the inherent
tendency of banks to relax excessively lending standards during economic
upturns and tighten them excessively during downturns
• the risks are underestimated during upturns leading to credit booms with
loans extended with prices set too low,
• subsequent downturn leads to re-pricing under the impact of higher
default rate, potentially ending in credit crunch.
• Forward-looking provisioning should therefore help to ensure correct
pricing of expected credit risk emerging at time when the credit is
extended.
To provision or not to provision
• The international accounting standards currently in force (IAS 39) allow
banks to provision only for loans for which there is clear evidence of
impairment (i.e. backward-looking provisioning).
• specific provisions are created and entered in the accounts only after
credit risk comes to light (which usually occurs in times of recession),
• In the general/dynamic provisioning system provisions are also created
when credit risk comes into being (i.e. to a large degree in times of boom)
• banks provision against existing loans in each accounting period in
accordance with the assumption for expected losses:
• at times when actual losses are smaller than assumed a buffer is created
which can then be used at times when losses exceed the estimated level…
• This looks straighforward, but in practice it is not so.
Provisioning in Spain
• Spain used „traditional“ provisioning up to 2000:
general provisions (GP) reflected estimate of average expected loss from
total loans:
GP = g*ΔL , where L stands for total loans and g for the parameter (between
0.5% and 1%),
while specific provisions (SP) were set in a standard way:
SP = e*ΔM, where M stands for impaired loans and e for the parameter
(between 10% and 100%).
total provisions: TP = g*ΔL + e*ΔM.
• In 2000, additional compotent was added – statistical provisions:
Total provision (TP) = Specific (SP) + General (GP) + Statistical (StP)
Provisioning in Spain
• Banks sorted loans to six homogenous categories with different risk
coefficient s (defined by supervisor as average specific provision rate
over the whole cycle).
• StP = Lr – SP, where Lr is a latent risk s*L, where s stands for the
coefficient of a historical average specific provisions (between 0%
and 1.5% in the standard approach),
 SP < Lr (low impaired loans)  StP>0 (building up of the
statistical fund),
 SP > Lr (high impaired loans) StP<0 (depletion of the
statistical fund),
 balance of the statistical fund: StF = StPt+StFt-1, with a limit:
0 ≤ StF ≤ 3 * Lr
Provisioning in Spain
• System had to be modified with effect from 2005 due to the
IRFS – statistical provisions were hidden in newly defined
general provisons:
Total provision (TP) = Specific (SP) + General (GP)
SP: unchanged,
 6

GPt    i Lit     i Lit  SPt 
GP:
i 1
 i 1

• banks must make provisions against the credit growth according to
parameter  which is the average ratio of estimated credit losses
(“collective assessment for impairment” in a year neutral from a
cyclical perspective) and  parameter which is the historical ratio of
average specific provision (coefficient s in previous version),
• 1st component reflects losses in the past, 2nd reflects specific provisions
in the past relative to current ones (dynamic component),
• limits for fund set as 0,1% ≤ GF ≤ 1,5% of total loans.
6
Provisioning in Spain
• Developments in provisioning funds in Spain after 2000 –
developments of provisions‘ components
Total provisions
Especific provisions
General provisions
million €
60.000
50.000
40.000
30.000
20.000
10.000
0
dic-00
jun-01
dic-01
jun-02
dic-02
jun-03
dic-03
jun-04
dic-04
jun-05
dic-05
jun-06
dic-06
jun-07
dic-07
jun-08
dic-08
Source: Saurina, J. (2009): The Spanish experience of counter-cyclical regulation. Prague, October 23, 2009.
jun-09
Provisioning in Spain
• Spanish authorities considered a new system IFRS compatible (IFSB not).
• Fund was set in good times, buffer was created prior to current crisis
• NPLs 200% covered at the beginning of 2008 (EU average 60%),
• Nevertheless, at the end of 2008 only 100% covered,
• not sure whether the fund will suffice ... still better that nothing.
• Spanish system viewed as accounting tool – though BdE considers it as part
of toolbox for macroprudential supervision.
• BdE does not think it distorts accounting statements:
• Banks are required to disclose the amount of the dynamic provision, apart
from the specific provision.
• Thus, users of accounting statements can “undo” the impact of the
dynamic provision on the P&L.
Provisioning in Spain
• Spanish system was rather simple – a kind of pre-dynamic provisioning:
• not optimal, just one of potential solutions,
• not sure whether it really restricts excessive lending,
• can hardly be adopted in current recessionary conditions,
• unilateral attempts to do so might do more harm than gain – see
Brunnermeier, M. et al. (2009),
• proposal by Commission to use it via CRD supported neither by industry
nor by supervisors (including the CNB).
Do the Czech banks provision procyclically?
Loan loss provisions/total loans and GDP growth
(Czech Republic, 1998 - 2008)
8
7
6
5
4
3
2
1
0
-1 0
2
4
6
8
10
12
-2
-3
Source: CNB, CZSO
Note: y-axis: GDP growth in %; x-axis: ratio of provisions to loans in %
14
• There is a negative
relationship between GDP
growth and the ratio of loan
loss provisions to total
loans in the Czech Republic
for the period 1998–2008.
• Does it reflect procyclical
behaviour?
• If yes, how strong are the
non-procyclical features of
banks‘ behaviour?
• For results see Frait and
Komárková (2009)
Do the Czech banks provision procyclically?
( LLP / TA)i ,t  1   2   ln GDPt   3  UNEMPL _ gapt   4 ( EARN / TA)i ,t 
 5 ln LOANSi ,t   6  ( LOANS / TA)i ,t   7 (CAP / TA)i ,t   i ,t
Variables:
(i) macroeconomic: the growth rate of real GDP (ΔlnGDP),
the unemployment gap (UNEMPL_gap);
(i) bank-specific: the ratio of loan loss provisions to average total assets
(LLP/TA), loan growth (ΔlnLOANS), the ratio of total
loans to TA (LOANS/TA), pre-tax earnings (EARN), the
ratio of equity capital to TA;
(ii) other: „t“ denotes time and „i“ the individual banks, TA stands for the
average total assets for the two periods (0.5(TAt+TAt-1)).
Do the Czech banks provision procyclically?
• If banks behave procyclically, the rate of economic growth will be
negatively correlated with provisioning, unemployment rate gap
positively, loans growth and the ratio of total loans to total assets
positively if banks behave prudentially, pre-tax profit positively, capital
ratio more likely negatively.
Results of panel regression for loan loss provisions
Variables
LLP/TA, lagged by 1Q
GDP growth
Unemployment gap
Pre-tax profit
Loans growth
Loans/TA
Capital/TA
No. of observations
R2 - within (among banks)
R2 - between (over time)
Coefficients
0,3390
-0,0003
0,0012
0,6565
-0,0022
0,0118
-0,2230
172
0,942
0,993
375,46
F test of equality of constants for banks (FE)
F (3,161)
2,24
Std. Deviations
0,5084
0,0020
0,0006
0,0567
0,0022
0,0048
0.0319
R2 - overall
rho
Prob > F
Prob > F
Note: The data were statistically significant at the ***1%, **5% or *10% level.
t
6,67***
-1,74**
1,84**
11,57***
-1,00
2,46***
-6,98***
0,947
0,102
0,000
0,0857
Do the Czech banks provision procyclically?
Conclusions:
•
The negative GDP growth and positive unemployment rate gap
suggest that provisioning is significantly procyclical and lacks to a
large extent forward-looking assessment of cycle-related risk;
…however
•
The procyclicality is being partly reduced:
(i) positive and relative high coefficient of the pre-tax profit = the
income smoothing or tax optimization,
(ii) positive coefficient of loans to total assets = prudential
behaviour confirmed;
… but banks set aside fewer provisions to cover their expected losses
when their capital buffer is larger (negative capital/TA coeff.).
IV.
Proposals for taming procyclicality
Existing proposals for taming procyclicality
• Through-the-cycle expected loss provisioning (TELP) – EU
Commission consultation to further changes in CRD from July 2009:
• Based on through-the-cycle expected loss – forward looking estimation of
losses that should be covered by TELP.
• TELP designed in line with Spanish approach – baseline method uses both α
and β parameters, more simple method considers parameter β only.
• Prudential measure of a „corrective kind“ which nevertheless has impact on
the accounting.
• Proposal does not address the issue of consistency between IFRS and CRD.
• TELP potentially in conflict with regulatory concept of expected loss in
Basel II.
• IRB institutions (only) apply models to set expected losses and their
coverage by provisions is tested (if provisions not sufficient, difference
deducted from regulatory capital).
Existing proposals for taming procyclicality
• Expected loss approach (IASB, June 2009)
• The expected cash flow approach - currently being considered as a part of
IASB project on replacing IAS 39 Financial Instruments Measurement and
Recognition.
• A major deviation from incurred loss approach - no trigger for an
impairment test required
• it should reflect better the economic reality of banks’ lending activities
than the incurred loss approach in that it requires an earlier recognition
of expected credit losses,
• it should help to avoid ‘incurred but not reported losses’.
• The present value of the expected future cash flows is measured using an
initial internal rate of return calculated on the basis of cash flows actually
expected at inception (taking into account expected credit losses), and not
on the basis of contractually agreed cash flows.
Existing proposals for taming procyclicality
• Expected loss approach (IASB, June 2009) cont.
• Initial internal rate of return will thus be lower than the contractual rate,
with the difference representing the risk premium charged to the borrower in
order to cover the statistically foreseeable risk of non-recovery.
• Difference between cash flows received that represent contractual interest
and interest recognised as revenues on the basis of the (lower) internal rate
of return would be recognised in the balance sheet as a credit expected loss
provision.
• Subsequent or additional impairment loss is recognised through continuous
re-estimation of credit loss expectations. Reversal of impairment loss is
recognised in profit or loss when there is a favourable change in credit loss
expectations.
• Would bring subjectivity, number of complex issues, transparency issues.
• Spanish approach and economic cycle reserve can serve as complementary
tools to it.
Existing proposals for taming procyclicality
• Economic cycle reserve (ECR) – UK Turner review
• An additional non-distributable reserve which would set aside profit in good
years to anticipate losses likely to arise in future.
• A formula driven method would simple and non-discretionary similarly to
Spanish system:
• a buffer of the order of magnitude of 2 – 3 % of RWAs at the peak of the
cycle,
• reserve could vary according to some predetermined metric such as the
growth of the balance sheet or estimates of average through-the-cycle
loan losses.
• A discretionary method would be entity-specific, tailored to the peculiarities
of each bank’s portfolios.
Existing proposals for taming procyclicality
• Economic cycle reserve (ECR) – UK Turner review cont.
• The approach has a macro-prudential defensive focus and is meant to be
accounting neutral
• it is to be shown only as a movement on the balance sheet, rather than
on the P&L (is intended to be built and drawn by appropriation of
retained earnings),
• but there are very strong arguments that it should also appear
somewhere on the P&L,
• allowing bottom line profit and earnings per share (EPS) to be
calculated both before and after its effect, and thus providing two
measures of profitability, the ‘traditional’ accounting figure and a second
figure struck after economic cycle reserving.
• Counter-cyclical capital buffers (under Basel III) – now at the most advanced
stage due to its attractiveness to the regulators and supervisors.
V.
Counter-cyclical capital buffers
Capital buffers: nothing new
• Borio and Lowe (2001) revisited
• One possibility … is a clearer treatment of the relationship between
provisions and regulatory capital …
• to exclude general provisions from capital and to set provisions so that
they cover an estimate of the net embedded loss in a bank’s loan portfolio,
• capital could then be calibrated with respect to the variability in those
losses (their “unexpected” component). (p. 46)
• Another approach … supervisors could supplement capital requirements
with a prudential provisioning requirement …
• instead of having the annual statistical provisioning charge deducted from
a bank’s profit and loss statement, have it added to the bank’s regulatory
capital requirement for unexpected losses. (p. 48)
Capital buffers: nothing new
• Procyclicality of Basel II was widely debated prior its implementation.
• There was a clear understanding that risk-sensitive regulatory capital
requirements tend to rise more in recessions and grow less during
expansions, laying the ground for potentially pro-cyclical effects.
• The authors of the framework therefore pretended that they included some
mitigating factors to dampen the potential pro-cyclical effect of Basel II's
increased risk-sensitivity.
• Although improved risk management was one of the arguments for the
introduction of Basel II, it now appears that neither regulatory capital nor
economic capital has been set adequately to capture actual risk,
particularly the risk contained in the trading book.
Capital buffers: nothing new
• High (perceived) costs of scraping Basel II down have been reflected in
the desire of regulators/supervisors to continue relying on Basel II
framework in dealing with procyclicality.
• First, they hoped, after the current crisis, micropolicies might become
easier for implementation including „theoretical“ tools within current
Basel II-Pillar 2:
• Internal Capital Adequacy Assessment Process, Supervisory Review and
Evaluation Process
• Stress testing with scenarios and methodology from supervisors
• Backward testing of PDs and LGDs, downturn LGDs, conservative
margins, tests of adequacy of provisions ...
• Second, they struggled to add some procyclicality-mitigating factors
into the concept.
CEBS proposal
• CEBS (CEBS, 2009) proposed practical tools for supervisors to assess
under Pillar 2 the capital buffers that banks have to maintain under the
Basel II/CRD framework (focusing on procyclicality of banking book of
IRB banks).
• CEBS was considering the use of mechanisms that adjust probabilities of
default (PDs) estimated by banks, in order to incorporate recessionary
conditions.
• Current PD: the long-term average of the default rates (either at the grade or
•
•
•
•
portfolio level).
Downturn PD: the highest PD over a predetermined time-span.
The scaling factor is: SF = PD_downturn / PD_current (close to 1 in a
recession and higher than 1 in expansionary phases).
The size of the buffer decreases in recession and increases in an upswing.
CEBS says proposal might easily be adapted in a Pillar 1 context, but ...
Countercyclical capital buffers
• BCBS‘s Countercyclical Capital Buffer proposal (2nd stage, issued for
comments in September 2010)
• The CCB proposal is designed to ensure that banking sector capital
requirements take account of the macro-financial environment in which banks
operate.
• The primary aim is to use a buffer of capital to achieve the macroprudential
goal of protecting the banking sector from periods of excess credit growth that
have often been associated with the build up of system-wide risk.
• Protecting the banking sector in this context is not simply ensuring that
individual banks remain solvent through a period of stress. Rather, the aim is to
ensure that the banks in aggregate has the capital on hand to maintain the flow
of credit in the economy without its solvency being questioned, when the
financial system experiences stress after a period of excess credit growth.
• This focus on excess aggregate credit growth means that jurisdictions are likely
to only need to deploy the buffer on an infrequent basis, perhaps as infrequently
as once every 10 to 20 years.
Countercyclical capital buffers
•
The starting point is Basel III new regulatory capitalization
minimums:
1. New common equity ratio (Core Tier1, CT1) of 7%, split between a 4.5%
•
•
minimum requirement and a conservation buffer of 2.5%.
2. A countercyclical buffer of up to 2.5% of common equity,
implemented according to national circumstance.
3. A supplementary, non-risk-based leverage ratio, to be tested at 3%.
4. Systemically important banks to carry loss-absorbing capacity “beyond
the standards announced”.
The CCB is thus presented as an add-on to the capital conservation buffer,
effectively stretching the size of the range in which restrictions on
distributions of profits are applied.
To allow banks time to adjust to a buffer level that exceeds the fixed capital
conservation range, they would be given 12 months to get their capital levels
above the top of the extended range, before restrictions on distributions are
imposed.
Countercyclical capital buffers
•
The starting point is Basel III new regulatory capitalization minimums
(cont.):
• Goldman Sachs view of Basel III (GS Global Investment Research):
1. CT1 ratio of 7% as the new regulatory minimum for banks of non-systemic
importance - for banks deemed to be of systemic importance, the CT1
minimum is subject to an additional surcharge and is therefore to be set at a
level above the 7% CT1 minimum.
2. A regulatory minimum is just that: a minimum. In practice, banks will aim to
exceed the minimum to be on the safe-side; and exceeded it further, before
capital return to shareholders is considered. 7% is not the “magic” number;
rather, it is a floor.
3. From an equity investor’s perspective, the relevant level of capital is not the
regulatory minimum but rather one above which all key parties—bank
managements, regulators, debt holders, “the market”—would not object to
capital being returned to shareholders. This level—the GS target
capitalization—will also differ among banks.
Countercyclical capital buffers
•
The starting point is Basel III new regulatory capitalization minimums
(cont.):
Goldman Sachs view of Basel III
Countercyclical capital buffers
• The essence of CCB:
• Calibration of CCB should be based on credit-to-GDP ratio and its deviation
•
•
•
•
from its long-term trend.
The proposal uses a broad definition of credit that will capture all sources of
debt funds for the private sector (including funds raised abroad) to calculate a
starting buffer guide. Ideally the definition of credit should include all credit
extended to households and other non-financial private entities in an economy
independent of its form and the identity of the supplier of funds. .
Conversely, the buffer would be released when, in the judgment of the
authorities, the released capital would help absorb losses in the banking system
that pose a risk to financial stability. This would help reduce the risk that
available credit is constrained by regulatory capital requirements.
Authorities in each jurisdiction will be responsible for setting the buffer add-on
applicable to credit exposures to counterparties/borrowers in its jurisdiction.
The buffer that will apply to an internationally active bank will reflect the
geographic composition of the bank’s portfolio of credit exposures.
Countercyclical capital buffers
• The essence of CCB (cont.):
• By design, the constraints imposed on banks with capital levels at the top of the
range would be minimal.
• The buffer range is divided into quartiles determining the percentage of
earnings to be conserved (calibration not finished yet).
Countercyclical capital buffers
• The essence of CCB (cont.) - the example:
• Minimum CT1 requirement for all banks is 4,5% of RWA + the capital
conservation buffer is set at 2,5% of RWA.
• Under this setting a bank with a CT1 ratio of 7,5% or higher would not be
subject to any restrictions on distributions of capital as restrictions are only
imposed in the range of 4,5% – 7%.
• If this bank becomes subject to a CCB add-on of 2%, the range in which
restrictions on distributions are imposed becomes 4,5% – 9%.
• CT1 capital ratio of 7.5% is in the third quartile of this range and so, using the
numbers in the table above, would be required to conserve 60% of earnings.
Countercyclical capital buffers
56
• The CCB gives a national regulator wide discretion:
• Calibration of CCB should be based on credit-to-GDP ratio and its deviation
from its long-term trend, but this will be common reference point only.
• The calculated long-term trend of the credit/GDP ratio is a purely statistical
measure that does not capture turning points well. Authorities will form their
own judgments about the sustainable level of credit in the economy.
• Authorities in each jurisdiction will be free to emphasise any other variables
and qualitative information that make sense to them for purposes of assessing
the sustainability of credit growth and the level of system-wide risk, as well as
in taking and explaining buffer decisions.
• Particular consideration was given to the question of how to take account of
jurisdictions with financial systems at different stages of development. Each
jurisdiction will have the discretion to impose buffers above or below the guide
buffer add-on level, subject to appropriate transparency and disclosure
requirements.
Where will this lead?
• There is a risk that combination of redrafted Basel II combined with
capital buffering, leverage limits and expected-loss-provisioning will
produce something unexpected …
• There is a visible lack of coordination of authorities in terms of
simultaneous considerations of both regulatory and accounting aspects.
• D. Tarullo (2008): „ … there is a strong possibility that the Basel II
paradigm might eventually produce the worst of both worlds—a highly
complicated and impenetrable process (except perhaps for a handful of
people in the banks and regulatory agencies) for calculating capital but
one that nonetheless fails to achieve high levels of actual risk
sensitivity”...
• Still, if the cycle is driven by overly optimistic expectations, only
combined effect of several other policies could do the job.
Money, regulation and supervisors courage
• The imbalances leading to current crisis were developing in a very
complex manner due to the combined effect of globalization, financial
market deregulation and increases in productivity that seemed to be more
than temporary.
• Such a process was reflected in a build-up of optimistic expectations
leading to „this time it will be different“.
• Monetary policy was really not much helpful, but not the major source of
asset price booms (see IMF World Economic Outlook, October 2009).
• There was no “key source“, “major policy fault“, “most important
wrongdoer“ behind the sources of crisis and a major difference in a single
policy could not prevent it.
• Or, do we really think that central bankers and supervisors were strong
enough to stop a high speed train with a massive political support?
• Or even, how strong would be the support of policy-makers in one country
who would try to cut off the music when the whole world was still dancing?
Money, regulation and supervisors courage
• The lesson for myself – if the international economy in the future starts
undergoing a dynamic drive again, accompanied by credit and asset price
booms, the authorities should apply concerted set of microprudential and
macroprudential measures to tame the immoderate optimism.
• Factors mitigating procyclicality embodied in regulation should ensure
accumulation of buffers and better supervision should prevent the bank
managers from taking excessive risks.
• Monetary policies might need to step in directly via interest-rate channel
or indirectly via macroprudential/microprudential tools changing its
transmission.
• Still, plenty of courage, luck and communication skills would be needed
to succeed.
VI.
Policy Reactions to Credit Expansion
Policy reaction to credit expansion
• Prior to crisis some central banks believed in bening neglect scenario while some
other viewed credit dynamics as a risk (especially these with foreign currency lending
and large external deficits).
• Potential impact of lending boom on quality of banks’ balance sheets is hard to
assess:
• new loans tend to dilute the old loans including the bad ones,
• vulnerability indicators are thus strongly lagging.
• The risks were not ignored by the authorities, some countries even adopted
prudential, supervisory and administrative measures:
• special reserve requirements for foreign exchange liabilities,
• marginal reserve requirements based on credit growth,
• higher liquidity requirements on foreign exchange liabilities,
• tighter capital requirements related to foreign currency lending,
• increasing the risk weighting of housing loans in capital, adequacy calculations.
Policy reaction to credit expansion
Policy reactions to fast credit growth in the EU economies
Countries with fixed/ pegged
exchange rate
BG
EE
LT
LV
Monetary policy tools:
Interest rate increase
Reserve requirements
Regulatory measures:
Higher risk weights
Restrictions on LTV
Provisioning rate
Tighter regulation on higher risk/large
exposures
Quantitative restrictions on lending
growth
Limits on inclusion of bank profits into
capital
Rules on collateral value of mortgage
backed covered bonds
Administrative measures:
Eligibility criteria for borrowers
Restrictions on payment-to-income
ratio
Introduction of first down-payment
III & XI 2004;
VII & XI 2006;
III & V 2007
Source: ECB
20042008
2004;
VII 2004; I 2005;
2005;
X 2006 V 2002
XII 2005; V 2006
VII 2007
X
III 2006 II 2007
I 2008
IV 2006
VII 2007
XI 2005
I 2008
Euro area countries
CY
ES
GR
IE
VI 2006
V 2008* I 2005
I 2007
V 2009;
III 2010
II 2004
SI
X
X
I 2006;
I 2007
XI 2003;
VII 2007
2006
XII 2007
IV 2005 XII 2006
IV 2005
I 2008
XII 2007
X
VI 2010
IX 2007
II 2004;
VIII 2005
X
XII 2005
VII 2007
VII 2008
II 2006
MT
IX 2006
IV 2006
Submition of income statement from
State Revenue Service
Tighter rules on taxes related to real
estate transactions and governmentsubsidised mortgage conditions
Guidelines/recommendations for banks
or customers
Countries with floating
exchange rate
HU
PL
RO
2003;
2004
X 2006
IV 2006
2003;
2004
X
I & VII 2007
VIII 2008
2003;
2009
2004
VIII 2006
Policy reaction to credit expansion
Policy reactions to fast credit growth in various economies
Source: ECB
Source: Borio and Shim (2007)
Policy reaction to credit expansion
CNB‘s list of potential policy reactions (1)
Monetary policy tools
o Hike in policy interest rate
o Increase in minimum reserve requirements
o FX interventions in appreciation direction
Regulatory tools
o Introduction of marginal reserve requirements selective for various ways of financing
o Increase in risk weights for loans collateralized by real estate, for loans with higher LTV or
for loans extended without an income check
o Direct regulation of LTV – setting the limit for mortgage loans – for individual loans or for
the whole portfolios
o Instruction of higher provisioning to the NPLS according to the days overdue or setting the
filters according to supervisory and accounting provisioning
o Higher provisioning for large exposures or higher capital requirements for more risky loan
segments
o Reduction of possibility to add current year profit to regulatory capital
o Increased limit of excessive collateral for covered bonds
o Direct or indirect pressure for keeping higher capital adequacy
o Specific requirements for liquidity buffers for selected sources of funding (especially
sources from abroad).
Policy reaction to credit expansion
CNB‘s list of potential policy reactions (2)
Administrative tools
oTightening of eligibility criteria for borrowers – through on-site inspections or via stricter stress testing of
individual applications for mortgage loans
oIntroduction of restrictions on installment to income ratios
oSetting the minimum share of downpayment when using mortgage loan for buying real estate (de facto
different way of LTV regulation)
oRequirement to substantiate the income by government acknowledgment if high mortgage loan is applied
for
oRecommendations and warnings towards bank customers
Macroprudential tools of „built-in“ sort
oThe change in regulation of provisions in a pre-emptive direction (through-the-cycle provisioning or other
form for building a buffer in good times)
oThe change in capital regulation making banks build capital buffers or reserves in good times.
Strenghtening of coordination of fiscal and other government policies
oStricter tools of taxing the real estate (for 2nd and further ownerships), removal of tax deductability of
interest on mortgage loans (regulator pressures on the government)
oReduction of government expenditures aimed at reducing the optimistic expectations and preventing
overheating in boom times
oJoint campaign of central bank, supervisor and government aimed at explaining risks of excess borrowing
oRestrictions on capital mobility and introduction of transaction taxes on selected foreign finance flows
Policy reaction to credit expansion
• These measures were not fully supported by the international community in
the „old“ days.
• IMF World Economic Outlook (September 2005, p. 13):
• "in cases where house price inflation remains robust, a combination of moral
suasion and if necessary prudential measures could help limit potential risks; over
the long term, regulatory features - including those that potentially constrain
supply - that may exacerbate price pressures need also to be addressed"….
• prudential measures: higher and differentiated capital requirements, tighter loan
classification and provisioning rules, dynamic provisioning to dampen cyclical
fluctuations in lending activity, stricter assessment of collateral, tighter eligibility
criteria for certain loans (like loan-to-value ratio);
• supervisory measures: increasing disclosure requirements, closer inspection,
periodic stress testing.
Policy reaction to credit expansion
• Paul Hilbers, Inci Otker-Robe, and Ceyla Pazarbaşıoglu: Going too
Fast? Finance & Development, Volume 43, Number 1, March 2006:
• Prudential measures are not generally viewed as first best option.
• „ … measures should be used when there are financial stability risks or
when there is room to bring a country's prudential and supervisory
framework in line with international best practice. That said, there are limits
to what prudential policies can do in the absence of prudent fiscal policies
or if monetary or fiscal regimes create incentives that encourage credit
growth.“
• „The ability to further tighten prudential and supervisory policies varies
across the CEE countries. In many of them, the frameworks have been
strengthened, meaning there may be limited room for further tightening.“.
Policy reaction to credit expansion in reality
•
During the last decade micropolicies were increasingly difficult to apply in reality. The
experience suggests that the EU and international regulatory framework presents
tough limits for national macroprudential discretions. The existence of the limits is
indicated by the findings that the instruments now viewed as macroprudential ones
were used in the last decade much more frequently in emerging market economies
than in developed countries (see for example CGFS, 2010).
•
It means that for the especially for EU economies, some tools were not and can still
not be available due to the potential non-compliance now (after all, nowadays
appraised dynamic provisioning applied in Spain was declared as non-compliant prior
to the crisis, see Saurina, 2009).
•
Restrictions imposed on local banks were got around by providing loans directly from
parent banks. And on some occasions the non-bank institutions (even these set by
the banks) took the part of the restricted banks.
Policy reaction to credit expansion
• We were also quite sceptical – we viewed various recommendations as
dispensing advice from on high – advise of rather limited value.
• „Measures“ are difficult to apply in reality due to competition from non-banking
subjects and foreign banks and their local branches.
• Basel II rules together with the international accounting standards made the
application of some nonstandard measures not so easy.
• High demand for credit was linked to international macroeconomic environment,
macroeconomic-policy approach should therefore be attempted.
• Distortive administrative regulations surely have undesirable side effects. They
are harming newcomers to the market, may create perverse incentives for banks
to bias their lending into riskier ends of the lending spectrum.
• Temporary success of „measures“ can conceal real sources of problems.
VII.
Links between monetary policy, financial
supervision and financial stability in a small
open economy – the CNB case
Monetary policy, exchange rate and financial stability
• There is an old “truth” that central bank will do its best by focusing its
monetary policy instruments on achieving its macro goals, while using its
regulatory, supervisory and lender-of-last resort powers (micro policies) to
help ensure financial stability.
• CNB‘s approach was somehow different – reflection of specific features of
small and converging economy.
• Monetary policy worked also against the potential sources of financial
instability. If real appreciation pressures emerge, tightening of monetary
conditions via stronger currency should be viewed as a potential way of
slowing the growth of optimism in the economy down.
• At the same time, the authorities should be ready to use their regulatory
and supervisory powers for macroeconomic stabilization providing the
monetary tools lack the effect. Correcting macroeconomic imbalances
would also reduce the risks for financial stability.
Monetary policy, exchange rate and financial stability
• Due to the fact that the major central banks were keeping policy rates at a very
low level after September 11, in the face of appreciation pressures, the Czech
National Bank naturally had to keep its policy rate also at a similar or even a
lower level.
• Your first impression might be that such a policy must lead to a credit boom. In
reality this policy has served more as a shield against the risks coming from
the external environment.
• There was no best solution – low interest rates could support credit boom while
high interest rate would create risk of even much faster appreciation and
deterioration of external imbalance.
• We opted for second best solution – low interest rate environment combined
with sustained „mild“ nominal currency appreciation.
• It may sound as a strange idea to use policy of low interest rates in small
emerging economy to shield country from risks stemming from developed
countries policies. But monetary scene in recent years has been strange
indeed.
Monetary policy, exchange rate and financial stability
• Sustained nominal appreciation of the Czech koruna has served as a key
stabilization „tool“ after 2001 in a following way:
• Besides the downside impact of currency appreciation on inflation, reaction of
private agents to it contributed to the flexibility of the economy.
• The CNB was explaining that these were the global pressures behind nominal
appreciation that a small economy could not avoid.
• The public gradually accepted the idea that exchange rate is not something that
the central bank should try to manage.
• Exporters and their workers gradually adjusted to the appreciation trend:
• The exporters factored in future development of ER into their expectations.
• The labour unions realized that currency appreciation improves the purchasing power
of workers’ wages which helped to discipline the wage dynamics.
Monetary policy, exchange rate and financial stability
• Combination of currency appreciation and low interest rates environment helped to
maintain financial stability.
• Sustained appreciation worked against the formation of overly optimistic
expectations in the corporate sector which tamed the potential for a corporate
sector credit boom.
• Currency appreciation was also shifting part of existing domestic demand from
nontradeables to tradeables along the long-term trend towards higher
consumption of non-tradeables, contributing to a more balanced macroeconomic
and structural dynamics.
• Households did not have any incentive to borrow in foreign currencies which had
made their balance sheets insulated from exchange rate risk.
• Households had strong incentives to save and deposit in domestic currency.
Monetary policy, exchange rate and financial stability
• The Czech case confirms that the key driver behind demand for foreign currency
loans is differential between lending rates in home and foreign currency.
• Fixed exchange rate regime is what drives people to ignore the exchange rate risk.
• The share of FX loans provided to households is the lowest in two countries with a
history of profound and sustained nominal currency appreciation - Czech Republic
and Slovakia.
• This is despite the fact that taking a loan in foreign currency if the domestic
currency appreciates is ex post „cheaper“.
• The effect might go via currency denomination of deposits - currency structure of
borrowing must be linked to the one of saving. If people have long-term incentive
to save in domestic currency, they will also view as natural to borrow in it.
Foreign currency loans – interest differential is what matters
• Number of EU countries tried to do something, while the CR not – we won anyway.
Countries with fixed/pegged
exchange rate
BG
EE
LT
LV
Countries with floating exchange
rate
HU
PL
RO
Euro area countries
AT
CY
GR
SI
III 2007
VII 2006;
XII 2007
Monetary policy tools:
VIII 2004;
VIII 2005;
I & III 2006
Higher reserve requirements on
bank liabilities in FX
Regulatory measures:
Higher risk weights
V 2008*;
V 2009
I 2008
Higher provisioning rate
Restrictions on LTV for FX loans
IX 2005
III 2010
Quantitative restrictions on FX
lending
Administrative measures:
Eligibility criteria for borrowers
IX 2005
VI 2010
Restrictions on payment-toincome ratio
Guidelines/recommendations for
banks or customers
Source: ECB
X
VIII 2008
I 2007;
VII 2007; IX 2006
X 2008
VII 2006
X 2003;
X 2008
XI 2006
Thank You for Your Attention
Contact:
Financial Stability Department in the CNB:
financial.stability@cnb.cz
CNB: Financial Stability Reports, various issues available at http://www.cnb.cz/en/financial_stability/
Jan Frait
Financial Stability Dept.
Czech National Bank
Na Prikope 28
CZ-11503 Prague
Tel.: +420 224 414430
E-mail: jan.frait@cnb.cz
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•
•
•
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