Challenges to implementing macroprudential policy

The seeds of the financial crisis were sawn long before any international institution started to worry as domestic imbalances increased due among others to excessive credit growth. In fact, there were structural changes in the financial sector that went unobserved by the regulators and in the end the two different functions of the financial system (to provide a mechanism for the flowing of all payments and to provide a framework for the efficient allocation of credit) are not distinct anymore. The division between money and credit is blurred and borrowings are a source of liquidity with the same risk attached (Henry Kaufman).

The sovereign institutions have failed to act until the crisis hit at full strength because there was an international imbalance created by a “global monetary order in which currencies were free to misalign” (Jacques de Larosière).

Central banks and regulators were unprepared for the size and complexity of financial innovation; hence credit growth went beyond the institutional and operational mandate as well as the instruments of central banks.

Central banks have two instruments in their arsenal and these were the last resort during the crisis. A central bank can create liquidity by expanding its balance sheet. Moreover, the inflation targeting strategy offers transparency and most important credibility to the central bank’s actions.

The model of these two instruments of central banks can be expanded to macroprudential policy but central banks cannot engulf the entire financial sector and be the institutional agent for the macroprudential policy.

This presentation is divided in three parts – the first dealing with the operational challenges of implementing the macroprudential policy and second with the institutional ones, while the third concerns the National Bank of Romania’s experience with implementing macroprudential policy both before and after the crisis.

Operational implications: monetary policy and macroprudential policy

In October 2011 the BIS, IMF and FSB put together a list of indicators that could be used to identify the systemic risks in the financial system both at national and global level. Among these indicators there are at least three that make the link between the macroprudential policy and the monetary policy: the credit growth rate; the dynamic of asset prices and the liquidity conditions.

For many analysts and institutions the credit growth was the tale-tale sign of the crisis. The increasing financial intermediation is a measure of the depth of the financial sector and is in itself a cushion against volatility in financial markets. However, the acceleration of credit growth can only be the result of resources attracted from another sector which is tantamount to an imbalance for the domestic financial sector.

The evolution of asset prices and particularly real estate bubbles are a good indicator of an event in the financial system. However, the crisis has changed the attitude of the institutions in the event of an asset price bubble. The monetary policy is able to deal with asset price bubbles as long as these have not yet burst (contrary to the previous FED orthodoxy which argued that the FED will step in after the bubble burst to mop up liquidity). The macroprudential policy intends to use a set of instruments to recognise the asset price increase before it becomes a bubble.

The deterioration of liquidity conditions beyond a pre-established floor should trigger the alarm as this already is a manifestation of crisis. From the point of view of monetary policy the liquidity conditions should be considered the main information because liquidity is its key instrument. Liquidity conditions are essential in assessing the systemic risk because this is the last line of defence for the financial system.

Although there is no question about the utility of the above mentioned indicators both for monetary policy and macroprudential policy, there is yet no mechanism by which to decide the precise moment when disequilibrium, from the point of view of the monetary policy, becomes a systemic risk, from the point of view of the macroprudential policy. By the same token, it is possible that conservative actions based on these indicators directed towards a reduction of systemic risk can affect the development of the financial system.

There are several conditions of an economy that can require an acceleration of credit growth. In principle, as long as there is an increase in the supply of production factors there will be an increased credit demand. Nonetheless, if the credit feeds into excess capacity (and inventory) then there is no overlap between monetary policy and macroprudential policy.

If one considers asset price increases the result of productivity differential of different types of capital then the intervention of the macroprudential policy would be detrimental as it can cause an inefficient allocation of resources. However, interest rate differential that help finance asset price increases are to be treated with caution and under the macroprudential policy mandate, as the margin of profit does not come from an efficient allocation of resources.

Further reference: SHAREHOLDERS’ RESPONSIBILITIES: in addition to “pushing” for an increased profit, from now on they have the responsibility to know how the profit is made

Operational implications: regulation and macroprudential policy

Financial innovation, greatly supported by financial deregulation, has helped to blur the distinction between money and credit. Thus, today many companies (be they monetary or not) as well as households consider borrowings as a source of liquidity. This is a reality that has to be properly acknowledged and not suppressed through regulation by the monetary policy or by the macroprudential policy. However, excessive debt by sector or across sectors is not to be tolerated by the macroprudential policy.

The first set of instruments (indicators) of crisis proposed by the three international institutions mentioned above is of macroeconomic nature and it addresses mainly credit and asset price growth. A second set of instruments (triggers of crisis) refers to sector issues that can transform into cross-sector risks. As such, this second set of instruments concerns the banking sector through the capital and liquidity requirements, the capital markets through the margins and haircuts in securities markets and the corporate sector at large through the accounting rules. This second set of indicators reflects the regulation policy.

Capital and liquidity requirements represent a common instrument for the financial stability policy in any country. They do not envisage the health of the banking sector only but the regulation in this field is considered with an eye to the microeconomic development as well as to systemic risk. Nonetheless, capital and liquidity requirements are more of a regulatory policy instruments (trigger) than a macroprudential policy one. There is at least one essential reason for this. The objective of this instrument is very narrow to be shared with the macroprudential policy, which is an overarching field. Capital and liquidity requirements are part of the regulatory policy, while the indicators referring to the capital markets are by and large a macroprudential policy instrument. The BIS, IMF and FSB have considered the measures to stabilize margins and haircuts across the cycle in securities markets as an instrument for pre-empting crisis. By its nature this is a counter-cyclical instrument and it addresses the resilience of the system to crisis and not the conjuncture, or the situations (risks) at a given point in time. Mention should be made that capital and liquidity requirements is a more powerful instrument since it addresses both the conjunctural and resilience aspects of the macroprudential policy.

Following the same rationale, the international institutions have indicated another instrument (trigger) for assessing systemic risks with the same objective of reducing the procyclicity - the accounting rules regarding loss provisions. From the regulatory point of view loss provisions are not a good indicator of the crisis. They are relevant only when corroborated across markets and sectors.

There are numerous theoretical contributions that have underlined possible overlaps between the regulatory and macroprudential policy. One of the most debated subjects is that of capital and liquidity requirements. It is difficult to pinpoint the moment when regulation has to concede power to macroprudential policy in this field. In short, one could say that capital and liquidity requirements should be relaxed to the extent to which growth and mergers and acquisitions are possible. However, the macroprudential policy should step in and strictly prohibit the concentration to the point of forming too big to fail institutions.

There is no overlap between the regulatory and macroprudential policy when considering the measures regarding the securities markets (the stabilisation of margins and haircuts across the cycle) as these are mainly anti systemic risk measures. However, at any given point the capital market can consider the macroprudential measures too cumbersome in that they hinder its development. Hence, one could say that increased access to liquidity from different sources (instruments derived from financial innovation) is not a bad thing in itself, unless there is a rapid growth coupled with deteriorating quality of debt.

Losses and the way financial markets value them are a natural occurrence in the business sector and they help the efficient allocation of financial resources in the economy. Hence there should be no obstruction to this mechanism. For the business sector as such, financial deregulation is a good thing and macroprudential policy should intervene when there is a sharp increase in the volatility of financial assets (or currencies).

Further reference: INNOVATION – not suppressed; it is one of the main sources for PROGRESS

Operational implications: fiscal policy and macroprudential policy

Many scholars have rated high among the main causes of the crisis the tax structure. The culprit, at least in the UK and the US, is the provision that allows interest payments to be generally deductible. Under these circumstances, it is no wonder that the three international institutions (BIS, IMF, and FSB) have listed the levies and taxes among the indicators (triggers) of the crisis.

These three institutions have indicated that countries should introduce levies and taxes on financial activities to damp undue exuberance. From the point of view of fiscal policy this comes down to changing the structure of public resources. Indeed, some gains (provided no legal escape is found) will be made under revenues from taxes on debt reimbursements (income and/or profit before tax). However, there will be also a reduction to be counted under revenues from income and/or profit after tax. The higher the efficiency of transforming financial capital into profit the lesser advantageous it will be such a change for the fiscal policy.

Then, the big question for the macroprudential policy is about the efficient rate of transformation of financial capital into profit that does not affect negatively total public revenues. More to the point, the macroprudential policy might be forced to intervene in the decision of investors and decide (in view of assessing systemic risk) which level of interest payments (or what kind of debt) is more dangerous for the financial system. In this case it seems that there is more overlap, almost contradiction between the actions of the two policies. The overlap can be divided into three separate issues: the objectives of the policies, the instruments of the policies and the implementation of the policies.

The objective of any fiscal policy is ultimately to achieve some sort of redistribution across the society. The objective of the macroprudential policy – albeit not very clearly defined nowadays – is to save the economy from financial collapse. Both policies are united in that they admit that excessive debt is risky. Despite this, the fiscal policy can impose to some extent only to the public sector a certain level of debt and it remains to the macroprudential policy to raise the alarm when the debt level ACROSS the sectors of an economy can no longer be sustainable.

The taxation system is the instrument for both policies but their objectives do not provide for an answer regarding the optimum level and structure of taxation. Taxing debt can be self-defeating as it is to encourage debt. In fact, the implementation of the two policies is the answer to the question. There is no real overlap in implementing the two policies if it is agreed that once the debt level across sectors (public, corporate and households) reaches unsustainable levels the habit of growing through debt is inhibited through taxation.

Further reference: Financial activity tax (FAT) - difficult to reach an agreement at EU level

Goal: against excessive risk taking and remove distortions that create disturbances between economic activities.

1. Hot money tax on banks
• to avoid excessive reliance on “easy come easy go” funding
• to induce medium and long term funding and relatively stable funding
• to reduce the gap: funding short – assets medium/long term
2. Taxes on Debt
• Lenders: double exposed – leverage themselves and leveraged customers
3. VAT on financial services – customers will pay the tax (now companies and business are overcharged).

Institutional implications: monetary policy and macroprudential policy

The G20 as well as the other international and regional institutions that are involved in the governance of the systemic risks in the aftermath of the crisis managed to draw up a comprehensive list of indicators and actions to be considered in order to avoid a crisis and to increase the resilience of the financial system in a crisis. However, there is not yet a recipe concerning the modus operandi with or without the crisis. Thus, although we have plenty of available analysis we do not have a clear map of reporting lines and of the decision making process. This is a convoluted issue if one considers that there is no best practice regarding the setting up of a separate entity to deal with the macroprudential policy and its institutional powers.

The case is even more compelling for the link between the macroprudential policy and the monetary policy because the crisis has thought us that the final defence line is the liquidity provision from the central bank.

The responsibilities of central banks have increased after the financial crisis both for normal times and for crisis period. We now know that with normal risk conditions in the financial sector the central bank will supervise the credit growth, asset prices and liquidity conditions not only for the banks but also for other institutions in the financial system (the treatment of the shadow banking system is still under discussion). Hence, there are more reporting lines for the central banks.

The responsibilities of the central banks during the crisis bloated since 2007 in that they will not only be the last line of defence providing liquidity but they will also secure international cooperation for smoothing the effects of the crisis over the international financial system.

The governance within the relation macroprudential policy and monetary policy is even more difficult to make sense of after this financial crisis. The biggest hurdle is that there is no clear objective of the macroprudential policy and moreover there is no particular institution to work for this objective. Hence, one could say that there should be no institutional problems between the macroprudential policy and the monetary policy. Yet, the crisis tells a different story.

In order to review the systemic conjuncture for now on central banks are the main integrator of information. However, there is no clear change in the mandates of other institutions that will force them to reveal all sort of prudential information to the central banks. In times of crisis the problem is reversed since monetary policy is forced to intervene over all other institutions. Even if there would be a separate institution to deal with the macroprudential policy, this would take the second position in times of crisis and would be at best overlooked in normal times.

Further reference:

Central bank responsibilities: price stability and financial stability

Potential feed-back between financial system and macroeconomics = this can be the main reason for the financial instability

Macroprudential concept: is referring to financial system stability in relationship with the macroeconomics. Its goal: to avoid macroeconomics’ costs resulting from financial system instability.

Macroprudential objectives:

• maturity mismatch
• liquidity ratio
• efficient allocation of credit (LTV,DTI,LTI)

Macroprudential policies are not a substitute for the microprudential policies (supervision and regulations). They are not substitute for monetary and fiscal policies (these are having primary focus against macroeconomic imbalances).

Institutional implications: regulation and macroprudential policy

The relation between the macroprudential policy and regulation is affected much in the same way as is the case of monetary policy in terms of reporting lines and governance. This is the direct result of the fact that there is no institution to perform the macroprudential policy.

However, there is an addition to this relation because regulation as well as macroprudential policy is not a field restrained to one institution. Hence, both reporting lines and governance are more difficult to conduct under these circumstances.

In terms of reporting lines, or the way macroprudential and regulation are done, there was much help from the G20 in deciding the major changes to be done in each country. But difficulties started at this point because many bridge institutions have to be created to help raise the issues from sector/market/company level to system wide implications. This is an ongoing effort and the difficulties in implementing the Dodd Frank reform are revealing.

Another important issue for regulation and macroprudential reporting lines is what actually happens in time of crisis. The numerous bailout packages (be they for companies or governments) prove that there still are opacity and bottlenecks in the channels that link regulation and macroprudential policy.

In fact it might be the case that the financial system will face a gradual settlement of the different risk factors as each type of security, measure, company will find its place in the macroprudential policy and regulation will be able to follow its evolution in normal times.

The incertitude regarding the relation between macroprudential policy and regulation is two sided in terms of governance. On one hand, in the absence of crisis the relation is more complicated and it can be counterproductive. In normal times, the institutions that make the regulation are supposed to be the guardian of the macroprudential objectives by altering their respective principles/indicators/measures. This double standard (targeted) system cannot be efficient as it can be reduced to a principal agent problem for these objectives, resulting in moral hazard. On the other hand, in time of crisis as we observed during and in the immediate aftermath of the events of 2007 and 2008 regulation is subordinated to the macroprudential policy.

Another flavour to the relation between regulation and macroprudential policy is added by the fact that in many countries an important actor in regulation is the central bank, and increasingly so after the last crisis. This factor helps as long as the risks to the financial system stem from the banking sector but should this originate in capital markets the system as nowadays built might not be effective. The biggest danger is that the credibility of institutions entitled to deal with the crisis will be lost.

Further reference: Central bank credibility and central bank main challenges: economical, intellectual and institutional.

An obvious issue to be raised here is if “Chinese Walls” would function for central banks when they are the agent in charge with both macroprudential and regulation policy. The answer to this question is that “Chinese Walls” might actually be a hindrance in this case and in fact may cover up certain risks. The financial crisis was among other things the result of miscommunication (read different definitions, assessment, procedures) between institutions regarding the risks they saw in the financial system. For this reason alone “Chinese walls” would not be value added for the macroprudential policy.

Institutional implications: fiscal policy and macroprudential policy

Macroprudential policy and fiscal policy have a complicated relation from the institutional point of view. There are at least two reasons for this and this impacts both the responsibilities and reporting lines as well as the governance and administration.

First, the two policies have different but powerful constituencies hence changes are difficult to decide and implement. In the case of the responsibilities (or reporting lines) deciding for instance on changing the tax system in order to give up interest payments deductibility is quite difficult as the losers’ constituency is powerful in politics. On the other hand, macroprudential policy can employ tougher measures that encompass a bigger constituency – for instance by changing the monetary policy. Fiscal or budgetary measures are more difficult to be implemented both in normal and crisis time because they need consensus in the parliament. In the case of governance or administration the exercise from the last crisis shows that although monetary policy was the last line of defence the budget and ultimately future tax raises were used in conjuncture with liquidity. In normal times it is close to impossible to envisage an institutional subordination of fiscal policy to the macroprudential policy. The difficulty in implementing tough adjustment policies in the euro area makes this point abundantly clear. (Further reference: FISCAL DOMINANCE ERA = 3D action: deficit, debt, deleveraging).

Second, the two policies have different time frames for becoming effective and this can become very difficult especially from the governance point of view. In the case of reporting lines, the moment a change is decided as essential from the point of view of the macroprudential policy can be totally unacceptable from the point of view of fiscal policy. The example of euro area economies where the adjustment policies trigger recession and then push for fiscal changes that in turn affect the macroprudential objectives is a good lesson. In the case of governance the macroprudential measures to be taken even under crisis conditions are very difficult to be imposed to the fiscal policy. In fact the example of the EU shows that not even international pressure can convince the fiscal policy of one state to subordinate to the macroprudential objective when the economy is in the downward sequence of the economic cycle.

One lesson from the sovereign crisis in the euro area is that the monetary policy is willing and able to submit to the macroprudential policy, while the fiscal policy even if it is willing is unable to surrender.

Further reference: Budgetary austerity

• not to be generalized - specially tailored country by country.
• May diminish internal demand and consumption
• Solving sovereign debt and deficits is a Marathon, not a sprint
• Premature and excessive fiscal contraction (austerity) can exacerbate the budget problems in a long run.
• Big challenge: Extraordinary steps that monetary and fiscal policies have to take to offset private sector deleveraging
• Fiscal expansion – Structural fiscal deficits
• Fiscal consolidation – government’s target
• A real independent central bank

Macroprudential policy in Romania before the crisis

In Romania the macroeconomic equilibrium deteriorated from 2004 to 2008. The main cause of this was the easy access to foreign denominated consumption credit. As a result, the current account deficit increased to double digit levels (13%) and the inflation rate was higher than the NBR’s target. Fiscal deficit well behaved until election times ballooned to almost 8% in the election year, while economic growth was much above the potential.

In Romania the NBR follows an inflation target strategy but also is responsible for financial stability being the regulator for the banking sector. Thus, the NBR has a number of responsibilities within the macroprudential field.

Since 2004 the NBR has tried some of the instruments that the macroprudential policy recommends as of today. In order to cool off the credit growth the NBR used its monetary policy instruments:

• increase the policy interest rate;
• increasing the minimum reserve requirements both for domestic and foreign denominated liabilities to record level (40%).

Obviously, the increase of the policy rate attracted foreign investors eager to take advantage of the interest rate differential. This capital inflow was appreciating the exchange rate encouraging even more foreign denominated borrowings especially for households.

The NBR then tried even to surprise the market by decreasing the policy rate hoping to inhibit some of the foreign capital inflows. This has only increased the aggregate demand while the banking sector was bringing even more resources from their parent banks.

The NBR coupled the monetary policy instruments with prudential (regulatory) measures in order to check the credit growth by:

• introducing a maximum debt service to income level for households;
• limiting the exposure of banks to the exchange rate risk;
• increasing the provisions for foreign denominated credit for unhedged borrowers;

The banks managed to circumvent these measures among others by externalising large chunks of their portfolios to their parent banks. This had very negative macroeconomic effects as the foreign debt expanded rapidly.

One aggravating factor was the public budget that allowed almost every year for a double digit increase in public sector wages. This was totally uncorrelated with the productivity and wages from the manufacturing sector.

Macroprudential policy in Romania after October 2008

The financial crisis hit Romania as well as other emerging economies in the region in October 2008. The Romanian current account deficit was unsustainable; the forex reserves of the NBR were almost 1:1 with the short term debt, while the structural public deficit was unsustainable.

The NBR turned to counter-cyclical measures in order to address the confidence and financial channels through which the crisis was transmitted into the Romanian economy. The NBR used all its policy options.

In the monetary policy realm it decreased the monetary policy interest rate several times. It also made changes in the liquidity management and money market functioning by using the lending facilities, FX swaps and repo operations, by reducing the minimum reserve requirements and by amending the rules for inter-bank interest rates.

The NBR also used its powers in the regulatory field by simplifying the mortgage lending rules, by adapting the provisioning requirements for loans overdue for more than 90 days and by allowing for interim profit to be included in own funds.

However, the credibility and the cushion from foreign investors (speculators) were secured by two factors. First, the IMF SBA that provided the NBR with the additional forex in order to compensate the rate of forex reserves to short term debt. Second, the so called “Vienna Initiative” – the agreement signed between the IMF and the nine foreign banks with the largest exposure in Romania to keep the overall exposure to Romania and to increase the capital of their Romanian subsidiaries if needed.

Of course there was a serious and painful adjustment that the Romanian economy went through in 2009 and 2010 in order to correct the macroeconomic imbalances but the crux of the matter is that the macroprudential objective could not be achieved in the absence of foreign cooperation as was the Vienna Initiative.

Conclusions

To sum up, the implementation of the macroprudential policy is hindered by three factors. First, the operational issues are the easiest to be overcome as there is already a list of indicators to work with and the experience of the IMF in designing and analysing cross-sector and cross-country indicators is very helpful. The operational issues take time to be solved but there is previous experience in this field.

Second, the institutional issues are difficult to overcome because there are problems to solve both at national level with constituencies having diverging interests and at international level where communication between institutions is yet to be exercised. However, the common actions of the central banks in the worst moments of the crisis can offer some guidance.

Third, the unsolved problem of the macroprudential policy implementation is that of cooperation between sovereigns. As of now there is no mechanism of convincing/forcing a sovereign entity to engage in economic adjustment. It may very well be that sovereignty must redefined itself and depart from the Westphalian definition.

The experience of the NBR shows that without international cooperation there is little success in macroprudential policy implementation and that the central bank even if it is one of the most credible institutions cannot do it alone.

A financial stability can be in danger even on the conditions of a price stability and macroeconomic stability.

Further references:

Financial stability:

• Central bank : executive responsibility
• MoF : crisis management and resolution

• 
• 
• 
• 
•