Challenges to Macroprudential Regulation
Bank of Portugal
Lisbon, February 10 2015
João Santos
Federal Reserve Bank of New York
&
Nova School of Business and Economics
These are my views and not necessarily the views of the Federal Reserve Bank of New York or the Federal Reserve System
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Challenges to Macroprudential Regulation


Macroprudential regulation is still not a well defined concept

What are its instruments?

Want are its objectives?

How does macroprudential regulation interplay with monetary policy?
The goal of regulating systemic risk has its own problems

Measuring systemic risk has proven difficult

Regulating systemic risk has proven difficult too
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Systemic risk is important
1.
Early studies find that output losses during a banking crisis
are, on average, in the range of 6%--8% of annual GDP.
2.
More recent studies find that cumulative output losses during a
banking crisis are, on average, 15%--20%, of annual GDP.
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Measuring systemic risk not easy

Definition is still the subject of debate

Justice Potter Stewart’s definition of pornography, i.e.
“systemic risk may be hard to define but you will know it
when you see it” is not useful

“any set of circumstances that threatens the stability of or
public confidence in the financial system” (Billio et al 2010)

Risk of financial instability “so widespread that it impairs the
functioning of a financial system to the point where economic
growth and welfare suffer materially” (ECB 2010)

“Systemic risks are developments or events that threaten the
stability of the financial system as a whole and consequently
the broader economy, not just that of one or two institutions.”
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PART OF THE PROBLEM IS THAT
SYSTEMIC RISK MAY EMERGE FROM
SEVERAL DIFFERENT SOURCES
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Many banks may fail at the same time because:
1.
Depositors panic and run indiscriminately on their banks.
2.
A failure releases information on banks’ financial condition
or nature of an aggregate shock, triggering runs on banks.
3.
Banks’ incentives to choose correlated portfolios of assets
creates the conditions for a joint failure.
4.
The payment system may collapse
5.
The interbank market may stop functioning
6.
The failure of a nonbank financial institution may trigger
large losses to the banking sector
7.
There are other possibilities and these are not mere academic
scenarios
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Historically, bank runs have been the key driver of
systemic risk
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Non-deposit funding has become a potential problem
Funding, All
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90
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.2
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Funding, Top10
Deposits
Subdebt
Deposits
Subdebt
CP
FF and Repo
CP
FF and Repo
Other Borrowed Money
Other Borrowed Money
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Decline in the importance of insured deposits
Deposits, All
Insured Deposits
Insured Deposits
Uninsured Deposits
Uninsured Deposits
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10
20
05
20
00
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95
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90
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95
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1
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Deposits, Top10
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Collapse of repo market cut funding to many banks
Source Gorton and Metric (2010) “Securitized banking and the run on Repo”
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The case of too-big-to-fail banks

U.S. Comptroller of the Currency: “Had Continental failed and
been treated in a way in which depositors and creditors were
not made whole, we would have seen a national, if not an
international financial crisis, the dimension of which were
difficult to imagine.”

Continental was the nation’s seventh-largest bank
Average size of top-5 banks: $86 B
Average size of top-10 banks: $63 B
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Dec-09
Nov-09
Oct-09
Sep-09
Aug-09
Jul-09
Jun-09
May-09
Apr-09
Mar-09
Feb-09
Jan-09
Dec-08
Bear
Nov-08
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Oct-08
Sep-08
Aug-08
Jul-08
Jun-08
May-08
Apr-08
Mar-08
Feb-08
Jan-08
Dec-07
Nov-07
Oct-07
Sep-07
Aug-07
Jul-07
Jun-07
May-07
Apr-07
Mar-07
Feb-07
Jan-07
Collapse of the interbank market still a possibility
Libor-OIS
Lehman
3,5
3
2,5
2
1,5
1
0,5
0
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Failure of a nonbank financial institutions
1.
Disappearance of liquidity following the Russian default
triggered a global “flight to quality” and contributed to the
collapse of LTCM
2.
Concern: Had the LTCM been allowed to fail, it could lead to
a collapse in asset prices, forcing intermediaries to sell,
leading to a further decline in asset prices. A widespread
financial crisis could follow.
3.
More recent examples include AIG, Lehman
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Problems with the MMFs following Lehman collapse
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IMPORTANT DEVELOPMENTS IN
MEASURING SYSTEMIC RISK BUT MOST
MEASURES HAVE SERIOUS LIMITATIONS
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Macroeconomic measures


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The idea behind this approach is that aggregate measures can help
to identify large-scale imbalances.
A limitation of this approach is that it does not pin down the
origin of the problem.
Another limitation is that any aggregation typically tends to
average away risk or dispersion.
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Network analysis measures



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Network analysis considers information at the firm level and try
to capture the interlinkages that may exist among financial
institutions.
Another objective of the network analysis is to capture how
financial events propagate.
This approach is very data-demanding.
Still unable to take into account firms’ responses to the shocks
and/or other firms’ policy reactions as well as market reactions.
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Stress tests


Stress tests are a special case of forward-looking analysis with the
potential for a significant role in systemic risk monitoring.
Stress tests, however, have their own challenges, including:



Design of the tests
Factor in banks’ and markets’ responses to stress episodes
Are vulnerable to the Lucas critique
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Forward looking risk measurement

This class of risk metrics has some important features:



For purposes of risk measurement it is important to have a forward-looking
view of the cashflows, positions and portfolios at different times in the
future, and under varying circumstances.
Forward-looking metrics may also help focus regulatory scrutiny on
emerging risk factors and other exposures before they begin to appear in
traditional financial statements.
However, the forward looking capabilities of these measures
hinge on the information firms’ disclose and on markets’ ability
to “assimilate” that information in a timely fashion
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Cross sectional measures

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The cross-section measures of systemic risk are a complementary
approach to the forward-looking measures of systemic risk.
Their focus is to determine the co-dependence of institutions on
each other’s “health”.
As with the forward-looking measures, they too depended on the
information firms disclose and the ability of markets to process
that information timely.
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Information content of CDS spreads: US evidence
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continued
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continued
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Portuguese evidence
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Continued
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REGULATING SYSTEMIC RISK HAS
PROVEN DIFFICULT AS WELL
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Regulating systemic risk has proven difficult



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Deposit insurance has proven effective at addressing one
particular source of systemic risk, but we do not have many
other success stories
Lender of last resort and the problem of stigma
Still unclear whether capital surcharges are commensurate
with banks’ systemic risk importance
Still unclear whether we have tackled the sources of systemic
risk outside the banking sector


E.g. Asset management industry
Recent attempts to tackle the problem of “too-big-to-tail” do
not appear to have been entirely successful
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Too-big-to-fail ,a problem that has become “bigger”?
0
500
$ B USD
1000
1500
2000
Average Assets
1990
1995
2000
Date
2005
Top 5 BHCs
BHCs 6-10
BHCs 11-20
All Other BHCs
2010
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Still unclear the Dodd-Frank Act succeeded at
dealing with the TBTF problem


Dodd-Frank Act introduced provisions that could make it
easier to intervene at the BHC level in order to protect
operating bank subsidiaries that run into financial difficulties.
However, market participants seem to have doubts about the
effectiveness of those provisions.
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Fitch views on bank assets with support ratings
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Bond investors: BHC vs. Subsidiary banks bond spread
Bank of New
York Mellon
Wells Fargo
Bank of America
30-day moving average of OAS difference.
JPMorgan
US Bancorp
CDS investors: BHC vs. Subsidiary banks CDS spreads
Capital One
Wells Fargo
JPMorgan
30-day moving average of difference in CDS spreads..
Bank of America
Final remarks


Over the last decade there was a recognition that regulation
should target systemic risk, a positive development.
However, the relative infrequency of systemic shocks, together
with the constant changes in the architecture of the financial
system, makes it challenging to develop useful empirical and
statistical measures to track systemic risk, let alone predict it.

To add to the difficulties, policies that aim at systemic risk
may interplay with monetary policy

There is nonetheless consensus over some sources of systemic
risk and the need to tackle them, including:

provision of maturity transformation services

provision of liquidity services

existence of extensive interlinkages

existence of too-to-fail institutions
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