World Bank endorses macroprudential

Advertisement

Below find the key excerpt from a new World Bank report examining the efficacy of macroprudential policies and giving them a broad tick of approval. It’s chock full of gobbledygook but given the increasing likelihood that such tools will be arriving in Australia by year end, I suggest you read it!

Capture

Broad Policy Toolkit: Monetary and Macro Prudential Policies and their Interactions

How has the global financial crisis and growing recognition of systemic risks altered views on what constitutes an appropriate policy framework? In chapter 4, Otaviano Canuto and Matheus Cavallari discuss the new paradigm for monetary and macro prudential policies. Their discussion takes stock of where monetary and exchange rate policies are heading as a result of recent experiences and revisit theoretical monetary tenets. As they note, the precrisis principles for a monetary policy framework did not give due attention to how financial markets and their channels of interconnectivity affect macro stability. Although many argued in favor of monetary policy “leaning against the wind” from financial developments, the prevalent opinion was that difficulties in detecting bubbles would outweigh the advantages of doing so and that furthermore, monetary policy tools would be too blunt to curb the rise of bubbles, because correspondingly sharp interest rate hikes would have harmful unintended consequences on output growth and volatility. Thus, the best approach would be to have monetary policy react only if and when “mopping up” or “cleaning up” the financial mess after bubble bursts was necessary.

Since the crisis, there is growing recognition that a framework of flexible inflation targeting and micro prudential regulations is not sufficient to ensure financial and ultimately macroeconomic stability. Given the high costs associated with asset price busts, including the possibility of protracted negative feedback between unsound private balance sheets and public sector imbalances and/or foregone employment and gross domestic product, attention is now being directed toward addressing this failure. Canuto and Cavalleri explore whether or not addressing this failure implies that central banks should incorporate indicators of financial stability into their reaction function in an “augmented Taylor rule.” They then consider whether macro prudential policies alone can reduce financial instability and guarantee both financial and macro stabilities.

As they note, most practitioners have expressed the view that a combined (articulate) use of both monetary and macro prudential policies is superior to a standalone implementation of either (Canuto 2011). Both policies are needed as neither one alone can achieve the two objectives. Monetary policy alone cannot achieve financial stability because the causes of financial instability are not always related to the degree of liquidity (which monetary policy can fix). Mitigating the effects of financial distortions or pricking an asset price bubble can require large changes in policy rates and when financial distortions (individual behavior that is distorted giving rise to excessive risk taking and externalities) are more acute in some sectors of the economy than others, monetary policy is too blunt a tool. Conversely, the use of macro prudential policies primarily for managing aggregate demand may in fact cause additional distortions by imposing constraints on behavior beyond areas where financial distortions originate (Claessens and Valencia 2013).

At the same time, the two policies can have impacts on each other’s objectives. For instance, monetary policy can affect financial stability when it pursues its primary objective by (1) shaping ex ante risk-taking incentives of individuals through leverage, short-term borrowing or foreign currency borrowing; or (2) affecting ex post the tightness of borrowing constraints and possibly exacerbating asset price and exchange-rate externalities and leverage cycles. Macro prudential policies also have side effects. By constraining borrowing and hence expenditures in one or more sectors of the economy, macro prudential policies affect overall output (Claessens and Valencia 2013).

The existence of side effects implies that the new paradigm needs to take into account how the conduct of both policies is affected in the presence of their interactions. If macro prudential policies have strong effects on output, more accommodative monetary policy can offset these effects as necessary. If changes in the monetary stance affect incentives too much, the relevant macro prudential policies would need to be tightened.

A number of models surveyed by the International Monetary Fund suggest that when both policies are available, it is desirable to keep monetary policy primarily focused on price stability and macro prudential policies focused on financial stability, while taking into account the impact that each has on the other’s objectives. In particular, these models suggest that the optimal calibration of the reaction to monetary policy to output and inflation does not change markedly when macro prudential policy is also used, even when different shocks are considered. In other words, the sole presence of side effects has no major implications for the conduct of both policies.

However, as Claessens and Valencia highlight, these models assume that both policies operate perfectly. In practice, policies face constraints. Macro prudential policies may not operate perfectly, especially given the still-limited knowledge about their quantitative impact, which makes calibration difficult, and they may not fully offset financial shocks or distortions; institutions are imperfect and time inconsistencies can arise. Should these weaknesses prove important, monetary policy may have to take a greater role in preserving financial stability and accept the associated trade-offs. Similarly, where monetary policy is constrained—as within currency boards and in many small open economies—there will be greater demands on macro prudential policies. Thus, as Canuto and Cavalleri note in their chapter, “instead of a corner solution where one instrument is devoted entirely to one objective, the macro stabilization exercise must be viewed as a joint optimization problem where monetary and regulatory policies are used in concert in pursuit of both objectives” (CIEPR 2011).

In chapter 4, Canuto and Cavalleri also explore the challenges of dealing with cross-country spillovers in the context of the new policy paradigm. As they mention, cross-border capital flows and the potential transmission of asset price booms and busts via interconnected balance sheets imply additional layers of complexity as opposed to purely domestic asset price cycles. Canuto and Cavalleri propose that capital controls and exchange rate interventions can be seen as options to be combined with monetary and macro prudential policies, options that can even increase, or at least help, with the effectiveness of the latter. Claessens and Ghosh, who also look at the challenges of dealing with crossborder flows in emerging markets in chapter 3 and document how large surges of capital inflows are associated with increased financial sector vulnerability across several dimensions, also reach the conclusion that for most EMs receiving large inflows, it is likely that a combination of macroeconomic, macro prudential, and capital flow management policies is needed to avoid trade-offs and limitations associated with each individual policy instrument. Both chapters emphasize that the appropriate combination will clearly depend on the vulnerability identified, country-specific conditions, and constraints on individual policies. Canuto and Cavalleri conclude chapter 4 with a discussion on the new challenges faced broadly by central banking in emerging markets.

Macro Prudential Framework and Efficacy of Macro Prudential Measures

In chapters 1 and 2, Shin and Acharya discuss what constitutes a macro prudential framework. They highlight that it requires two elements: a set of indicators that can inform judgments on the degree of vulnerability to financial instability and hence serves as the informational basis for policy actions; and the associated macro prudential policy tools or automatic stabilizers that can kick in when circumstances warrant to anticipate and mitigate the vulnerabilities.

From a pro-cyclicality perspective, given the centrality of the banking sector and its potential for amplifying business cycles and exacerbating systemic vulnerability in the process, as Shin notes, the pace of asset growth is of first-order interest. The challenge for policy makers, therefore, is knowing when asset growth may be “excessive” and finding policy tools that can address and counter excessive growth in a timely and effective manner.

Various potential indicators of vulnerability are discussed. Given that non-core liabilities play a key role in the funding of financial institutions’ asset expansion during a cyclical upturn, a key indicator of vulnerability discussed in the chapter is the ratio of non core-to-core liabilities. As Shin points out in chapter 1, what constitutes core and noncore liabilities will vary from country to country and will be context specific; he explores what may be relevant for an economy such as the Republic of Korea and also what may be relevant in countries where regulations restrict the banking sector from having access to the global banking system.

From a cross-sectional perspective, Acharya highlights in chapter 2 the value of using market-based signals of systemic risks. These measures are generally based on stock market data because it is most regularly available and least affected by bailout expectations. For instance, the marginal expected shortfall (MES) measure estimates the loss that the equity of a given firm can expect if the broad market experiences a large fall. A firm with both a high MES and high leverage will find its capital most depleted in a financial crisis relative to required minimum solvency standards and, therefore, faces high risk of bankruptcy or regulatory intervention. It is such undercapitalization of financial firms that leads to systemic risk. Notably he shows how the MES can be used to identify institutions that can pose risks to the system as a whole and shows how the information can be used to guide regulation in the U.S. banking system. Similar results are applicable for European institutions. He also explores how these measures may be adapted and used in emerging markets.

Efficacy of Macro Prudential Measures: Empirical Evidence to Date

Little empirical evidence exists to date on the efficacy of macro prudential policies, notably as to what policies work best in a country-specific context. This issue is explored in chapter 5 by Claessens, Ghosh, and Roxana Mihet. They first review the motivations for macro prudential policies. Then, following a review of the empirical literature on the effectiveness of various macro prudential policies, they report the results of their own analysis, based on an econometric estimation involving a sample of 2,800 banks in 48 countries (advanced and emerging) during the period 2000–10. In particular, they examine the effectiveness of different macro prudential policies—limits on loan-to-value (LTV) ratios, caps on debt-to-income (DTI) ratios, limits on credit growth, limits on foreign currency lending, reserve requirements, restrictions on profit distribution, countercyclical capital requirements, and dynamic provisioning—on reducing financial sector vulnerabilities. Their analysis looks at three dimensions through which the financial sector can become vulnerable: namely increase in leverage, growth in assets, and increase in noncore-to-core liabilities. In assessing the effectiveness of macro prudential policies they also distinguish by the stage of the financial cycle (upturn or downturn), on emerging-versus-advanced economies and in open-versus-closed capital account economies.

Regression results suggest that many of the macro prudential measures can help control banking system vulnerabilities. However, their analysis also suggests that macro prudential policies are much more effective in booms than in busts, with many coefficients statistically significant in expansionary periods and much fewer in contractionary periods. In principle, tools such as reserve requirements could provide liquidity cushions, while dynamic provisioning could help build capital buffers during upturns, supporting lending during downturns. Other tools such as limits on profit redistribution could also have counter-cyclical, buffer effects, helping banks’ willingness to maintain, or at least reduce less, their balance sheets in bad times. However, their regressions show that very few policies affect with any statistical significance the speed of decline when the credit cycle reverses. There are actually some negative signs, meaning that having a policy in place worsens the declines.

As they note, the fact that macro prudential policies are mostly effective only in expansionary times may not be surprising, since most macro prudential policies are not designed to mitigate contractionary periods. It could even be that tools like LTV limits actually act perversely during periods of credit contractions and asset price declines. Unless these limits are adjusted quickly in a rightly calibrated manner, that is, without unduly increasing systemic risks, their effects may be perverse.

Regarding the differences in effectiveness of macro prudential policies in emerging markets versus advanced economies, and in open-versus-closed capital account economies, they do find some differences—including that LTVs are less effective in reducing asset growth in open economies and DTIs are less effective in reducing leverage growth in emerging markets and open economies.

Case Studies: Brazil and the Republic of Korea

The two final chapters deal with the country experiences of Brazil and the Republic of Korea, which deployed macro prudential policies to address their unique macro financial challenges.

In chapter 6, Luiz Perriera da Silva and Ricardo Harris analyze and document Brazil’s experience. Brazil fared well during the global financial crisis. By 2010, its GDP was growing at 7.5 percent year-on-year (YOY) and its investment at over 11 percent YOY. But the strong V-shaped recovery—coupled with increased global liquidity, high commodity prices, and strong capital inflows—began to give rise to inflationary pressures, and by 2011 the economy was showing signs of overheating. In addition, an intensified flow of foreign financing increased the potential of financial instability within the economy, which was already going through an extended period of rapid credit expansion (over 22 percent per year between 2005 and 2011).

In this context, Pereira da Silva and Harris outline Brazil’s unique experience deploying macro prudential policy to complement existing monetary and fiscal policy tools to address its financial challenges. Brazil increased bank reserve requirements to dampen the transmission of excessive global liquidity to domestic credit markets; increased credit requirements for specific segments of the credit market to address with the aim of stemming the deterioration in the quality of loan origination; and enacted reserve requirements on banks’ short-spot foreign exchange positions and taxed specific inflows to correct imbalances in the foreign exchange market as well as to address intensified, volatile inflows of capital. Enacted in addition to policy rate hikes and credible commitments to reduce the public-debt-to-GDP ratio, these measures were successful in reducing the growth of household credit to a more sustainable pace. They affected not only the volume of new loans but also their interest rates and average maturities.

Global financial deterioration in the second half of 2011 (and extending into 2012) gave Brazil an opportunity to fine-tune its deployed macro prudential regulations to tailor them to the new economic outlook, but this proved a difficult task. Indeed, Brazil’s experience in this regard is indicative of the incomplete understanding of the economics profession of how systemic financial risks develop and how macro prudential tools impact those risks, particularly in emerging markets. For example, the bulk of the macro prudential regulations enacted by Brazil dealt with the time-series dimension of systemic risk, that is, with the procyclicality of the financial system. However, given the high degree of conglomeration in the Brazilian financial system, experience quickly showed that that cross-section risks arising from the interconnectedness of the financial system and the real economy also would need to be addressed.

Brazil’s experience as outlined by Pereira da Silva and Harris is illuminating, especially for emerging markets. Brazil was innovative during and after the peak of the global financial crisis, not least in exploring the boundaries of Tinbergen’s separation principle, using two instruments (the base rate and a set of macro prudential tools) to address two objectives (price stability and financial stability). The country’s experience exemplifies the need for regulators and central bankers to be “ahead of the curve” in dealing with ongoing financial stress in the present context of the global economy.

This mindset may be illustrated by the experience of Korea, as described by Jong Kyu Lee in chapter 7. Korea operated several macro prudential policy instruments prior to the advent of the financial crisis in 2008. Although not based on the concept of financial stability as currently discussed, these instruments did take forms similar to those now in vogue. For example, as part of its systematic macro prudential framework, Korea applied several types of liquidity ratio regulations as early as 1997 aimed at addressing potential weakness in domestic banking and foreign exchange transactions. Later, with a housing boom becoming apparent, Korean authorities also introduced an LTV ratio and, finally, a DTI ratio.

These arguably prudent measures notwithstanding, Korea faced a round of crisis-like events in 2008. The economy had accumulated a new type of financial imbalance in domestic banking as well as in foreign exchange transactions, associated in part with the housing market boom. Banks had raised funds through non-core liabilities and expanded their lending to households in line with strong housing prices. Meanwhile, to meet the growing demand for foreign exchange derivatives transactions, banks had simultaneously begun to rely increasingly on short-term foreign borrowing. Lee thus assesses that the macro prudential measures “were unable to achieve the ultimate goal of ‘preventing systemic events.’” Lee identifies a number of factors to which this failure may be attributed. The micro rather than macro prudential objectives of the measures are noted first. Another reason may have been the governance of the measures. Supervisory authorities, whose purview rests in micro prudential territory, were responsible for handling these measures and, thus, were not targeting macro level variables or events critical to financial stability. Chapter 7 outlines these and other factors in more detail, providing lessons for the rapidly evolving macro prudential policy arena.

That being said, Lee does find that these policy measures had some impact. He finds that the limits on LTV and DTI ratios helped maintain the soundness of financial institutions during the global crisis, but that these measures had only a temporary effect in dampening housing prices and housing loan volumes in the period prior to the crisis.

The Korean experience offers important lessons about the potential as well as the limitations of these types of regulations. Above all, the Korean experience serves as a basis for evaluating several macro prudential measures from a variety of viewpoints. For a well-defined macro prudential framework, the objective, scope, and other elements of the policy need to be specified. The choices of operational options, such as single versus multiple measures, broad-based versus targeted risks, and fixed versus time-varying application can also impact the effectiveness of macro prudential tools. In this regard, the Korean experience is a ood illustration of not only how macro prudential tools may be deployed but also what can go wrong in the deployment of macro prudential measures with respect to the factors outlined above.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.