A framework for the CCyB
Opening address at the Second Financial Stability Conference
(Banco de España /CEMFI)
Pablo Hernández de Cos
Governor

Ladies and gentlemen, good afternoon.
It is a pleasure for me to welcome you to the Banco de España to participate in
the Second Financial Stability Conference. As in the first edition, this event has
been jointly organised by the Banco de España and the Centro de Estudios
Monetarios y Financieros (CEMFI). So allow me to start by expressing my
gratitude to the organisers, in particular Rafael Repullo, director of CEMFI, and
to all the members of the scientific committee, responsible for promoting the
conference and selecting the papers included in the programme.
Let me also thank the keynote speakers, Agustín Carstens and Lars Peter
Hansen, for their willingness to attend. And also the rest of the speakers, the
discussants and, of course, the participants in the panel. It was difficult for the
scientific committee to select the eleven papers that will be presented in these
two days from the more than one hundred submissions received. In the end, in
my view, a good balance has been reached in the programme. It combines
excellent academic papers that will provide interesting insights into theoretical
and empirical developments related to financial stability with policy issues on
the most practical aspects of the organisation and governance structures of
macroprudential policy. I have no doubt that, in these two days, both supervisors
and financial stability policy-makers will have a constructive and enriching
dialogue with academia on macroprudential policy.
Macroprudential institutional framework in Spain: the creation of AMCESFI
The timing of the conference is particularly important for us, since our new
macroprudential institutional arrangements have just been set up. In early 2019
the Spanish Macroprudential Authority - Financial Stability Board (AMCESFI by
its Spanish acronym) was created. Its main goal will be to contribute to the
promotion of coordination and the exchange of information on financial stability
issues among the Banco de España, the Ministry of Economy and Enterprise,
the Spanish National Securities Market Commission and the Directorate-General
of Insurance and Pension Funds. Such an institution provides Spain with a
structure similar to that of other EU Member States, in line with the
recommendations issued by the European Systemic Risk Board and the IMF.
In parallel, the supervision of the financial system was reinforced, extending the
range of macroprudential tools available to the sectoral supervisory authorities,
which remain individually responsible for deciding when they should be
activated. In particular, the Banco de España is now empowered to require
banking institutions to establish countercyclical capital buffers by credit
segment, limits on concentration in relation to economic activity sectors, and
limits and conditions when underwriting new loans (in terms of loan-to-value,
loan-to-income and debt service-to-income, and also the maturity, the currency
in which the operation is denominated and whether the interest rate is fixed or
variable, among others).
Some of these new macroprudential tools, in particular those based on the
borrowers' ability to pay, have already been introduced into the national
legislation of other EU Member States to prevent excessive easing of credit
underwriting standards by banks and to contribute to the sustainability of
household and corporate debt. These new instruments complement those
already available to the Banco de España included in the European legislation:
the countercyclical capital buffer, the systemic risk buffer and the buffer for
systemic banks, among others.
All in all, this new institutional setting is a significant step forward in reinforcing
financial stability in Spain.
The importance of a macroprudential policy framework
In my view, the introduction of macroprudential policy instruments to
complement monetary and fiscal policy is probably one of the most significant
policy developments following the global financial crisis. For countries in a
monetary union, like Spain, the introduction of these tools is particularly
important. Indeed, it is one of the few domestically managed levers available to
guarantee the stability of the domestic financial system.
However, the design of macroprudential policy poses significant challenges.
This is mainly because there is little experience in the use of these tools and
scant empirical evidence on their effectiveness, at least when compared with
fiscal and monetary policy tools. In this setting, one of the main priorities for
those responsible for ensuring the stability of the financial system with powers
over macroprudential policy is, in my view, to develop a complete and coherent
policy framework for the application and communication of that policy. And, in
this task, the contribution of academia is of vital importance.
In what follows, I would like to share some preliminary thoughts on some of the
elements that, in my opinion, should be included in this framework. In particular,
I would like to focus on two specific issues: first, the macroprudential policy
objectives, which of course should be the basis for the activation of the
instruments; and second, the choice among the different tools at the disposal of
the macroprudential authority to best achieve these objectives in different
circumstances.
What should be the objective(s) of macroprudential policy?
Allow me to focus now exclusively on banks and on one particular instrument,
the Countercyclical Capital Buffer (CCyB), the Basel III macroprudential tool par
excellence. According to the Basel Committee on Banking Supervision (BCBS)
its first objective is rather narrow: The primary aim of the countercyclical capital
buffer regime is to use a buffer of capital to achieve the broader macroprudential
goal of protecting the banking sector from periods of excess aggregate credit
growth that have often been associated with the build-up of system-wide risk. In
other words, according to this criterion, the CCyB should be used to build up
resilience among banks against the reversals that typically follow periods of
credit exuberance. Thus, the idea is to protect banks against the risk of failure
in a similar way as under the traditional microprudential approach to capital
regulation.
However, the BCBS immediately added a second goal: Due to its countercyclical
nature, the countercyclical capital buffer regime may also help to lean against
the build-up phase of the credit cycle in the first place. This is a more ambitious
goal. It means actively combating excessive credit growth, aiming to curb the
development of a credit cycle boom.
Moreover, a third goal is also referred to by the BCBS, this time connected to
economic contraction phases: In downturns, the regime should help to reduce
the risk that the supply of credit will be constrained by regulatory capital
requirements that could undermine the performance of the real economy and
result in additional credit losses in the banking system. In fact, this objective
closely follows the original 2009 G-20 recommendations to mitigate
procyclicality, including a requirement for banks to build buffers of resources in
good times that they can draw down when conditions deteriorate.
Under this third objective, the CCyB should also be helping banks withstand the
capital implications of an economic contraction (lower profits, higher defaults,
and prospectively higher PDs and LGDs) without tightening the capital
constraints to the extent that the credit supply and hence the real economy is
damaged. In other words, under this definition, the CCyB should allow for the
accumulation of shock absorption capacity that banks could use in the
downward phase of the cycle to continue providing households and firms with
the necessary credit flow.
In many macroeconomic and financial contexts, the activation of the CCyB will
be justified on the basis of the three objectives mentioned by the BCBS
simultaneously. This would certainly have been the case in the boom period of
the Spanish economy before the last financial crisis.
However, there might be cases where, based on available data, only one or two
of these objectives can warrant the activation of the CCyB. In particular, there
have been numerous examples of economic recessions not preceded by
excessive credit growth. This promptly begs the question: should these buffers
be exclusively built when the credit cycle is in a boom phase, or also when the
economy is buoyant, i.e. when the business cycle is expanding?
In my view, sound arguments may justify the use of the countercyclical capital
buffer to accumulate loss-aborbing capacity in good times to be used in bad
times, even when there is no evidence of the emergence of excessive credit
growth. The main argument, in my view, stems from the evidence that, even in
those situations, when the recession comes, borrowers' default rates rise,
negatively affecting the profit and loss account and the capital position of banks.
And, when banks do not have a sufficient level of capital to absorb such a
deterioration or can not use their capital buffers, they tend to restrict credit and,
as a result, deepen the economic recession.
Besides, there is also some evidence that both the credit and economic cycles
are not independent of each other. On the contrary, a relatively stable empirical
pattern of lag-lead between both credit and GDP gaps arises: during the initial
phase of recoveries the output gap tends to lead the credit gap; yet when the
expansion is firmly in motion, the credit gap leads the output gap. Therefore,
activating the CCyB when the economic cycle is in expansion might help reduce
the likelihood of an excessive credit expansion.
Moreover, there is also some evidence that the effects on the
activation/deactivation of the CCyB in good/bad times are not symmetric. For
example, using individual and aggregate information during the introduction of
the Basel III requirements, the existing evidence shows that an increase of 1
percentage point in the banks' solvency ratio reduces credit growth by between
1 percentage point and 2.5 percentage points1. This same evidence shows that
the elasticity linked to the release of the countercyclical capital buffer
accumulated during the expansionary phase could be much higher during
downturns. In particular, the evidence points out that credit contracts between
3 and 6 percentage points less when the banks enter into the downturn with a
level of capital 1 percentage point higher2.
These results, mostly reliant on data from the last crisis, are consistent with other
studies taking a longer perspective on the impact of capital over the financial
cycle. One of these latter studies, which considers around 150 years of financial
cycles in Spain3, finds that increasing the CCyB by 1 percentage point prior to a
credit expansion might reduce that expansion by about 1 percentage point.
However, this same increase of the CCyB in the expansionary phase would
reduce the credit contraction in a downturn by around 6 percentage points.
Thus, a potential activation of the CCyB in good times will ensure that the capital
buffers are reserved for bad times. This will affect credit significantly at the
negative juncture, while not having a large effect either on credit or on GDP in
1
See, for example, "Bank Risk Taking and Capital Requirements". R. Anguren, G. Jiménez and J. L. Peydró.
Mimeo, and How effective are capital-based macroprudential measures in taming the macrofinancial
cycles? A structural enquiry into Spain, E. Gerba and J. Mancia (2017). Mimeo.
2
Empirical evidence with the countercyclical provisions in Spain during the credit expansion that preceded the global
financial crisis shows that the introduction of additional provisions in an expansive phase of the cycle did not have a
material impact on overall credit, although the composition of credit shifted to riskier companies for the most affected
banks. In contrast, in the later downturn the previously accumulated provisions provided 5.5 percentage points of
additional credit to non-financial firms and they also had a positive impact on employment and firms' survival
probabilities (see Macroprudential Policy, Countercyclical Bank Capital Buffers and Credit Supply: Evidence from the
Spanish Dynamic Provisioning Experiments (G. Jiménez, S. Ongena, J. L. Peydró and J. Saurina), Journal of Political
Economy, 125 (6), 2126-2177, 2017).
3
Bank capital, lending booms, and busts. Evidence from Spain in the last 150 years. M. Bedayo, A. Estrada and J.
Saurina. Banco de España Working Paper No. 1847.
the expansionary phase. In fact, the cyclically varying nature of the elasticities
signals that the cost of tardy activation can be much higher than the cost of an
excessive anticipation. Moreover, this evidence also shows that the capacity of
the CCyB to control the expansion of credit could be low, reinforcing the view
that its main objective should be, on the basis of this evidence, to create
resilience for the downturn.
As I mentioned earlier, the current regulation makes this possibility perfectly
feasible. Moreover, although it grants a preponderant role to the credit-to-GDP
gap (the so-called "Basel gap"), which would tend to capture the existence of
excessive credit dynamics only, it also allows the use of other complementary
indicators along with expert judgement.
Indeed, in Spain we complement the Basel gap indicator with another four
indicators. They have been selected on the basis of their ability to predict
systemic banking crises. These complementary indicators are: house price
imbalances, current account balance, change in credit relative to GDP (credit
intensity) and the private sector debt burden. And as an additional important
indicator, we are planning to incorporate the output gap, under the assumption
that the position of the economy in the business cycle must also play a role in
the activation of this tool. The usefulness of using different indicators is
especially important in cases like ours, in which the Basel gap does not work
well because of the shorter average duration of credit cycles in Spain. Given the
time lag implementation in the CCyB, we also carefully monitor the forcasted
values of the indicators.
Admittedly, accepting the role of macroprudential policies as an additional set
of macrostabilising tools increases the potential interactions with other
macroeconomic policies. Indeed, the interaction between monetary and
macroprudential policies is particularly relevant in a monetary union such as
Europe's and makes a strong case that justifies the introduction of national
macroprudential policies. This is because, in a monetary union, monetary policy
is defined on the basis of the state of the economy in the Union as a whole and,
in some circumstances, it might lead to financial conditions that are too loose
for certain country conditions and, therefore, can generate pockets of financial
risk in some countries. Activating domestic macroprudential policy by those
national authorities in such circumstances will help precisely avoid the
emergence of systemic crises.
The activation of the macroprudential tools in order to create a buffer to be used
in bad times incorporates a new dimension into the interactions with monetary
policy. That is an issue which, in my view, should be analysed further. At a
minimum, in these cases, monetary policy and macroprudential policy should
take into account their respective decisions when calibrating the use of their
instruments.
As for fiscal policy, it is also important to emphasise that the creation of
shockabsorption capacity through macroprudential decisions should not be used as
an argument for relaxing fiscal policy. In other words, fiscal policy should also
create buffers in good times to be used in bad times, through automatic
stabilisers or discretionary action, in particular in countries belonging to a
monetary union.
Another key issue related to this discussion is that the capital buffer built up in
good times is expected to be released when the phase of the cycle changes.
Significantly, this decision can be even more complex than those made in the
activation phase. In this respect, and given the empirical evidence we have, there
is a clear issue of timing. If it is released too early, it may even accentuate the
expansion of the financial cycle. If it is released too late, it may entail a significant
cost to the real economy. It is also necessary to assess whether the release has
to be once-and-for-all or gradual. The release of the buffers may induce negative
market reactions or generate conflicts with the microprudential supervisor.
A more automatic system of activation could solve many of these problems,
while at the same time introducing an additional automatic stabiliser for the
lending and/or the business cycle. However, given that we do not have much
experience to date with the working of this tool, the calibration of an explicit
policy rule would be premature and the principle of "guided discretion" seems a
second-best option.
Assesing how to use the different macroprudential tools
Let me now turn to the second issue I wanted to tackle. Systemic risk, unlike
inflation or the public deficit, is multidimensional and this is why having different
macroprudential tools at the disposal of the macroprudential authority is crucial.
However, it is not always obvious how to discriminate among the different
macroprudential tools, in particular given the potential interactions between
them.
A first example is the decision to activate the CCyB as opposed to activating a
sectoral CCyB. It is perfectly feasible that some credit segments show
exhuberant behaviour in the economy without any evidence of the credit cycle
being in an expansionary phase. The activation of the countercyclical capital
buffer to address a situation of this type does not seem advisable. If this
particular activity is sufficiently profitable (at least in the short term) and that is
why it is gaining weight in the overall credit portfolio, the increase in the
aggregate cost of financing derived from the activation of the CCyB could be
counterproductive. In fact, it cannot be ruled out that banks will step up the
growth of the most profitable portfolios, which are precisely those the authorities
are trying to moderate, to the detriment of the rest, in order to safeguard
aggregate profitability.
To achieve the objective of exclusively moderating the growth of the exhuberant
portfolios, it would be necessary to act on the relative costs of financing, making
these more expensive in relative terms, through the activation of a
countercyclical capital buffer to be applied exclusively on those credit segments.
However, the coexistence between both tools can be complex, especially if a
transition from one or several sectorial buffers to the total buffer must be made.
Accordingly, its use should be confined to very specific circumstances.
Another example is the use of capital instruments vs borrower-based tools. From
my perspective, making all prudential supervision rely upon the amount of
capital that entities need is too reductionist: the experience accumulated during
the last financial crisis clearly shows how credit underwriting standards are a
crucial element for the stability of the banking system. And this same evidence4
also shows that the analysis of credit standards must be multidimensional.
Therefore, it is not enough to supervise and control a specific characteristic of
the loan; rather, a comprehensive approach must be adopted in which the
different dimensions are addressed. This would also prevent entities from
eluding restrictions by adjusting some other dimension of the loan.
At present, however, credit underwriting standards are not contemplated in
European legislation, although some authorities, including the Banco de España,
are empowered to set them. I do believe that consideration should be given to
including them in future revisions of the European regulation. In my view, this
would offer at least three advantages. First, it would allow harmonisation of the
different dimensions of the credit standards. Second, it would enable the
different jurisdictions to request reciprocity of the measures adopted, which
would duly make them more effective. Last but not least, it would allow the
European Central Bank to top up the measures, reducing the potential inaction
bias of national authorities.
On the use of borrower based tools vs capital instruments, it seems reasonable,
in my view, that, if credit is showing high and sustained growth over time but
without credit standards being relaxed, the ideal would be to increase entities'
resilience using capital instruments. But, even if credit were to show moderate
growth, if the conditions for granting these loans are being relaxed (thus
increasing the volume of credit at risk of default), it would probably be more
efficient to use the borrower-based tools to guarantee sound credit underwriting
standards.
In any case, our experience shows that, especially at the end of expansionary
credit cycles, high increases in the volume of credit tend to go hand-in-hand
with a substantial easing of the conditions for granting the loans. Accordingly,
both types of tools should perhaps be used simultaneously. With what
gradation? It will depend on the circumstances, but always based on a rigorous
and detailed analysis.
Another good example of the interactions among the different macroprudential
instruments is related to the surcharge on systemic entities (globally systemic or
domestically systemic banks), which is the main capital tool to address the
cross-sectional dimension of systemic risk. On top of how to calibrate this buffer,
we need to study further how it interacts with the countercyclical capital buffer.
This is especially important in countries where credit from systemic banks
represents a high proportion of total credit and, in addition, when these banks
have a significant international presence. On the one hand, the empirical
evidence is quite unanimous in showing how higher levels of capital in the
banking system as a whole reduce the probability of systemic crises occurring.
Consequently, if systemic entities are the main determinants of how the credit
cycle evolves and the buffer applied to them is sufficiently high, it would be
reasonable to think that the probability of having a systemic crisis is smaller.
Conceivably, then, the degree of activism necessary with the countercyclical
capital buffer would be lower than in other jurisdictions in which the systemic
banks are less relevant. However, even if the probability of a systemic crisis
occurring is lower, this does not guarantee that its intensity diminishes, and this
buffer was not designed to be released in these circumstances. In addition, as
this buffer is demanded on all exposures, nothing guarantees that its release will
affect the provision of credit in a specific jurisdiction.
The other instrument in the macroprudential policy-maker's toolkit to address
non-cyclical risks is the systemic risk buffer. Here, we welcome the European
initiative to allow its application to sectoral credit portfolios, thus providing it with
more flexibility.
Finally, let me also stress that, for the moment, the bulk of macroprudential tools
affect banks exclusively. While banks continue to account for most financial
intermediation, they are losing relevance and could do so even more in the
future. This can give rise to regulatory arbitrage and undermine the effectiveness
of macroprudential tools.
The Spanish case is to some extent innovative5, as similar borrower-based tools
to those granted to the Banco de España were given to the financial markets
authority (CNMV) and the insurance supervisor for their own sectors. Thus, one
of the tests for the Spanish macroprudential institutional setting will be whether
it is able to achieve enough coordination across authorities to maximise the
effectiveness of the macroprudential toolkit.
In any event, we should bear in mind that global financial integration can also
have similar effects to the domestic development of the non-bank financial
sector, with banking and non-banking entities operating in different jurisdictions.
Especially in this last area, major steps have been taken (with reciprocity
agreements); but there is still ample room for improvement. I am sure we will be
able to address these challenges in future editions of this conference.
Let me now conclude by stressing that, in this context in which a homogenous
framework and experience in the use of macroprudential tools is lacking, having
adequate communication is crucial. From my point of view, this is a critical
element of the whole process. Even before that, macroprudential policy-makers
must be very careful to prevent the identification of risks from becoming a
selffulfilling prophecy. And when deciding to activate any tool, it is necessary to
convince stakeholders with arguments and evidence that, even if there are
apparent short-term costs, the medium and long-term benefits are clearly
greater. Obviously, this implies an in-depth ex-ante impact assessment analysis
including all the different options and a general equilibrium approach, and also
an ex-post impact assessment analysis to test the efficiency of the selected
tools.
And now, let me give the floor to our first keynote speaker, Agustín Carstens,
who we all know so well. Dr. Carstens is currently General Manager of the BIS,
but in the past he was governor of the Bank of Mexico, vice minister of finance
also in Mexico and vice president of the IMF. He is, then, not only an expert in
banking and financial sector regulation and supervision, but has also had to take
decisions on monetary and fiscal policy. And if this were not enough, the value
of international experience in the IMF and in the various international committees
he has presided make him a person especially sensitive to the commercial and
financial interrelations between the different economies. In sum, we are fortunate
to have with us today a policy-maker whose wide-ranging experience in different
areas of the economy is second to none. Agustín, many thanks once again for
accepting our invitation. The floor is yours.