José Viñals, IMF Financial Counsellor and Director, Monetary and Capital Markets Department
European Commission and ECB Conference on Financial Integration and Stability
Let me begin by thanking the Commission and the ECB for inviting me to speak to such a distinguished audience. My comments today are on the latest hot-button issue for policymakers—namely, macroprudential policy. I will begin by explaining what’s behind the hype, and why it is important—for Europe and the rest of the world. I will then discuss where the thinking on macroprudential policies is heading, and what we have learned to date on how to do it; and how not to do it.
Macroprudential policy: What it is and why it matters
When the global financial system was thrown into crisis, many policymakers were shocked to discover that they had lacked the tools to prevent problems in one part of the financial system from spiraling out of control.
We learned through this crisis that system-wide, or systemic, risks cannot be addressed through the traditional mix of macroeconomic policies and “microprudential” measures aimed at individual financial institutions. By focusing on the health of the financial system as a whole, macroprudential policy can improve the authorities’ grasp of the intricate web of connections between financial institutions, financial markets, and the macro-economy.
The new tools would enhance policymakers’ ability to cope with two, interrelated drivers of systemic risk:
(i) The risks associated with swings in credit and liquidity cycles, driven by procyclical forces such as leverage and herding behavior by financial institutions, non-financial firms, and households; and
(ii) The concentration of risk in certain financial institutions and markets that are highly interconnected within, and across, national borders.
Since then, progress has been made in developing macroprudential policies—the set of measures and institutional frameworks that is specifically aimed at containing risks in the financial system as a whole. This issue is one of the top agenda items at international forums. For example, the new bank capital framework under Basel III includes a countercyclical capital buffer aimed at addressing the pro-cyclicality of financial systems. To limit the risks associated with interconnectedness, the IMF has proposed a systemic capital surcharge and a systemic liquidity surcharge based on a financial firm’s marginal contribution to systemic risk.
Many countries have been experimenting with macroprudential policies. In Europe, for example, we have very recently seen the launch of the European Systemic Risk Board and various national institutional arrangements, such as the Financial Policy Committee in the UK, or the Financial Regulation and Systemic Risk Council in France. In the US, we have seen the establishment of the Financial Stability Oversight Council; and there have been similar institutional changes in emerging market economies such as Mexico and Malaysia. Some countries have sought to address risks in their real estate markets by putting limits on Loan-to-Value ratios (Hong Kong, Singapore, South Korea, and China). Others have used caps on Loan-To-Income ratios (Serbia), and caps on Debt-to-Income ratios (South Korea). Some countries have used direct monetary policy instruments to constrain credit supply during booms. These instruments include limits on the level, or growth rate, of aggregate credit or specific exposures (Serbia and Malaysia), and changes in reserve requirements (Brazil, Bulgaria, Colombia, China, India, and Saudi Arabia). There have also been fiscal policy measures such as stamp duties on property holdings to tame speculation in real estate markets (China, Hong Kong). Recent structural measures include the “Volcker-rule”, which would create a ban on proprietary trading for systemically important U.S. banks. In the European Union, we have seen structural policy proposals to restrict short selling and limit the use of certain derivatives in the event of a serious threat to financial stability.
As you can see, progress in developing macroprudential tools has been uneven. Therefore, greater efforts are needed to transform this policy patchwork into an effective—and internationally coherent—crisis prevention toolkit. That is why the Group of 20 leading economies asked the IMF, the Financial Stability Board, and the Bank for International Settlements to develop a coherent framework for this new policy.
Developing a coherent policy framework is a challenging task. National policymakers have been grappling with this, both at the conceptual level and in practical terms. We, at the IMF, have worked to clarify the concept of macroprudential policy and its role in preserving financial stability. So where are we now? And what have we learned? Let me make five separate points.
First, use it but do not abuse it
We need to lay out a clear understanding of what macroprudential policy is, and what it is not; and what it can and cannot do. Macroprudential policy seeks to limit systemic financial risks by using (primarily) prudential tools. These prudential tools are designed to prevent financial instability and the associated social and economic costs.
This system-wide perspective is very important, because of the so-called “fallacy of composition” of traditional prudential policy—that is, actions that are appropriate for individual firms may collectively lead to, or exacerbate, system-wide problems. The complexity of processes that can generate systemic risk, and the ease with which risk can migrate across the financial system, call for a focus on the whole range of financial institutions (banks and non-banks alike), instruments, markets, and infrastructures.
But macroprudential policy is no substitute for robust prudential policies of the traditional kind—now called microprudential policy, which primarily aims at ensuring the solidity of individual financial institutions—and is clearly no substitute for sound macroeconomic policy. Macroprudential policy needs to be defined narrowly, because it should not encourage expectations that cannot, and should not, be fulfilled. Strong regulation and effective supervision of individual financial institutions are necessary preconditions for effective macroprudential policies. And monetary and fiscal policies should remain the first line of defense against macroeconomic distortions and imbalances. As we develop macroprudential policies, we must be clear that this policy innovation should not be used as an excuse to avoid difficult, but necessary, macroeconomic choices.
Equally important, independence in other policy areas—including monetary and microprudential policy—should not be undermined in the name of macroprudential policy. The institutional arrangements in which macroprudential policy is embedded should not become a “Trojan horse”—undermining hard-won policy autonomy in other areas. Thus, macroprudential and other policies should be coordinated in a manner that is compatible with the achievement of each policy’s objectives. This will require appropriate separate mandates, and suitable governance and accountability structures.
Second, don’t leave it alone in the pursuit of financial stability
No matter how different policy mandates are structured, ensuring financial stability is a shared responsibility. Other policies, for which financial stability is—at most—a secondary objective, should not lose sight of the systemic consequences of their action, or inaction, and should not be a source of financial instability. An especially prominent role is played by microprudential policy and monetary policy, both of which affect the amount of risk the financial system is willing (and able) to bear. For example, the larger the buffers created by microprudential policy, the smaller the need for macroprudential policy to step in.
Macroprudential and other policies interact in complex ways that are not yet fully understood. Policy conflicts may arise. For instance, if monetary policy is loosened for a long period, macroprudential policy may want to become tighter to avoid excessive risk-taking. Or, if macroprudential policy encourages drawing down bank capital buffers in a downturn to sustain the flow of credit, microprudential policy may be inclined to keep buffers unchanged to guard against the heightened risks.
All this calls for mechanisms for coordination across policies. These may take an institutional form, such as a board, a committee or council, or other forms, such as a requirement for the macroprudential authority to be informed, or consulted, on key decisions by other policies, which also affect the financial system. Clearly, this should be done in a manner that fully respects the independence of monetary policy. Yet at some point, addressing systemic risks will also require policy action. Coordination will be particularly important in this context, because operational control over the instruments of macroprudential policy may, or may not, rest with the macroprudential body itself. The European Systemic Risk Board, for example, does not have direct control over policy instruments.
Third, one size does not fit all (but central banks should play a prominent role)
In the design of macroprudential policy frameworks, one size does not fit all. The tools to identify and monitor systemic risk, the operational toolkit, and the chosen institutional set-up will vary from country to country, depending on the level of development, financial structure, policy regime, and other historical and political factors.<
But some key features are already emerging. One is that central banks should play a prominent role. Central banks’ expertise in monitoring macroeconomic and financial market developments could help shape policies aimed at containing the build-up of systemic risks. And given their existing roles in monetary policy and payment systems, central banks are well placed to analyze systemic risks and the impact of individual bank failure. This analytical expertise can help achieve greater clarity about the benefits and costs of macroprudential policies. They also bring much-needed reputation and independence. Finally, central banks have strong institutional incentives to ensure that macroprudential policies are effective—because if they are not, central banks will have to take costly corrective measures.
In addition to the central bank, the regulatory and supervisory agencies need to be involved in an adequate manner. They would need to activate macroprudential policy tools in cases where such tools are not under the operational control of the macroprudential body. The involvement of finance ministries has its pros and cons: it would be valuable because of the importance of taking into account fiscal policy and some of its instruments. Finance ministries could also play a pivotal role in the discussion of legislative changes that may be required to mitigate systemic risks. However, there is one important risk associated with the strong role of finance ministries: because of election cycles and other political considerations, they may be reluctant to take the punch bowl away when the party gets going. This could lead to a crucial delay in the application of macroprudential measures. So, finance ministries should be involved, but in a way that does not jeopardize the process.
Fourth, we have a broad toolkit—let us now learn to use it
As I noted earlier, macroprudential policy uses primarily prudential tools to address systemic risk. Some of the key tools are being constructed specifically for this purpose—such as countercyclical bank capital charges that lean against the economic cycle, or systemic capital surcharges that grow as the systemic impact of individual financial institutions grows. There is also a range of tools that has already been used in some countries—such as traditional prudential tools adjusted specifically to address the build-up of systemic risk (the use of loan-to-value ratios to lean against housing bubbles is a good example). Because there are different dimensions of systemic risk and different aspects within them, the range of tools is potentially large.
How should these tools be used? One key issue is whether we should use rules, discretion, or a combination of both. Rules would help overcome the bias for inaction that is likely to arise, because the benefits of macroprudential policy (i.e., the absence of financial crises) are only evident in the long run. By contrast, the cost of macroprudential policy tends to be highly visible and is often felt immediately. Some form of discretion is also needed to help adjust policies to a financial sector that evolves rapidly, and where the specific sources of systemic risk are subject to change. A combination of both approaches may eventually emerge as the sensible choice—incorporating more rules than is the case for monetary policy; but leaving scope for some discretion to adjust to a dynamically evolving financial sector. The combination should reflect existing local conditions.
Because of the dynamic nature of financial systems, macroprudential policy requires continuous monitoring of a broad set of information—measures and indicators on the causes of financial crises, business and financial cycles, credit booms, and related sources of systemic risk. Macroprudential policy also includes measures to identify systemically important financial institutions, markets, instruments, as well as firms and activities that might be outside of the perimeter of regulation. Policymakers may never be able to rely solely on quantitative tools to identify and monitor systemic risk to guide their macroprudential actions. Hence the need for additional qualitative assessments, including supervisory assessments and market intelligence.
Lastly: macroprudential policy is necessary—but it is not a magic bullet
Macroprudential policy is in its infancy. Many issues remain unresolved. For example, how can systemic risk be measured? How strong is the evidence that macroprudential policies can, in fact, prevent or contain credit or asset price bubbles? What is the transmission mechanism of macroprudential policy? What are the policy conflicts, and how can they be resolved? How should micro- and macroprudential policies relate to each other? And how can we address the trade-off between stability and efficiency in macroprudential policy making?
This is a daunting task. It is worth noting that modern macroeconomics evolved in response to the policy limitations that were painfully underscored by the Great Depression. Macroprudential policy could prove to be the next quantum leap. To illustrate the challenge of developing a macroprudential policy framework, it is useful to draw some parallels to monetary policy. That policy has a precisely defined objective—price stability. In the case of macroprudential policy, systemic risk is multidimensional and difficult to measure and monitor. Monetary policy includes a well-defined set of policy tools. By contrast, there are multiple possible macroprudential instruments, many of which have never been applied in practice. Monetary policy transmission mechanisms are better understood, but we have yet to fully understand the equivalent mechanisms in macroprudential policy.
All this suggests that we need to be humble in our ambitions and recognize the limits of what can be achieved, at least in the near term. Some of the main challenges facing policymakers include the following:
• Creating a comprehensive analytical framework and a consistent set of policy tools, including through rigorous back-testing.
• Establishing macroprudential authorities, where they are not already in place, with clear mandates to enhance their accountability and reduce the risk of political pressures.
• Assuring that all systemic risks are addressed and all potential policy conflicts managed through cooperation among national authorities.
• Increasing international cooperation to ensure the consistent application of national macroprudential policies. Cooperation in macroprudential policies can reduce the scope for international regulatory arbitrage that may undermine the effectiveness of national policies. International cooperation is also needed to contain the risks associated with systemically important institutions that operate across borders. The new supervisory and resolution colleges for cross-border firms will play an important role.
In conclusion, I would like to stress that even the most effective macroprudential policy framework may not be a panacea for all problems related to systemic risk. To deal effectively with this destructive threat, macroprudential policy has to be supported by other policies relating to the financial sector and the macro-economy. This may require some changes in the way in which monetary policy and fiscal policies operate.
During the crisis, price stability was maintained. This is good news for monetary policy, which is the guardian of price stability. Yet the crisis has shown that some adjustments may be needed in many countries in the way in which monetary policy pursues its price stability objective. Specifically, it has to take better account of financial developments in the monetary policy analysis and decision making process, because our understanding of the financial sector and macro-financial linkages is far from adequate. Moreover, credit should be given a more important role, and monetary policy should non-mechanistically lean against the build-up of financial imbalances, especially when credit and asset prices are rising at the same time. Research conducted by the IMF1 suggests that adding credit growth to the monetary policy reaction function improves macroeconomic stability when the economy is hit by a financial shock. Policy reactions guided by the standard Taylor rule may be too weak in the face of loosened lending standards and credit accelerator effects.
We need a truly countercyclical fiscal policy, too. To some extent, counter-cyclicality is built into fiscal policy in the form of automatic stabilizers. However, the current crisis proved that this is not enough. In order not to become a source of fragility to the financial system and maintain an ability to support it in crisis situations, fiscal policy needs to accumulate sufficiently high surpluses in good times that can be used in bad times. This will require a substantial improvement in the quality of fiscal institutions and policy frameworks.
The IMF stands ready to support national and international policy reforms through its surveillance mandate and financial sector expertise. Our collaboration with the FSB and BIS will enhance our understanding of macroprudential policies. A joint progress report will be presented to the G-20 Leaders in November.
As I have tried to explain during my talk, while macroprudential policy is still in its infancy and is not the silver bullet that will avoid future crises, it is a most useful addition to policy frameworks aimed at preserving economic and financial stability Let’s use it properly!
1 (WEO Oct 2009 Ch.3)
José Viñals, IMF Financial Counsellor and Director, Monetary and Capital Markets Department