Zhou Xiaochuan: Changing pro-cyclicality for financial and economic
stability
Essay by Mr Zhou Xiaouchuan, Governor of the People's Bank of China, on "Changing
Procyclicality for Financial and Economic Stability", Beijing, 26 March 2009.
The major points were presented at the G20 Meeting of Financial Ministers and Central Bank Governors in São
Paulo, Brazil, on 15 November 2008.
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Much has been discussed on the root causes for the current financial crisis, including but not
limited to lessons on monetary policy, financial sector regulations, accounting rules. This
note aims to stimulate debate and discussions on some of the pro-cyclical features in the
system, possible remedial measures, and how monetary and fiscal authorities can play their
professional roles at times of severe market distress. It also touches upon China's financial
sector reform and macroeconomic policy to counter slowdown in economic growth. The
major points here were presented at the G20 Meeting of Finance Ministers and Central Bank
Governors in São Paulo, Brazil on November 15, 2008.
1. The built-in pro-cyclical features in financial architecture
When we discuss system stability, we can borrow some concepts from electronic
engineering or control theory. In a complicated system, there are usually many feedback
loops, some of them are positive, some of them are negative. A positive (plus) feedback loop
enlarges amplification (like multiplier), tends to create oscillation (like boom and bust
procyclicality) and zero-point shifting (like a reference of bubble). While a negative (minus)
feedback loop can reduce amplification, help for system stability and self-correction of
zeropoint. In economic and financial systems of recent years, we have too many positive
feedback loops on macro and micro levels, and a small number of negative feedback loops.
Thus the system shows a strong pro-cyclicality. What we need to do is not to totally rebuild
the system, but to add a few negative feedback loops, which are able to sufficiently change
the characteristics of our system.
Financial crises normally originate in the accumulation of bubbles and their subsequent
bursts. Usually, economists pay a lot of attentions to pro-cyclicality on the macro level.
However, on the micro level, there are quite a number of notable pro-cyclical features
embedded in the market structure today, which should be addressed as we deal with the
current crisis and reform the financial system. In the current market structure, more
countercyclical mechanisms or negative feedback loops on micro-level should be put in place to
sustain a more stable financial system.
1) Rating problems and herding phenomenon arising from outsourcing
The global financial system relies heavily on the external credit ratings for investment
decisions and risk management, giving rise to a prominent feature of pro-cyclicality. The
rating industry is dominated by a few large players, which provide practically all important
rating services. Specific ratings from the big three tend to be highly correlated and they are
combined to form a strong cyclical force. Economic upswings produce euphoria and
downturns generate pessimism. Many market players adopting ratings from the three
agencies and using them as the yardstick for operations and internal performance
assessments clearly result in a massive "herd behavior" at the institutional level. Moreover,
the rating process is filled with conflicts of interest by virtue of the issuer-paying business
model (issuers also pay for the rating agencies' advisory services on structuring their
products, which leads to more problems). Moreover, the rating models for mortgage-related
structured products are fundamentally flawed. During the current crisis stemming from the
subprime mess, the high ratings assigned to many subprime products and the massive
downgrades of them within short period were unprecedented, which drove the massive
writedowns by financial institutions, and exacerbated downward spirals.
Herding phenomenon can also be explained as too many positive feedback loops to cause
an oscillation. In investment area, we always preach on the virtue of diversification. Portfolio
diversification means when you bet for upside in some products, you should also place
protection elsewhere for downside. Investor diversity and heterogeneity is predicated on the
notion that market needs both optimists and pessimists. Thus the system should not
encourage all investors and their portfolios to behave in the same way. However, too many
financial institutions outsourced the development of their internal control systems and the
technical models used by their bankers and traders in internal assessment and risk control,
including the program trading models that had been widely adopted at an earlier time.
Outsourcing of system technologies at such a prevalent scale contributed to high degree of
homogeneity in the financial system, which strongly added to pro-cyclicality. For complex
financial products, most institutions use models built by a handful of quantitative analysts that
get widely adopted throughout the industry. Such models tend to produce similar directional
results at the same time when certain conditions prevail. In other words, outcomes from such
models are highly correlated. When they are used by the whole financial industry world-wide,
asset price boom is made much stronger and bust much more damaging. And due to high
synchronizations of market participants' behaviors as a result of using the similar models,
systemic risk arises. Regulators should require systemically important financial institutions to
complement external pricing models with internally developed capabilities to exercise
judgment. In addition, to give issuers of structured products more incentives to better assess
their risks, regulators should ask them to retain a meaningful share of the underlying assets
on their balance sheets in order to alleviate the myriad of problems associated with the
"originate-to-distribute" business model, including moral hazards and fraudulent loan
underwritings.
On the users' side of ratings, there is the long-standing moral hazard issue. Various rules
have required investment management decisions and risk management practices to be
benchmarked on financial instruments attaining certain ratings from the so-called Nationally
Recognized Statistical Rating Organizations (NRSRO). This practice has enabled industry
practitioners to piggyback on the external ratings and not to worry about the inherent risks
once the instruments have achieved the threshold ratings. Over time, the financial industry
has become accustomed to the practice and become complacent of the ratings they rely on
so heavily. Some market players seem to have forgotten that the ratings are no more than
indicators of default probabilities based on past experiences but were never meant to be
guarantees for the future. Along with complacency, there is inertia and sloppiness on the part
of investment managers to ask tough questions about the inherent risks of instruments sitting
in their portfolios. Once problems take place, as we have seen during the current crisis,
fingers are pointed to the rating agencies. The institutional users (e.g., the money managers
and financial institutions) of credit ratings should be ultimately accountable to their customers
and shareholders and should exercise their own judgment of risk, not just outsource risk
assessment duties to the rating agencies. To the extent they have to use external expertise,
internal and independent judgment has to be deployed as a complement. As a matter of fact,
the problem has become so serious that regulators need to encourage financial institutions to
enhance internal rating capability to rely less on external ratings, and that central banks and
regulators should impose requirement whereby use of external ratings should not exceed 50
percent of business activities, at least for systemically important financial institutions. Internal
capabilities should be developed to exercise independent judgment on credit risks at such
organizations.
2) Fair value accounting, mark-to-market and mark-to-model
Both IFRS and GAAP require mixed value measurements of different type of assets and
liabilities according to their features and the management's intentions of holding them, i.e.
assets on the trading book and available-for-sale assets should be measured on the fair
value basis, while hold-to-maturity assets, loans and liabilities without an objective fair value
should be recorded at historical costs.
GAAP and IFRS define fair value in a similar way, which is a price at which an asset and
liability can be traded with a willing counterparty in an orderly manner. Both accounting
frameworks provide measurement approaches at differentiated levels. Level 1: prices can be
observed on active market, which are used to measure the value of assets and liabilities, a
practice called mark-to-market. Level 2: when there is no active market, prices are assessed
by using models with observable parameters as inputs, a process called mark-to-model.
Measurement approach used on level 3 is similar to the mark-to-model approach, but it
involves unobservable parameters and model assumptions as inputs. Both IFRS and GAAP
require disclosure of the adoption of fair value approaches and specific assumptions as well
as risk exposures and sensitivities.
The problems of fair value accounting have been exposed by the current crisis. First,
compared with the historical cost approach, fair value accounting intensifies market
fluctuations. While the fair value approach is more dynamic and can better reflect the real
time value of assets and liabilities, it also magnifies the changes in their values and
increases the volatility of returns through the profit and loss account as a consequence. As a
result of the massive collateralized securities they held, financial institutions registered
mounting unrealized losses which actually involved no cash flow under the fair value rule.
Though these losses were only meaningful in accounting, such astronomical book losses
distorted investors' expectations and formed a vicious cycle of prices tumbling - asset
writedown "panic selling" further prices slumps. Second, the poorly guided adoption of fair value in
non-active markets exacerbated market volatility. As defined, the using of fair value
approaches must be based on the prerequisite of orderly trading. At times of crisis, as a large
number of institutions were forced to liquidate their assets, prices developed under this
situation did not meet the prerequisite for fair value measurement. However, due to the lack
of specific guidelines on dealing with such circumstances, reporting entities had to conduct
fair value measurement on the basis of unreasonable market prices, which magnified book
losses and exacerbated the vicious cycle.
We could say, in a normal situation or in a low frequency band, mark-to-market is a negative
feedback loop. However, in an extreme situation or high frequency band, mark-to-market
mechanism can not catch the changing phase. When phase lag is larger than 90o, a negative
feedback loop can become a positive feedback loop in characteristics. In this situation, what
we need to do is to cut off this loop, thus we need a circuit breaker. We can resume the
system when it returns to normal condition. In economic system, we need to put into place a
sort of circuit-breaker mechanism to stem the pro-cyclicality caused by mark-to-market and
fair value accounting in specific situations.
3) Internal rating based (IRB) approach under Basel II
The New Basel Capital Accord (Basel II) released in 2004 improved the capital adequacy
ratio framework, shifting from singular requirement on capital adequacy to highlighting the
importance of risk-based banking supervision, and including minimum capital as one of the
three pillars of banking supervision (regulatory capital requirement, regulatory responses,
disclosure and market discipline). Under Basel II, the minimum capital requirement of 8
percent was unchanged, but the notion of risk weighted asset was improved to reflect not
only credit risks, but also market risks and operational risks. Following the release of the
Basel II, major economies have outlined steps and the timetable for its implementations, and
major European countries have basically implemented the new Accord. China is also making
preparations for implementing it.
The Basel II framework allows financial institutions to apply internal rating-based approach in
pricing and assessing risk of complex products. Risk weights for purpose of capital adequacy
calculation are derived from internal modeling. Such weights are generally low and lead to
high capital adequacy ratio (CAR) during economic upswing, and are high and lead to low
CAR during cyclical downturn, everything else equal. As a result, financial institutions tend to
have high leverage ratios during good times and have to deleverage during bad times. This
amplifies bubble buildup during upswings and leads to credit squeeze and asset dumping
during downturns, thus increase cyclical volatilities. This reflects a strong pro-cyclicality. We
took notice that FSF has formed working groups to cooperate with BCBS in studying ways to
strengthen Basel II framework, and to address its weaknesses revealed during the crisis
including its pro-cyclicality.
2. Give full play to the professional role of authorities of overall financial stability
and establish a counter-cyclical mechanism for capital requirement
Among the supervisory requirements on financial institutions, banking institutions in
particular, capital adequacy ratio is one of the most important prudential requirements. The
current financial crisis suggests that a sound capital buffer is critical for banks' resilience to
risks and financial stability in a broader sense. Effectively addressing the pro-cyclicality
elements in the existing capital requirement framework is essential for avoiding a repetition of
serious financial crisis. The ongoing crisis has exposed much vulnerability in capital
adequacy framework of banks in the following areas: inadequate capture of risks by the
Basel II framework for complex credit products; the minimum capital requirement and the
quality of capital did not provide adequate buffer during the crisis; the pro-cyclicality of capital
adequacy amplified economic oscillations; the differences in capital requirements among
different types of financial institutions. Efforts are being made in some countries to widen the
coverage of capital requirements, including setting requirements on asset-backed securities,
off-balance sheet risk exposures and trading account activities, improving the quality of tier 1
capital, and enhancing the global consistency of minimum capital requirements. In addition,
as a complement to capital adequacy ratio requirement, a notion is under discussion that a
properly constructed leverage ratio indicator will play a role in the macro prudential regulation
framework as the new indicator can both measure potential excessive risk-taking and
dampen the amplification of cyclical fluctuations.
In addressing the vulnerability of the existing capital adequacy ratio framework, particularly
the pro-cyclicality of capital buffer, national authorities responsible for overall financial
stability can actively play their professional role. If economic cycle comes into an unusual
phase, or economic system needs an unusual counter-cyclical adjustment or special
stabilization measure, it can be considered to let authorities of overall financial stability issue
quarterly indicators of prosperity and stability, which can then be used by financial institutions
and regulatory supervisors by multiplying into risk weights for capital adequacy ratio
calculation. Thus the risk weighted capital adequacy requirement and other control criteria
(like internal rating-based approach), can reflect counter-cyclicality preference of the stability
authorities.
Traditionally, finance ministries have counter-cyclical fiscal policies and monetary authorities
have counter-cyclical monetary policy tools at their disposal, but these tools are macro in
nature. As a remedy to pro-cyclicality at micro level, counter-cyclical multipliers can be
developed and used to dampen the pro-cyclical factors such as the risk weights that come
out of the internal rating-based exercises. To begin with, as mentioned above, it may become
necessary for financial stability authorities to develop a set of prosperity indices from which
counter-cyclical multipliers can be derived. There already exist a multitude of private sector
indices linked to business cycles, investor and consumer sentiments. Prosperity indices can
be built on the basis of these indices. During market boom, everything points to the up-tick,
market exuberance prevails, and prosperity indices are high. As a contrast, during economic
downturn, the opposite holds. Once prosperity indices are available, the derived
countercyclical multipliers can be applied to the pro-cyclical factors such as risk-weights mentioned
above, default probabilities for credit rating purposes and discount (i.e., haircuts)
percentages for various collaterals used in financial transactions. In suitable forms, they can
be applied to other pro-cyclical factors too. One example of using them is to apply a multiplier
greater than 1 (say, 1.5. Please note this is only an example and the actual multiplier is
determined by specific calculations. The same applies below) during economic upswing and
another multiplier less than 1 (e.g., 0.7) during downturn to the IRB-based risk weights to
alleviate the pro-cyclical problems. The magnitude of the multiplier can be refined by taking
into consideration other factors such as product type, industry and country of risk exposures.
Through the applications of the counter-cyclical multipliers, we can not only mitigate the
procyclicality elements in capital requirements but also improve quality of capital by improving
management of collaterals and by using multipliers-adjusted default probabilities and better
managing the risk in complex credit products.
To stabilize markets under severe stress, finance ministries and central banks need to act
fast and apply extraordinary measures. Untimely or delayed response falls behind the curve
and would make the outcome less than desired even if the response is correct and strong. In
modern Western societies, a prolonged political process for mandates to finance ministries or
central banks often miss the best timing for action. We have observed such cases during the
current crisis. Going forward, national governments and legislatures may consider giving
preauthorized mandates to ministries of finance and central banks to use extraordinary means
to contain systemic risk under well-defined stress scenarios, in order to allow them to act
boldly and expeditiously without having to go through a lengthy or even painful approval
process. Such systematic pre-authorized mandates would put the specialized expertise of
finance ministries and central banks to the best use when markets need it the most.
3. China's financial sector reform and ongoing macroeconomic stimulus
measures
In 2003, fully aware of the systemic vulnerabilities of China's banking industry, the Chinese
government made a courageous and strategic decision to restructure the four state-owned
commercial banks. It was commonly recognized at that time that Chinese banks, especially
the big four, could hardly withstand a big economic downturn if not seriously reformed. The
banking system was then vulnerable to shocks, especially external shocks, which would
trigger confidence crisis or even systemic meltdown. The Chinese government decided to
first inject capitals into Bank of China and China Construction Bank by tapping into the official
foreign reserve. The banking reform got a quick start and captured a good time window.
Before the reform, Industrial and Commercial Bank of China (ICBC), CCB and BOC were
plagued by high NPL ratios, low or negative capital base and a culture not accountable to
shareholder value. Through capital injections and subsequent public listings, these major
banks now enjoy strong capital base even after fast growth during the last five years.
Through NPL carve-out and strengthening of risk management practices, all of these banks
have maintained NPL ratios of low single digits. In terms of corporate governance, boards
are comprised of independent non-executive directors and full-time and dedicated directors
who can provide strategic guidance for future development and effective checks and
balances. Strategic investors from overseas were brought in to help them improve in areas of
weakness such as risk management, business processes, product innovations, cash
management, and credit cards and so on. More importantly, through the restructuring
processes and public listings and the transparency that followed, accountability culture
started to sink in and shareholder value became respected, not ignored as before.
In the securities industry, the shaky firms were closed down and some important ones
received government capital injection and were restructured. Their customers' cash accounts
were put into independent custodian arrangements with the major banks, thus removing the
possibility of customer asset commingling and misappropriations. The banking reform and
the securities industry cleanup have proved to be successful and have laid a solid foundation
for the financial sector to withstand economic downturn, in particular the ongoing global
financial crisis. For example, despite the steep drop of the stock market since late 2007, no
securities firms have gotten into big trouble so far. And the major banks are in a strong
position to weather economic slowdown. ICBC, CCB and BOC top the global list of banks'
market capitalizations. A more robust financial industry after the reform places China in a
better position to withstand the financial crisis. Meanwhile, it should be noted that China's
financial system has been helped by the progressive opening-up strategy and its limited
exposure to overseas markets. We should bear in mind that despite the notable
achievements in banking reform, the major banks have not gone through a full business
cycle and still have much to improve. An economic slowdown will be the ultimate stress test
for the robustness of the banks' strengths.
Irrespective of China's sound financial sector, the Chinese economy, especially the export
sector, has felt the impact brought by the slowdown of the global economy. Since the fourth
quarter of 2008, as international economic crisis worsened and exerted greater impacts on
China's economy, the Chinese government made rapid responses by decisively adopting a
proactive fiscal policy and an adaptively easing monetary policy, and launching a bundle of
timely, targeted and temporary policies and measures.
First, ten measures were launched to stimulate domestic demand and promote stable and
relatively rapid economic growth. The central government planned to invest an extra 4 trillion
RMB over two years, which would mainly go to the agricultural sector, welfare and affordable
housing, transportation infrastructure, and energy conservation and emission reduction.
Second, ten measures to revitalize the industrial sectors were initiated, aiming to strengthen
policy support for enterprises. At present, the revitalization plans cover 10 industries
including the light industry, automobiles, steel, textile, equipment manufacturing, shipping,
petrochemicals, non-ferrous metals, IT and logistics, with the aim to curb and reverse the
trend of declining growth in these industries. Third, bolster financial support for economic
developments. Since September 2008, People's Bank of China has lowered the benchmark
interest rates five times and reduced the reserve requirement ratios on four occasions, for
the purpose of maintaining adequate liquidity for the banking sector and promoting stable
growth of monetary and credit supply. In addition, 9 measures to strengthen financial support
for economic growth were launched. Fourth, earnest efforts have been made to promote
employment, improve people's livelihood, better support and benefits for farmers, and
stimulate household consumption demand. Fifth, policy measures were adopted to advance
the reform of important areas including VAT tax transformation, reform of taxes and fees
imposed on oil products, and medical and healthcare system reforms. Having taken the
above-mentioned measures, China expect to maintain stable economic growth by boosting
domestic demand and reducing dependence on external demand, thus serving as a
stabilizing force in global economy.
In overall, the macroeconomic measures have produced preliminary result and some leading
indicators are pointing to recovery of economic growth, indicating that rapid decline in growth
has been curbed. Facts speak volume and demonstrate that compared with other major
economies, the Chinese government has taken prompt, decisive and effective policy
measures, demonstrating its superior system advantage when it comes to making vital policy
decisions.