A Possible Macro-prudential Approach

A Possible Macro-prudential Approach

July 2010

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Contents Introduction and Executive Summary 3 Background: what is macro-prudential regulation? 5 Why is macro-prudential supervision needed? 6 The objective of macro-prudential policy 8 Types of macro-prudential instruments 9 Experiences of applying macro-prudential instruments 10 Implementation considerations 11 A possible model for macro-prudential supervision in the UK 13 Conclusion 18 Annex 1: Examples of balance sheet instruments 19 Annex 2: Linking macro economic analysis to micro- supervision in the EU 20 Annex 3: Examples of macro-prudential tools utilised in other jurisdictions 21 Annex 4: A possible model for macro-prudential supervision in the UK 26 Annex 5: Indicators of exuberance 27 Endnotes 29

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Introduction This paper is intended to demonstrate that one of the lessons to be drawn from the financial turmoil is the need for macro-prudential regulation to provide a link between the stewardship of the economy and the oversight of individual firms. It proposes a model for how this might be made operable in the UK and be linked to international and European initiatives. Its starting point is that the level of capital held in the system should be linked to the level of risk. It recognises, however, that there is a need for a credible authority to identify risks in the system and, ultimately, have the task of moderating behaviour when financial markets become excessively exuberant. Whilst regulatory reform can go someway towards guarding against failure, and mitigating its consequences, it cannot be the only answer. An international approach is essential. It is critical to avoid any excessive measures that impair the international competitiveness of the UK banking industry as a whole. The paper is intended to build on the Bank of England’s November 2009 Discussion Paper on ‘The role of macroprudential policy’. It fits in to the wider BBA series of occasional papers titled ‘Next Steps for Banking’ and is designed to stimulate debate. Executive Summary Why is macro-prudential policy needed? Monetary policy and micro-prudential regulation are limited in their ability to control the credit supply at the systemic level and to translate systemic risk warnings into policy actions. The adoption of a macro-prudential approach would offer the authorities a means of better protecting the economy against the consequences of financial instability so as to maintain the essential services banks provide to the real economy through otherwise severe economic disturbances. The need for a macro-prudential regime should not, however, obscure the fact that it is not sufficient in itself. Without a holistic approach, which recognises shortcomings in monetary policy, fundamental economic imbalances, the need for sustainable fiscal policy and effective micro supervision, macro-prudential regulation, however well designed, intentioned and implemented is unlikely to prevent a future crisis occurring. What should be the objective of macro-prudential policy? The objectives of macro-prudential policy can be broadly or narrowly defined along a continuum at one end of which lies the stability of individual financial institutions and, at the other, the prevention of asset bubble emerging. Our view is that there is a balance to be struck between the two. The objective should be more ambitious than simply increasing the resilience of firms; the targeting of asset prices bubbles should be part of the regime but not its overriding objective. A part of its role should be to 'join up the dots' of micro supervision as well as look at wider macroeconomic risks. Tools to implement a macro-prudential approach The tools to implement a macro-prudential regime will be dependant upon its objectives. Tools can be broadly divided into those which impact the asset and the liability sides of the balance sheet. The decision on which to adopt should be based upon thorough analysis and an understanding of the trade-offs involved in terms of the impact on individual businesses, households and the economy overall. It is critical that the debate is conducted internationally and is not exclusively UK-focused. There are many precedents from Asia where specific macro-prudential measures have been employed. Lessons can be learnt from these. Perhaps more fundamentally, the quality of economic statistics needs to be improved so that policy decisions are based on an accurate picture of what is really going on.

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A possible model for macro-prudential supervision in the UK The paper sets out a model to demonstrate how macro-prudential policy could be adopted in the UK and to examine the practical considerations the implementation of such a model would raise. It is based on the upgrading of the Bank of England’s (new) Financial Stability Committee to a stature similar to that of the Monetary Policy Committee. The model would provide both a link between the identification of macroeconomic risks to the economy and the actions taken by the supervisors of individual firms and provide a greater degree of influence over the supply of credit to the economy. The FSC would be required to identify macroeconomic and systemic risks in the financial system as a whole, including areas of potential exuberance in the economy. It would have a range of tools available to transmit its conclusions to the market. In order to achieve operational effectiveness, the FSC needs to ensure its interaction with the industry works well. Thought also needs to be given to the democratic process. Accountability therefore needs to be established through the Council for Financial Stability (or an equivalent body). At one end of the spectrum would be moral suasion via the publication of its minutes which would identify potential areas of risk. The existing Financial Stability Review could be upgraded to convey specific risk warnings for consideration by the tripartite Council for Financial Stability, which could be mandated to consider the warnings and account to Parliament on the steps it had taken to mitigate them: from stress testing to changes in legislation or fiscal policy. At the other end the FSC could have a mandate to assess the level of capital or liquidity that should be held in the system and to set, for example, a range for core tier 1 capital which should be held by banks against specific risks. If counter-cyclical capital buffers are adopted, the FSC could also play a role in indicating the right time for buffers to be drawn down.

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Background: what is macro-prudential regulation? ‘The debate on the reform of the international financial system follows a cycle. In the middle of each crisis – and there have been at least six since the Debt Crisis which started in Mexico in 1982 – there are deafening demands for the whole-sale reform of the entire international financial system. A few months on from the end of each crisis and those demands fade. There were clear and present parallels between calls made in previous crises and those made in the thick of the last crisis, for the IMF to become a lender of last resort, injecting substantial liquidity in times of crisis, and for hedge funds to be regulated. Every crisis inspires plans for a new financial architecture and as the crisis ends, most of these plans are tided away.’i Although these words were written long before the current turmoil began in August 2007, they are remarkably prescient and could easily have been written to describe the response to the events of the last two years. The response to this crisis, however, can be associated with demands for one type of new approach more than any other: macro-prudential regulation. Although there is evidence of the term being used in the academic community since the late 1980s, usage has become more prominent during the course of 2008 and 2009 and in the process the term has been used to describe such a wide array of policy approaches and tools that it is now understood to mean different things to different people. Each of the key analyses of the financial turmoil issued since the crisis – Turner Review, De Larosiere Group Report and G20 recommendations – have emphasised the importance of a ‘system-wide macro-prudential perspectiveii’, and it is now the subject of a dedicated Bank of England Discussion Paperiii. Lord Turner laments the absence of such a perspective arguing that ‘the failure to specify and to use levers to offset systemic risks were far more important to the origins of the crisis than any specific failure in supervisory process relating to individual firms’. He concludes: ‘getting macro-prudential analysis and tools right for the future is vital’iv. The concept of macro-prudential regulation, however, is not new. The term was in circulation at the Bank for International Settlements at least as early as the late 1970s to denote ‘a systemic or system-wide orientation of regulatory and supervisory frameworks and their link to the macroeconomy’v. In policy circles the concept gained credence gradually until it was thrust to the fore by the recent turmoil.

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Why is macro-prudential supervision needed? Until now, there have been two parts to the authorities’ stewardship of the economy:

at the macroeconomic level the Monetary Policy Committee of the Bank of England has the ability to influence the price of credit by flexing interest rates against an inflation target; and

at the micro level, prudential authorities have some control over an individual institution’s ability to supply credit by flexing capital requirements through the Pillar 2 process.

Although there has been no shortage of macro-prudential analysis conducted by central banks - including the Bank of England’s long running, half-yearly, Financial Stability Report - and international institutions such as the IMF, these analyses have not been connected or translated into policy actions. In effect, it has been nobody’s job to take away the punchbowl when risks to the economy have been identified. Over the last decade, for example, as global imbalances grew and the yield on risk-free government bonds declined, there was a rapid increase in the credit supply and a ‘ferocious search for yield’vi which stimulated financial innovation. Whilst these trends were all identified by financial stability reviews, in the absence of a macro mechanism, the supply of credit grew out of control. The authorities were unable to control the credit supply at the systemic level with either the macro or micro tools available to them. This is important because credit/asset price cycles can be key drivers of macroeconomic volatility and potential financial instabilityvii. If bubbles and examples of macroeconomic volatility can be identified at an early enough stage then it may be possible for corrective measures to be taken. For example, although acting on the conclusion that US housing had reached bubble territory in 2006 would have been too late to prevent many people purchasing houses at extreme high levels (and many lenders granting mortgages) a clear understanding that housing was in a bubble could, even then, have helped the authorities prepare for serious problems, especially once it was clear that house prices were falling. The real prize, however, would have been to identify the bubble far earlier and so prevent it inflating as far as it did. The limits of monetary policy As the Bank of England has noted, although the Monetary Policy Committee has the latitude to respond to medium term risks, to the extent to which they may affect inflation or output prospects, they have just one policy tool available to achieve this and there are good reasons why short term changes in interest rates are unsuitable for this taskviii:

it is unclear what impact a rise in short-term interest rates would have on the risk-taking propensity of the financial system;

it can be argued that in order to have prevented the current crisis from occurring, monetary policy would have needed to have been tightened to a degree inconsistent with that required to meet the inflation target. This would have had a cost in terms of lower output relative to trend which could have been large if risk choices were relatively insensitive to movements in short-term interest rates; and

using interest rates to target specific asset bubbles risks de-coupling the private sector’s expectations of inflation. Persistent deviations of inflation from target may, in the long-run, make the MPC’s ability to return inflation to target more challenging.

This view is shared by a growing number of commentators. For example, Charlie Bean has argued that it is not practicable to expect monetary policy to tame the credit cycle in addition to ‘steering the path of nominal demand in order to maintain low medium-term inflation expectations’ix. Similarly Lord Turner has identified the assumption “that low and stable inflation is a sufficient definition of financial macroeconomic stability” as one of the mistakes which contributed to the financial turmoilx. In his view “low and stable inflation does not by itself guard against volatility in the supply of credit, against

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surges on credit supply and risk appetite which drive asset prices to unsustainably high levels, followed by sudden collapses of confidence and credit supply which drive asset price falls and wider economic recession”xi. As Paul Tucker has made clear, however, this is ‘not to say that monetary policy should not take into account risks to the inflation outlook that accumulate slowly and with great uncertainty about when and how they will crystallise. But it makes a compelling case that monetary policy is not sufficient on its own’xii. The limits of micro supervision As noted above, the authorities have some influence over an institution’s ability to supply credit, via the Pillar 2 supervisory review process in the Basel framework. Discussions are currently underway globally to enhance the range of tools available to supervisors in this area so as to increase the resilience and reduce the pro-cyclical tendencies of individual institutions. For example, the Basel Committee has been instructed by the G20 to enhance prudential standards so as to:

improve the risk capture of capital requirements; increase the quality and quantum of capital in the system; develop new standards for liquidity buffers; and mitigate pro-cyclicality in regulatory requirements.

There are several interrelated pieces of work being conducted in this last area which go someway towards capturing broader macro risks in the system. The Basel Committee is developing proposals to reduce the cyclicality of the minimum capital requirement itself, in terms of through the cycle PDs and scalars, the accounting authorities are working to move the accounting framework from an ‘incurred’ to an ‘expected’ basis to enable the earlier recognition of losses, and the Basel Committee is considering means of building capital buffers, over and above the minimum capital requirement, which can be built up during periods of economic growth and drawn down in downturns. Although the desire to develop these measures is understandable (concerns over calibration and quantitative impact aside), in that they will increase the number of policy levers available to supervisors, their target is the resilience of individual institutions and the banking system not the economic system as a whole. They might go someway towards smoothing the provision of credit to the economy but they fail to provide that direct link between the supervisor’s actions and micro or macro monitoring.

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The objective of macro-prudential policy If there is indeed a gap between the macroeconomic oversight of the economy and the supervision of individual institutions, what should be the objectives for the policy tools designed to fit in this space? Although the high-level objective of macro-prudential supervision should be the maintenance of financial stability, there is a broad spectrum of possible objectives for macro-prudential policy. This can be said to consist of at one end, protecting the banking system from the economic cycle to, at the other, seeking to moderate asset price bubbles or financial imbalances more broadly. It is probably unrealistic to make the prevention of asset bubbles emerging the principal objective of macro-prudential policy (not least for the ‘leakage’ reasons discussed below), although it could reasonably be expected that by moderating the exuberant supply of credit, macro-prudential policy might go someway towards mitigating bubbles. Conversely, the objective should be more ambitious than simply increasing the resilience of financial institutions in the face of the economic cycle. There is clearly a balance to be struck between these two. This paper concurs with Paul Tucker that this balance, and therefore the objective of macro-prudential policy, should be to protect the economy against the adverse consequences of financial instability and to maintain, through otherwise severe economic disturbances, the essential services banks provide to the real economyxiii. The targeting of asset price bubbles should be part of the regime, but not the overriding objective. The regime should focus on wider issues such as the possible build-up of risk (with systemic consequences) within the supply of credit, as well as control over the overall supply. Furthermore, it should seek to identify risks such as concentration risks from unregulated counterparties, or broader concerns around lending standards and the quality of documentation. Macro-prudential regulation should be used to 'join up the dots' of micro supervision as well as look at the wider macroeconomic risks. From the perspective of the banking industry, a key objective for any macro-prudential model would be to ensure that it complemented rather than simply added to measures being taken in the prudential regulation and supervision spaces. It should help lead to the development of a ‘smarter’ regime which is based upon the level of capital held in the system accurately reflecting the level risk. It should also be a system-wide approach and not just focus on the banking industry. The behaviour of business and households must also be considered. Consideration should also be given to the time lag that may exist between the identification of a systemic risk and the application of a macro-prudential tool or the changing of macroeconomic parameters.

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Types of macro-prudential instruments Once the objective of macro-prudential policy is identified, the tools used to achieve those aims must be considered. Numerous specific tools and levers have been identified – and utilised – in this space. Broadly they can be divided between measures which impact the asset side and measures which impact the liability sides of a bank’s balance sheet. The table in Annex 1 summarises the tools which could be used to influence the supply of credit via price or quantity. Any decision on the suitability of such tools must first be based on a thorough assessment of the likely impact each would have. As the Bank of England has noted, “Choosing between these instruments involves trade-offs. It involves balancing the desire to exercise leverage over credit supply decisions on the one hand, and the desire to minimise effects on the commercial decision-making of financial institutions on the other”xiv. Adjusting headline capital adequacy ratios as a means of attempting to control the supply of credit to the economy could, for example, have perverse effects. If policy makers were to increase headline capital requirements in response to concern at over exuberance in one area of the economy, banks could respond in very different ways. “This could include the perverse reaction of cutting lending to the unexuberant parts of the real economy, while continuing to lend on overly relaxed terms to…the exuberant” partxv. Any tool which is adopted, therefore, must be capable of targeting activity in specific segments of the economy. This is something which perhaps the most favoured macro-prudential tool - counter-cyclical capital ratios – can do. It has been argued by Stephen Green that a counter-cyclical capital approach would be “more alert to systemic stresses and…more closely aligned with key macro indicators in the real economy than has hitherto been the case”xvi. To focus such a system either the risk weights on exposures to particular classes of borrower could be altered or the minimum collateral haircuts on secured lending could be varied. Such a system would force banks to gradually “increase the amount of capital they hold against assets, across the board or in key sectors, to discourage excess and to build up their reserves before leaner times.” As Stephen Green notes, such a system is attractive because it also means “that during the bad times, capital ratios could be managed to help offset a dangerous drop in lending to a suffering economy”xvii. Focused tools such as these have the attraction that they are less blunt than across the board capital increases and thereby recognise that ‘different categories of credit perform different economic functions’xviii. Whichever tool or combination of tools is considered, it is important to weigh the potential impact on the real economy, financial institutions and the competitiveness of the UK as an international financial centre. It is also important not to forget past experience. The Bank of England has reminded us that earlier UK experience shows that “[m]ultiplying the number of restrictions on banks’ balance sheets was rarely beneficial. It added complexity and thus distortion without any correspondingly greater degree of control. As in a monetary policy context, this suggests there should be a strong preference for simple, targeted measures wherever possible and we should aim to avoid a proliferation of instruments”xix.

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Experiences of applying macro-prudential instruments There is some evidence of macro-prudential tools being used in practice (see annex 1 and 3). The 1997 financial crisis, for example, led to several Asian central banks developing and implementing macro-prudential capabilities. The table below illustrates the types of tools which have been used in Asian economies and their objectivesxx.

Objective Tools Examples Manage the aggregate risk over time (i.e. pro-cyclicality)

Counter-cyclical capital buffers linked to credit growth

Counter-cyclical provisioning

Loan-to-value ratios Direct controls on lending to

specific sectors

China* China, India China, Hong Kong, Korea,

Singapore Korea, Malaysia,

Philippines, Singapore

Manage aggregate risk at every point in time (i.e. systemic oversight)

Capital surcharges Liquidity

requirements/funding Limits on currency

mismatches Loan-to-deposits

requirements

China, India, Philippines, Singapore

India, Korea, Philippines, Singapore

India, Malaysia, Philippines China, Korea

*Under consideration Measures such as manipulation of loan-to-value multiples for mortgage lending that differ for segments of a domestic property market are an effective tool used by Hong Kong and Singapore. Similarly, use of reserve requirements is a supplementary means of tightening/loosening the monetary stance across Asia. In principle, these could be targeted for specific institutions/groups of institutions, and are less of a blunt instrument than relying on interest rates alone. We need to take care, however, in assessing whether tools utilised elsewhere would be suited to the UK market. Loan-to-value ratios for example may be better expressed as implying variable capital requirements under Pillar 2 - and evidence of an appropriate pricing strategy on the part of the individual institutions – than through the introduction of absolute limits which may impede unduly on banks’ ability to lend to otherwise good credit risk. It needs also to be borne in mind that loan-to-values are a point in time limit and may work against the mortgagees’ ability to transfer providers in a downturn.

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Implementation considerations In developing a macro-prudential framework, it is vital to consider the limitations of a macro-prudential approach and how the tools to conduct it might be implemented. The key issues for consideration are discussed below. Rules v discretion? Of central importance is the degree to which the regime should be discretionary or rules based. Although rules-based regimes have the attraction of credibility, in that the rules of the game are transparent, they have the disadvantage of a lack of flexibility and run the risk of becoming obsolete as markets evolve and develop. In addition, and perhaps more importantly, macro-prudential regulation, by its very nature, is based on judgement. Policy actors must transfer their judgements about the risks which have been identified through macro-prudential surveillance into policy prescriptions. It would be vital, however, for these judgements to be made within a transparent framework where policy makers would “explain the basis of their decisions and how they relate to their mandated and specified objectives”xxi. In the Bank’s words, this points to a framework of “constrained discretion” in which some rule-like features would be combined with discretionxxii. Furthermore, if the objective is to identify the emergence of over exuberance, it is vital that this task is not approached as a binary question: is it a bubble or is it not? Bubbles vary in size and there is always a range of views about whether or not there is a bubble and how serious it is. Academic studies have shown that it is not possible to devise a simple decision rule for markets that would have correctly distinguished strong bull markets that ended with a crash from strong bull markets that reflected changed fundamentals. It is always a matter of judgement. It was partly this consideration that led former US Federal Reserve Chairman Greenspan to the conclusion that it was best not to try to make that judgement. But, having initially warned of “irrational exuberance” when the S&P500 was at around 700 in 1996 he was unwilling to worry about it when the index approached 1400 just three years later. If identifying a bubble is not a binary decision, how should we approach it? There are probably a number of ways and decision theory experts will have a contribution to make here. But the key is probably that the extent to which a bubble is emerging needs to be signalled on some sort of sliding scale. In turn the reaction to the signal can be scaled accordingly. Institution or system wide? The balance between the different objectives of macro-prudential policy (individual institution resilience v dampening the credit cycle) will drive the extent to which any regime is focused on the whole market or individual institutions. If the objective is to simply make individual institutions more robust in the face of the economic cycle then it follows that tools should be designed to impact individual institutions’ balance sheets. The greater the importance placed upon dampening the credit cycle and protecting the real economy from activities in the financial sector then the greater is the need for the tools to be system wide. If the objective is to stem credit growth on a system wide basis the issue of what is termed “leakage” by Paul Tucker arises. That is, if UK domestic authorities were to take steps to reduce the credit supply, these would only apply to UK headquartered firms and the subsidiaries of foreign owned banks. It would not impact branches of foreign-headquartered banks operating in the UK and would therefore have a lesser impact than it might otherwise do. That being said, the resilience of UK banks would still be strengthened but it does point to the desirability of a coordinated EU or global approach.

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National or international? In many ways, the European Union’s decision to adopt a new approach to macro-prudential surveillance is illustrative of the fact that it is much easier to work at a supra-national level to identify threats than it is to respond to them. Whilst the creation of the ESRB is an important step for the EU, it is equally important that macro-prudential surveillance and early warning exercises are conducted at an international level. The BBA therefore welcomes the G20 leaders’ decision to direct the IMF and Financial Stability Board to collaborate in developing a new global early warning system. As noted above, the Basel Committee is working to develop new tools to both strengthen the resilience of individual institutions via counter-cyclical buffering at the micro level as well as a framework to contain excess credit growth and protect the economy at a macro level. Although the agreement of a global framework therefore looks likely, there will be a strong national dimension as it will be national authorities who will retain responsibility for the supervision of individual institutions and the stewardship of national economies. Consistency with other policy goals Macro-prudential policy cannot operate in a vacuum. It will be vital for it to support both wider macro-economic and micro-prudential policy. As the Bank has noted, the objectives of macro-prudential policy are again key. “Narrower macro-prudential tools call for consistency with micro-prudential instruments; broader macro-prudential tools for consistency with monetary policy”xxiii. It will also be important to consider the behavioural impact the policy tools will have on institutions and consumers and the interaction with other regulatory measures. For example, recent history has demonstrated that the implementation of Basel II, and the differing levels of capital charged against instruments held in the banking and trading books, changed behaviour. In the US, the interaction of accounting standards and the leverage ratio drove the use of off-balance sheet vehicles. Furthermore, the development and introduction of tools to implement macro-prudential policy must be cognisant of other measures which are being applied to the banking system and the cumulative impact these will have on the ability of institutions to perform their intermediation role in the economy.

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A possible model for macro-prudential supervision in the UK Below we set out a model for macro-prudential supervision which seeks to meet the objectives outlined above: the protection of the economy against the adverse consequences of financial instability and the maintenance of the essential services banks provide to the real economy, through otherwise severe economic disturbances. The model builds on existing structures and tools to build an institutional framework to link macroeconomic surveillance with micro supervision. It is put forward as an example of the way in which macro-prudential regulation could be implemented. As such it is not a ‘ready made solution’ but is intended to tease out the implementation issues which would need to be overcome to make a regime workable. As noted elsewhere within this paper, however, the need for the development of a macro-prudential framework should not obscure the fact that it is not sufficient in itself. Without a holistic approach, which recognises shortcomings in monetary policy, fundamental economic imbalances, the need for sustainable fiscal policy and effective micro supervision macro-prudential regulation, however well designed, intentioned and implemented, is unlikely to prevent a future crisis occurring. The missing lever As argued above, the Monetary Policy Committee does not have the ability to influence the supply of credit to the economy, just the price (by adjusting interest rates against the inflation target). And, although the FSA has the ability to influence the way in which individual institutions supply credit, via the Pillar 2 process, there is no link between these actions and macro or systemic monitoring. The conditions which led to the current economic turmoil demonstrate that there is a need for a new macro economic lever to link the identification of macro economic risks with the supervision of firms and ultimately to provide a means of controlling the supply of credit to the economy. Linking macro to micro A number of important studies into the lessons to be learnt from the crisis have identified the need for a mechanism to link the macroeconomic monitoring undertaken by central banks to the supervision of individual firms. The G20 and EU have proposed structures for macroeconomic monitoring. The Financial Stability Board and IMF have been tasked with this role globally and the proposed new ‘European Systemic Risk Board’ (ESRB) is intended to perform the role in the EU. The European structure proposed by the De Larosiere Group on Financial Stability, and endorsed by the European Commission and Council, is the more ambitious of the two in that it is part of a system which is specifically designed to link the identification of risks at the macro level to the actions of micro supervisorsxxiv. We believe that a model similar to that proposed for the EU can be adopted in the UK. The model we envisage would provide both a link between the identification of macroeconomic risks to the economy and the actions taken by the supervisors of individual firms and create the ability for the Bank of England to manage both the price and supply of credit. Upgrading the Financial Stability Committee The Banking Act 2009 introduced important reforms to the Bank of England. Not least of these was the creation of a new sub-committee of the Bank’s Court of Directors endowed with responsibility for the Bank’s financial stability strategy. This Financial Stability Committee (FSC) is chaired by the Governor, with the membership comprising the two Deputy Governors, four other directors, a representative of the Treasury and outside experts co-opted as deemed necessary. In our model the FSC would be upgraded in stature to that of the Monetary Policy Committee. It would operate in a similar manner, meeting on at least a quarterly basis, to identify macroeconomic and systemic risks in the financial system as a whole, including areas of potential exuberance in the economy. The FSC would have a range of tools available to transmit its conclusions to the market.

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At one end of the spectrum would be moral suasion via the publication of the minutes of the FSC’s meetings which would identify potential areas of risk for government, the market and households to take note. The emphasis would be on raising awareness and nudging behaviour in the right direction. The Committee’s output could be supported by the publication of the analysis on which members had taken their decisions. We note that the Bank of England already publishes a biannual Financial Stability Review which ‘aims to identify the major downside risks to the UK financial system and thereby help financial firms, authorities and the wider public in managing and preparing for these risksxxv’. The Financial Stability Review could also be used to convey more specific risk warnings. To ensure that these were acted upon, the Council for Financial Stability1 could be mandated to consider the warnings and account to Parliament on the steps it has taken to address them. These could encompass, for example, the FSA undertaking a stress testing exercise or the Treasury acting to remove incentives in the tax system or legislation viewed as distorting behaviour. The production of risk warnings of this type would fit well with the nature of financial stability and the difficulty of identifying an indicator which could be targeted in the same way as the Consumer Price Index is by the Monetary Policy Committee. To the other end of the spectrum, the authority could receive a mandate to assess the level of capital or liquidity that should be held in the banking system and to set, for example, a range for core Tier 1 capital which should be held by banks against specific risks. If, as is anticipated, a variable counter-cyclical buffer element is added to the capital framework, the Committee could also indicate the time in the economic cycle for capital requirements to be relaxed and the buffer drawn down. Again there is a role for the CFS to play in ensuring that the tripartite authorities are coordinated in their actions and are working towards the government’s financial stability objectives. Should the FSC be empowered to go as far as to give guidance on the level of capital to be held against specific risks in the system, a mechanism would be needed to translate this macro analysis into supervisory action at the individual firm level. A modified Pillar 2 process would be one possible method of doing this. This would allow the FSA the discretion to tailor the capital requirements to the specific exposure of individual firms. A feedback loop would be created between the FSA and the FSC, with the latter determining its data requirements. In reaching its views on risks in the system, the FSC would take account of developments in the ESRB and FSB. Identifying risks The ability to identify the level of macro-economic and systemic stress in the system would be the key to making this model work. As the Bank of England has noted, in practice there is unlikely to be a single, quantitative indicator which captures accurately exuberance in credit markets. Furthermore, it is unlikely that any one indicator is likely to be a robust guidepost to policy overtimexxvi. It is, however, possible to identify a set of variables at an aggregate or sector level which might be considered for this purpose. We include a list of possible measures in the Annex to this paper, many of which have been identified by the Bank of England as possible candidates. However, we would add to this two other important indicators: ‘q’ and ‘cape’. ‘q’ is the ratio between the value of companies according to the stock market and their net worth measured at replacement cost. It can be defined to include or

1 The Financial Services Bill places the Council for Financial Stability onto a statutory footing. The Council represents the formalisation of the existing ‘Tripartite’. As such, it is chaired by the Chancellor and attended by the Governor and the Chairman of the FSA. The Council is responsible for considering emerging risks to the financial stability of the UK and global financial system, and coordinating appropriate response by the UK’s authorities.

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exclude corporate debt. ‘cape’ is the cyclically adjusted P/E ratioxxvii. In our view, both could serve as valid indicators of exuberance. In setting the capital ranges to be used by the supervisor to adjust individual capital requirements under a modified Pillar 2 process, the FSC would need to exercise judgement to translate the above indicators into risk weights and capital ranges. As the Bank acknowledges, one way of doing this might be to apply a prescribed set of stress scenarios to the factors driving default and recovery rates on classes of lending. These prescribed stresses could be dependant on the position of the credit cycle, moving in an anti-cyclical way so as to become more severe as a credit boom expanded and relaxing as it deflatedxxviii. Utilising other tools It might be appropriate to endow the FSC with further tools to assist it in meeting its objectives. For example, tools such as LTV caps, haircuts on certain transactions between the banking sector and non-banking sector could be used to extend the influence of the FSC and reduce the impact of ‘leakage’. Furthermore, similar measures could be extended to liquidity to counteract the propensity of liquidity risk to be underpriced during credit booms. As noted above, other jurisdictions have experience of using such tools and we should not be hesitant in learning lessons from their implementation. Making the regime workable Not just capital Much attention is, rightly, being paid to capital levels. However capital is just one of the fundamental constituents of the banking industry and as such it would be vital for any macro-prudential regime to look at a wider range of issues than credit supply, for example liquidity risk and systemic risks posed by weaknesses in clearing and settlement systems. There is also a need for a wider range of policy responses such as on liquidity measures in addition to capital requirements. Ranges or targets & timetable It would need to be considered whether the FSC would provide guidance on a minimum target or a range and whether, similar to the MPC, it would be looking at a target in two years time or seeking a more immediate move. Where targets are directed at specific key sectors there is also the need to consider the issues of cross-subsidisation within larger groups that may arise. Credibility An issue of fundamental importance to the workability of such a regime would be the ability of the mechanism to release capital at the appropriate point in the cycle. Unless the regime is wholly credible, it is very likely that the market would punish any institution attempting to reduce capital ratios during a recession. We believe that the FSC, if upgraded in stature to that of the MPC, would possess this credibility. It would be fully independent of both Government and Whitehall, its members would be authoritative, commanding the respect of government and the market; it would operate transparently, with the publication of formal minutes, and on the basis on known data. Accountability Allied to the issue of credibility is that of accountability. The MPC is responsible to the Government and Parliament via the inflation target. If inflation deviates from the target by one per cent then the Governor must write to the Chancellor setting out the reasons why and the steps to be taken to return to target. A clear means of holding the FSC accountable would need to be found before any

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such regime could be considered workable. This raises the question of whether it would be appropriate to set a target which the FSC should be directed to focus upon. Feedback data This issue is linked to the need for a clear feedback mechanism to ensure that the FSC’s macro-prudential analysis was informed by market information on the impact of its measures. The information would need to enable the FSC to judge the level of confidence and liquidity in the markets and allow it to assess the likely market reaction to any to any recommendation particularly if it related to increasing or decreasing capital requirements. In our view, the FSC should have access to real time, aggregated data about the economy, the rate of defaults and transaction information. This data is not currently available but could be provided to make the regime workable. If it was, it would break the authorities’ current reliance on historic data to underpin the calibration of riskxxix. Willingness to act Before the present crisis, there was an understandable unwillingness among supervisors to prick bubbles too early for fear that this could ultimately cause more economic damage than allowing the bubble to burst. We believe that the events of the past few years have changed this balance and that there is a growing consensus that it is better to see errors on the side of caution than it is to deal with the consequences of economic failure. Nevertheless, any action to target exuberance is likely to be met by hostility from those active in the markets being targeted who will no doubt believe that action is being taken prematurely. This underlines the importance of the model operating on a transparent basis and being open to public scrutiny – particularly from banking analysts. That being said, the implementation by the micro supervisors via Pillar 2 must be kept confidential to ensure the stability of individual firms which could otherwise be the subject of destabilising speculation. Unforeseen consequences The willingness to act may also be tempered by the possibility of unforeseen consequences arising from any judgement made. If not properly managed there is a risk of sending a signal to the market that an asset bubble which is building could actually precipitate a collapse in that market that worsens bank balance sheets and liquidity concerns. Leakage As discussed above, cross-border ‘leakage’ is perhaps one of the biggest obstacles to making such a regime workable. However, there is nothing in this model which could not be replicated in other jurisdictions to provide the authorities with a similar mechanism on a structurally neutral basis. We note that the Bundesbank already undertakes an element of credit price management in Germany. Furthermore, the new arrangements for macroeconomic oversight being developed in the EU and at the G20 could play a crucial role in joining up national regimes. For example, each of these bodies could agree to monitor the same macroeconomic variables and systemic data. After reaching their decisions at a local level, they could then use colleges of supervisors to reach agreement on the appropriate capital levels to be held by the overseas operations of cross-border groups in markets where exuberance had been identified. The second aspect to leakage is that to other non-regulated sectors. Even if the credit supply from the regulatory sector was constrained there is the possibility that demand would be filled by the non-regulated sector or in the long-term lead to structural changes in the economy whereby, for example, large corporates disintermediate and access credit directly from capital markets. As noted above, there are means of containing, at least to a certain degree, the non-regulated sector’s access to credit via haircuts on margins etc. The second issue, however, is a more complex and difficult to resolve. Some have argued, as noted, that this is a limitation that must be accepted and that the increase in stability that would result from a macro-prudential regime, even a limited one, is a goal worth pursuing.

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Business and household behaviour Although a mechanism of this type could influence the behaviour of financial institutions, it is much more limited in its ability to influence businesses and households. Whilst it is to be hoped that the publication of risk warnings would feed through into the public consciousness, it is by no means guaranteed and therefore possible that if UK financial institutions are constrained from lending into a specific market segment then businesses and households will turn to alternative sources of finance. Conversely, as we have seen with the UK government’s lending targets, banks can make finance available to certain sectors but this does not guarantee that there will be the demand to take up this supply. This underlines the importance of a holistic approach and reinforces the limitations of macro leavers.

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Conclusion This paper has sought to use lessons learnt from the events of the past few years to identify a means of enhancing the stability of the financial system going forward. Whilst it is incontrovertibly the case that at least some of the answer to doing this lies in reform of prudential regulation, financial markets and the internal governance and processes of institutions and their supervisors, this paper has attempted to demonstrate that part of the answer lies in filling the gap between macroeconomic stewardship of the economy and the prudential supervision of individual institutions. Filling this gap with macro-prudential regulation can meet the objectives of protecting the economy against the adverse consequences of financial instability and help ensure the maintenance of the essential services banks provide to the real economy, through otherwise severe economic dislocations. It can provide the authorities with influence over the price and supply of credit: in effect it gives them the ability to take away the punch bowl. The paper has set out a model tailored to work in the UK but which could be made to work globally via the web of structures currently being created in the EU and FSB. The fundamental model could be replicated in any comparable jurisdiction on a structural neutral basis. Fundamentally, it needs to be recalled that no system of supervision can guarantee that a future crisis will not occur. Macro-prudential is not a panacea and should not be used to disguise the need for reform in other areas where the financial crisis has exposed weaknesses. This does not mean, however, that a model cannot be constructed which increases the stability of individual firms and the system as a whole whilst at the same time retaining the principle that the level of capital in the system should accurately reflect the risk in the system. British Bankers’ Association 31 March 2010

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Annex 1: Examples of balance sheet instrumentsxxx Balance sheet side

Variable affected

Policy tool Comments

Lending controls (ceiling)

Direct controls on the quantity of bank lending were in place prior to the introduction of Competition and Credit Control in 1971. Between 1965 and 1971, ceilings were used to target a specific rate of lending growth.

Loan to value/loan to income ratios (ceiling)

The Turner Review discussed the possibility of regulating LTVs or LTIs to constrain credit growth and excess in the property market so as to reduce the amplitude of the economic cycle. It considered the possibility also of dynamic regime which would vary these over the economic cycle.

Quantities

Cash reserve requirements (floor)

Requirements to hold government bonds or cash reserves deposited at Central Banks. The FSA’s new liquidity regime moves in this direction in that it will require banks to run more conservative treasury operations.

Asset

Prices

Loan rate control (floor or ceiling)

If used as a ceiling, loan rate control could decrease lending because it would reduce the ability of banks’ to lend to higher risk customers. If used as a floor it could act directly on the demand for credit.

Capital requirements (floor)

There are many options here. The Basel Committee is considering the appropriate level of capital in the system, at the same time as developing a counter-cyclical buffering mechanism. The Turner Review proposed the development of an Economic Cycle Reserve built loosely on the concept of the Spanish system of dynamic provisioning.

Core funding requirement (floor)

Liquidity regulation could impose constraints on the extent to which banks can use less stable sources of funding to grow rapidly. Again, the FSA proposed core funding ratio is an example of this.

Margining requirement (floor)

Broad-based collateral arrangements or a margin setting authority could enforce margining rules.

Quantities

Controls on the growth of banks’ interest-bearing eligible liabilities (ceiling)

For example the ‘Corset’ used in the UK during the 1970s. This penalised banks whose IBELs grew faster than a prescribed rate.

Liability

Prices

Deposit rate ceiling

A deposit rate ceiling could be used to constrain banks’ ability to expand rapidly, funded by high-paying retail deposits.

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Annex 2: Linking macro economic analysis to micro supervision in the EU The model below, based on the report of the De Larosiere Group, is currently under consideration in the European Parliament.

EUROPEAN SYSTEMIC RISK BOARD

European System of Financial Supervisors

European Banking

Authority

European Insurance Authority

European Securities and

Markets Authority

National Supervisors



Financial institutions & markets

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C:\Documents and Settings\richard.herridge\Desktop\A_Possible_Macro-Prudential_Approach.DOC 21 September 2010

Annex 3: Examples of macro-prudential tools utilised in other jurisdictions Hong Kong The macro-prudential measures in Hong Kong mainly target the housing market: 1. Hong Kong Monetary Authority issued a circular on 23 October 2009 to banks to provide

guidance to cap the loan-to-value ratio at 60 per cent for properties valued at above HKD20mn; 2. On the same day, the Hong Kong Mortgage Corporation announced that the maximum loan size

eligible for the Mortgage Insurance Programme would be lowered. In addition, non owner-occupied properties have been suspended from coverage under the programme;

3. On 3 March 2010, HKMA instructed lenders to set their mortgage rates 0.7ppt above the one-month HIBOR rate to prevent interest price competition from eroding banks’ profit margins and potentially the stability of the financial system; and

4. In the FY2011 budget, Financial Secretary John Tsang acknowledged that the “increased risk of a bubble forming” had “aroused public concern about the difficulty of buying a home”. In response, the government proposed four measures:

a. Increase housing supply, especially of small- and medium-sized residential flats, by fine-

tuning the land auction mechanism and reviving the secondary market for Home Ownership Scheme (HOS) flats;

b. Increase transaction costs for luxury property speculation by increasing stamp duty; c. Improve market transparency; and d. Prevent excessive growth in mortgage lending.

China Local government investment vehicles (LGIVs) In the past 18 months projects and financing have increased in reflection of the central government’s response to the economic crisis. Now the central government has begun to address outstanding debt and potential repayment problems. First, the Ministry of Finance has proposed draft rules to restrict the ability of LGIVs to credit, and is considering the possibility of allowing localities to issue their own bonds. On the banking regulation side, in early 2010, the CBRC instructed to banks to: (1) be very careful about lending to new LGIV projects; (2) evaluate LGIV projects they have previously lent to in order to ensure they are legal, have

adequate capital funding, and that the money will be repaid; and (3) clarify exactly which collateral has been provided and which guarantees have been offered by

local governments. The intention is to ensure that banks have evidence of local governments’ commitments to these loans. For LGIVs with more than two bank loans, the CBRC is encouraging banks to co-ordinate on calculating total exposures and clarifying who has the rights to which collateral. Property Market The government is attempting to cool the property market, in response to a surge in prices in large cities. Policies introduced since 2009 include: (1) To encourage the building of welfare and lower-end-market housing, developers granted a lower

minimum capital ratio of 20 per cent for such homes versus the 30 per cent for other types of commercial housing;

(2) In June 2009, Ministry of Housing and Urban-Rural Development (MoHURD) published detailed plans for annual targets for welfare housing over the period before 2011;

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(3) In November 2009, the Ministry of Land & Resources and NDRC jointly issued policies on land use (an extension of 2006 regulations), including limits on land to be used for commodity residential developments (< 7 hectares for a small city (town), < 14 hectares for medium-sized, and < 20 hectares (300 acres) for large cities);

(4) 50 per cent down-payment of land premium from government land with the subsequent amount being paid within a year and developers with overdue land premiums being prohibited from participating in land auctions before all overdue payments have been settled;

(5) Tax exemption period for business tax on secondary market transactions restored back to five years from two years, starting from 1 January 2010. All property transactions will be charged with 5.5 per cent business tax on the entire sales proceeds, unless the properties are held for more than five years;

(6) Reiteration of 11 policies from the State Council to increase supply, encourage first-time home purchases but rein in speculative purchases. Local governments released their own 11 policies, with regulations specific to local housing markets, e.g. Beijing, Chongqing, Guangzhou and Hangzhou; and

(7) 40 per cent deposit required for the purchase of second homes. Money Supply The Peoples Bank of China (PBoC) targeted CNY7.5trn new credits in 2010, which amounts to a credit growth rate of 18 per cent year on year. To manage the amount of liquidity in the market, PBoC increased the reserve requirement ratio (RRR) twice by 50bps each in January and February. Taiwan Property Market The existing regulation limits mortgage lending to less than 30 per cent of a bank’s deposit base. Although some banks are reported to be nearing this cap, overall mortgage loans to total deposit in the banking system as a whole is about 20 per cent. Meanwhile, the government is considering plans to raise property taxes and increase land supply as a means to rein in property market speculation. To this end, some state-owned banks have lowered their LTV ratio to 70 per cent, especially for clients deemed to speculators, and have lowered the approval limit for managers on mortgage loans. Money Supply In CBC’s quarterly policy meeting on 25 March 2010, CBC signaled it will accelerate the withdrawal of funds from the financial system and impose “prudent” measures on property lending to prevent the emergence of asset bubbles. Korea Financial system The Financial Services Commission released a white paper in December 2009 that unveiled plans to adopt loan-to-deposit ratio as one of its bank management guidance ratios. The Financial Supervisory Service amended the regulation on 26 March 2010 to employ banks’ liquidity or loan-to-deposit ratio to measure bank management soundness. The target for banks’ loan-to-deposit ratio is to be set at 100 per cent with a grace period until the end of 2013 whereupon banks will be required to maintain a ratio of less than 100 per cent from 1 January 2014. To oversee the progressive lowering of the ratio during the grace period, the FSS will review the ratio retrenchment plans of each respective bank on an annual basis.

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To strengthen local financial institutions’ FX management, the Financial Services Commission and Financial Supervisory Service proposed the following measures on 19 November 2009 to strengthen its supervision: (1) Fine-tuning the Regulation on FX Liquidity Ratio; (2) New Standards for FX Liquidity Risk Management; (3) Mandatory Minimum Holdings of Safe FX Assets; (4) New Standards for FX Derivatives Risk Management; (5) Tightened Regulations to Increase Mid- to long-term Financing in Foreign Loan Portfolios; (6) Promotion of Reasonable FX Hedge Practices by Asset Management Companies; (7) Clarification of Rules over Mandatory Reporting of Foreign Exchange Transactions; and (8) Review the Foreign Asset Limit (leverage ratio) by the Basel Committee on Banking

Supervision. In the 2010 Financial Policy Agenda, the Financial Services Commission, the Fair Trade Commission and the Ministry of Strategy and Finance set out the policy objectives for 2010 with the following proposal to enhance the soundness of financial system: (1) Improve the coverage of deposit insurance through the Korea Deposit Insurance Corporation on

newly introduced financial instruments; (2) Revitalise the RP market by improving on the RP trading infrastructure and easing RP

regulations for asset management companies to resolve the issue of excessively active Call trading; and

(3) Reform the CP market by adopting an electronically traded short-term borrowing market under the Short-term Borrowing Act.

Philippines Monetary policy Bangko Sentral ng Pilipinas (BSP) began its exit strategy from extraordinary support measures introduced in late 2008. The unwinding included in the 28 January policy meeting, BSP increased the Peso rediscount rate by 50bps to restore it to the same level as the overnight Reverse Repo Rate, as the need for rediscounted loans was reducing as stability returned to the financial system. In the 11 March policy meeting, BSP reduced the Peso rediscounting budget from PHP60bn to PHP40bn (still PHP20bn higher than the pre-crisis level). Meanwhile, BSP restored the loan value of all eligible rediscounting papers from 90 per cent to 80 per cent of the borrowing bank’s credit instruments, and reintroduced the non-performing loan ratio requirement of 2 percentage points (from 10 percentage points) above the latest available industry average NPL for banks wishing to access the rediscounting facility. India Macro-prudential regulation by the Reserve Bank of India (RBI) has been facilitated by RBI’s framework of multiple objectives, multiple targets and multiple instruments. Other than looking at standard inflation measures, RBI is mandated to monitor aggregate credit growth, sectoral credit growth and the incremental credit-deposit ratios of banks. These variables provide the backbone for macro-prudential regulatory framework in India. Although there have been no explicit asset price targets, RBI has always considered asset price inflation and taken appropriate steps to curb it. Lack of proper asset price measures (house prices) have been one of the big challenges but RBI has still used the twin tools of adjusting risk weights and altering provisioning norms on lending to particular sectors to moderate credit flows to sectors which showed signs of overheating. This sector specific approach has ensured that the flow of credit to productive sectors has remained unaffected as excessive credit growth has been limited to a few sectors.

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Although there is no formal dynamic provisioning regime, RBI lowered provisioning norms in the wake of the crisis to improve profitability of the banks and restore confidence. Furthermore, the mandatory requirement of lending a certain proportion of assets (40 per cent) to the priority sector (agriculture and agriculture related, SMEs etc) has also ensured that leverage to other sectors has not grown in a disproportionate fashion. Banks’ exposure to equity markets has been capped at 5 per cent and deposit taking non-banking financial companies have also been regulated by RBI with respect to their exposures, capital and liquidity. The RBI is considering whether to extend this to non-deposit taking, non-banking financial companies also. In this context, the RBI has identified a small number of financial conglomerates (based primarily on size) which are perceived to be systemically important. Their intra-group transactions and exposures and exposures to other counterparties are monitored by all regulators but no 'systemic capital surcharge' has been introduced. To counter liquidity risks, the RBI has put in place prudential limits on banks on their purchased inter-bank liabilities as a proportion of their net worth to encourage greater reliance on stable sources of funding. The mandatory requirement of 25 per cent of liabilities being held in government securities is regarded as a solvency and liquidity buffer. The excess securities, over the 25 per cent limit, have moved in a counter-cyclical fashion to reflect risk appetite and liquidity perception. Opening up of the capital account has been done in a gradual fashion. While equity inflows have been mostly allowed, debt inflows have been prudentially capped through both quantity and price based measures. Outflows on the capital account are still quite highly regulated. This was one of the reasons why Indian banks exposure to global toxic assets were extremely limit Singapore The Monetary Authority of Singapore (MAS) has set limits on banks exposures to single counterparties, the types of exposures to be included in or excluded from those limits, the basis for computation of exposures, the approach for aggregating exposures to counterparties that pose a single risk to the bank, the recognition of credit risk mitigation and aggregating of exposures at the bank group level (25 per cent or such other percentage of the eligible total capital of the bank group as may be approved by the Authority). Initially, the MAS intended to set the limit on banks' property exposure at 35 per cent of its total loans and debt instruments. The government announced the immediate withdrawal of the Deferred Payment Scheme (DPS) for property purchases in view of the strong economic and property market conditions. Malaysia The Bank Negara Malaysia (BNM) has set limits on exposures to a single counterparty group. The BNM also imposes a limit on property lending by banks at 20 per cent of its total loans and debt instruments. The Malaysian currency MYR has not operated outside the international system since September 1998, because of the 1997 Asian financial crisis in which the central bank imposed capital controls on the currency. As a part of a series of capital controls, the currency was pegged between September 1998 and 21 July 2005 at USD/MYR 3.80. In recent years, the BNM started to relax certain rules to the capital controls, although the currency itself is still not traded internationally/off-shore yet.


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Thailand In addition to the supervision under Basel I, commercial banks in Thailand are also subjected to "Single Lending Limit". Namely, banks are not permitted to have exposes (lending and derivative exposure) to a company (including its subsidiaries) of greater than 25 per cent of the bank's capital. For mortgages, commercial banks are permitted to provide only prime loans (or standard loans). That said there are no sub-primed loans (or sub-standard loans) in Thailand. Canada Canada has tight limits on the overall leverage of banks. The leverage ratio limits total assets/Tier 1 + Tier 2 capital to 20 times. In addition, the Canadian government largely requires mortgages with loan to value ratios above 75 per cent to have a guarantee. These guarantees are provided (for a fee) by the government-owned Canada Mortgage and Housing Corporation (CMHC) or by a number of private insurers, though these themselves are guaranteed by the CMHC. The CMHC therefore effectively underwrites the housing system. Were there to be a crash in house prices it would be the government taking the losses. The CMHC effectively controls lending terms, maximum LTV etc.

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Annex 4: A possible model for macro-prudential supervision in the UK

Macroeconomic/systemic (macro-prudential) analysis: The Financial Stability Committee

RISK

Level of macro-

economic and systemic risk in the system

as identified by monitoring key

indicators Number of institutions

Proportion of RWAs

Financial Stability Committee OUTPUT:

Range set for capital

ratios/liquidity Plus identification of

RWA categories at risk

Total capital required against risk in the

banking sector

Micro-prudential supervision: FSA: enhanced Pillar 2

Banking Book

% RWAs

Trading Book

% RWAs

BANK B Core tier 1 Sectoral risk weight Liquidity formula For bank B

Banking Book

% RWAs

Trading Book

% RWAs

BANK A Core tier 1 Sectoral risk weight Liquidity formula For bank A

X

Previously unconnected to micro-prudential supervision

Feedback of market, global transaction and institutional data

Interconnectedness

Input Output

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Annex 5: Indicators of exuberance The Bank of England has identified the following as potential measures to inform the calculation of capital surchargesxxxi:

Credit flows, stocks and spreads.* Income and capital gearing of households, corporates and other financial companies (OFCs).* Unemployment rate.* House price to earnings ratio, house price inflation.* Maximum loan to income and value ratios of first-time buyers.* Commercial property prices and rents.* Property pipelines and vacancy rates.* Credit conditions surveys.* Volumes/spreads data on LBO (leveraged buyout) and private equity deals.* Volumes/spreads data on syndicated loan activity.* Growth in assets under management at hedge funds and OFCs.* Contribution to growth in mortgage market from other specialist lenders.* Reliable data on leverage ratios of hedge funds/other OFCs. A granular geographical breakdown of banks’ loan books. Richer data on the quality of institutions’ loan portfolios — such as the loan to value breakdown of

their mortgage and commercial real estate lending; a breakdown of their mortgage book between prime, adverse credit, self-certified and buy-to-let.

• A consistent breakdown of trading assets by class and quality. Note: An asterisk (*) denotes that the data source is currently available to us. The Turner Review also identified a number of factors, reproduced belowxxxii:

2.6 Macro-prudential analysis and intellectual challenge A common theme of this chapter is the vital importance of a system-wide macro-prudential perspective. The lack of such a perspective, and the failure to specify and to use macro-prudential levers to offset systemic risks, were far more important to the origins of the crisis than any specific failure in supervisory process relating to individual firms. Getting macro-prudential analysis and tools right for the future is vital. This section covers: (i) What we mean by macro-prudential analysis and policy. (ii) How to ensure that it is effectively performed in the UK. (iii) How to ensure intellectual challenge at the international level. 2.6 (i) Macro-prudential analysis and tools Macro-prudential analysis needs to identify the trends in the economy and in the financial system which have implications for financial stability and as a result for macroeconomic stability, and to identify the measures which could be taken to address the resulting risks. The factors considered could include trends in:


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• The extension of credit to the economy, the pricing of credit, and levels of borrower leverage, and the implications for the risks which both borrowers (households, individuals and companies) and lenders are running. • The pattern of maturity transformation and resulting liquidity risks e.g. the extent to which banks are increasing or decreasing maturity mismatches, and are relying on wholesale funding or on ‘liquidity through marketability’. • Asset prices in property, equity and securitised credit markets and their possible relationship to long run equilibrium levels. • Leverage within the financial system, whether at the institutional level (bank capital to asset ratios) or embedded in collateral margins and ‘haircuts’. • The roles being played in the financial system by different institutions and in particular whether the institutions not currently subject to prudential requirements (e.g. hedge funds) are increasingly operating in a way which could create systemic risk. This analysis could inform the conduct of monetary policy. But it could also lead to decisions to use macro-prudential levers e.g. varying capital requirements in a discretionary and countercyclical fashion (see Section 2.2 (iv) above) or to vary liquidity policies and guidance (see Section 2.2(vii)). Fiscal policy choices might also be informed by the analysis.

To these we would add ‘q’ and ‘cape’xxxiii. q is the ratio between the value of companies according to the stock market and their net worth measured at replacement cost. It can be defined to include or exclude corporate debt. When debt is included, we refer to the ratio as Tobin’s q, as it was in this form that Nobel Laureate James Tobin introduced the concept. For stock market purposes, however, it is easier to exclude debt and we refer to it in this form as “equity q”. The data from which q is calculated are published in the “Flow of Funds Accounts of the United States Z1”, which is published quarterly by the Federal Reserve. This data source is available from 1952 onwards. Why is q Important? q is one of the two valid methods of measuring the value of the stock market. The other is the cyclically adjusted P/E. As they are both valid measures they both give the same answer, subject to small variations arising from the differences in data sources.


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i Persaud, A, (2000). “Sending the herd off the cliff edge: the disturbing interaction between herding and market-sensitive risk management practices”. World Economics 1(4):15-26 ii Turner, A (2009) “A regulatory response to the global banking crisis” FSA, pp83 iii “The Role of Macroprudential policy: A Discussion Paper”, Bank of England: November 2009 iv Turner, A (2009) “A regulatory response to the global banking crisis” FSA, pp83 v Borio, C (2009) “We are all macroprudentialists now” vi Turner, A (2009) “A regulatory response to the global banking crisis” FSA, pp15 vii Turner, A: “What do banks do, what should they do and what public policies are needed to ensure best results for the real economy?”: 17 March 2010 viii “Towards a macro-prudential instrument”, Bank of England: 2009, p11 ix Bean, C “The great moderation, the great panic and the great contraction”, Schumpter Lecture at the Annual Congress of the Economic Association, August 2009 and “Some lessons for monetary policy from the recent financial turmoil”, remarks at Conference on Globalisation, Inflation and Monetary Policy, November 2008 x Turner, A, “Speech to the CBI Annual Conference”: 23 November 2009 xi Ibid xii Tucker, P, “The debate on financial system resilience: macroprudential instruments”: Barclays’ Annual Lecture: 22 October 2009 xiii Tucker, P, “The debate on financial system resilience: macroprudential instruments”: Barclays’ Annual Lecture: 22 October 2009 xiv “Towards a macro-prudential instrument”, Bank of England: 2009, p4 xv Tucker, P, “The debate on financial system resilience: macroprudential instruments”: Barclays’ Annual Lecture: 22 October 2009 xvi Green, S: “Promoting a sustainable financial system”, Speech to Hermes Fund Managers and the Corporation of London Conference: 24 November 2009 xvii Ibid xviii Turner, A: “What do banks do, what should they do and what public policies are needed to ensure best results for the real economy?”: 17 March 2010 xix Towards a macro-prudential instrument”, Bank of England: 2009, p5 xx Hannoun, H: ‘Towards a global financial stability framework’, speech to 45th SEACEN Governors’ Conference: 26-27 February 2010, p19 xxi Tucker, P, “The debate on financial system resilience: macroprudential instruments”: Barclays’ Annual Lecture: 22 October 2009 xxii Towards a macro-prudential instrument”, Bank of England: 2009, p6 xxiii Ibid xxiv See diagram in Annex 2 xxv http://www.bankofengland.co.uk/publications/fsr/index.htm xxvi Towards a macro-prudential instrument”, Bank of England: 2009, p18 xxvii Smithers & Co: http://www.smithers.co.uk/faqs.php xxviii Ibid xxix Note that new rules are already moving in this direction and will, for example, enable the FSA to track large exposures and concentration risk and check assumptions for stress testing xxx Adapted from Annex B in “Towards a macro-prudential instrument”, Bank of England: 2009 xxxi Bank of England (2009), Table 4.1p 18 xxxii Turner, A (2009) “A regulatory response to the global banking crisis” FSA, pp83-84 xxxiii Smithers & Co: http://www.smithers.co.uk/faqs.php

A Possible Macro-prudential Approach

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