Vítor Constâncio: Strengthening macroprudential policy in Europe
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
Conference on "The macroprudential toolkit in Europe and credit flow restrictions", organised
by the Bank of Lithuania, Vilnius, 3 July 2015.
* * *
The current euro area environment, with policy rates required to stay low for a prolonged
period of time and an apparent disconnect between the business and financial cycle, clearly
points to a situation where monetary policy cannot deviate from price stability objectives to
influence the financial cycle. This is the task of macroprudential policy. While acknowledged
in principle, this fact has not yet been fully reflected in our policy frameworks.
Two major moves are required. First, macroprudential policy must place greater emphasis on
preventing large fluctuations in the financial cycle, rather than simply increasing resilience to
shocks when they occur. In addition to the bank-side capital based measures enhancing
banks' resilience, borrower-based instruments (such as LTVs or DSTIs), which have proved
to be more effective in curtailing excessive credit growth, and are also applicable in a
timevarying fashion, should gain more prominence. In particular, borrower-based measures
should be properly embedded in European legislation, which is not the case at present.
Second, a broader macroprudential toolkit is needed to address risks stemming from the
shadow banking sector due to its increasing role in credit intermediation. This could involve
measures such as redemption gates and loading fees to provide additional safeguards.
Guided stress tests can provide comparable assessments of the health of individual
institutions and of the resilience of the financial system as a whole. Appropriate policy
responses to mitigate growing risks need however to be calibrated, in order to ensure a
contained impact on credit supply to the real economy.
* * *
Ladies and gentlemen,
For seven years now, policy interest rates around the world have been at historic lows as
central banks have responded to the debilitating effects of a major financial crisis. While
some major central banks are now signalling their intention to begin a tightening cycle, there
remains some uncertainty about how much interest rates can be expected to normalise. This
is related to the so-called "secular stagnation" hypothesis and the possibility that long-term
real equilibrium interest rates have fallen to very low levels, exerting continued downward
pressure on interest rates even as the recovery strengthens. All this implies that, insofar as
disconnections emerge between business and financial cycles in advanced economies,
monetary policy is not available to address financial stability concerns.
This also applies to the euro area. In our case, however, the issue is made more acute by
the fact that cyclical conditions are also diverging across countries. We have signalled clearly
that our monetary policy is continuing its easing phase. Our main policy rates will stay low for
a prolonged period of time, as indicated by our forward guidance, and our balance sheet will
keep expanding until we see a sustained adjustment in the path of inflation. Managing the
business cycle and ensuring price stability will be the central focus of monetary policy over
the medium-term, as our mandate demands.
In this environment, monetary policy needs a complement, and that complement is
macroprudential policy. This is hardly a new statement, but in my view it is still not receiving
sufficient international attention. Developing the macroprudential toolkit is a real need for
advanced economies. Moreover, some key aspects of the situation we face today are yet to
be fully reflected in our policy frameworks. There are two points in particular that I would like
to underline.
The first is that macroprudential policy must place greater emphasis on preventing large
fluctuations in the financial cycle, rather than simply increasing resilience to shocks when
they occur. This means making full use of instruments that can effectively restrain excessive
leverage and credit growth, and deploying them in a time-varying way that is sensitive to
movements in the financial cycle. In my view, this can only be achieved by broadening the
toolkit available to policymakers at the European level to include borrower-based measures,
which are the measures thought to have the strongest impact on credit and real estate
developments.
The second point is the need for this broader toolkit to also cover the shadow banking sector.
The CRR/CRDIV legal framework covers mainly the banking sector, yet financial activity and
the financing of the euro area economy have increasingly shifted to non-banks.1 Since 2009,
shadow banking entities have increased their share in total assets of the financial sector from
33% to 37%, while credit institutions have seen their share of intermediation shrink from 55%
to 49%. In this context, a macroprudential framework focused solely on banks will be "blind in
one eye" - it will have only a partial perspective on intermediation patterns and the forces
driving the financial cycle. It will also be highly prone to regulatory leakages.
In the remainder of my remarks I will expand on these two points in some more detail.
The macroprudential toolkit and credit flow restrictions
Starting with the issue of tempering the financial cycle, the first challenge is of course to
identify more accurately which variables policy should aim to lean against. In this context
quite some conceptual work has been done by the BIS, and also taken up at the ECB.2 At
the ECB we include equity, interest rate, housing and credit markets in our preferred
measure of the financial cycle, and aim to account for correlations between sectors.3 The key
finding from our work, however, is in line with that of other studies: the most important driver
of the financial cycle is credit flows into real estate. The correlation between mortgage credit
flows and house prices is strongly self-reinforcing.4
Therefore, if macroprudential policy is to effectively curb the financial cycle having the tools
to address this credit-real estate nexus is fundamental. In principle, there are two ways this
can be achieved. The first is on the bank side by imposing restrictions on lending institutions
- so-called capital-based measures. In this context the toolkit at the European level based on
CRR/CRDIV already includes such measures as the Countercyclical Capital Buffer, the
Systemic Risk Buffer and capital add-ons for systemically important institutions. It also
includes large exposure limits and sectoral risk weights which can be applied to banks'
exposures to the residential and commercial property sectors.5
In the euro area, the Netherlands was one of the frontrunners in introducing systemic risk
buffers in July 20146. Since then similar measures have been adopted in Estonia, Denmark
1
For a description of the shadow banking activities see Pozsar, Z., T. Adrian, A. Ashcraft and H. Boesky
(2013): "Shadow Banking", FRBNY Economic Policy Review, December.
2
The early work by Drehmann, M., C. Borio and K. Tsatsaronis (2012), "Characterising the financial cycle: don't
lose sight of the medium term!" BIS Working Papers No. 380, has been updated by Hanno Stremmel (2015):
"Capturing the financial cycle in Europe", ECB Working Paper No. 1811.
3
Schüler, Y., P. Hiebert, and T. Peltonen (2015), "Characterizing Financial Cycles Across Europe: One Size
Does Not Fit All", ECB Working Paper (forthcoming).
4
Favara, G., and J. Imbs, (2015), "Credit supply and the price of housing," The American Economic Review,
105(3), pp. 958-992.
5
For a full overview of the macroprudential toolkit in Europe see ESRB (2014) "The ESRB Handbook on
Operationalising Macroprudential Policy in the Banking Sector".
6
Phasing in the SRB between January 2016 and January 2019 http://www.esrb.europa.eu/pub/html/
index.en.html?skey=29/04/2014%20Notification.
and Sweden. The latest country to announce measures was Austria, applying the systemic
risk buffer to a total of 12 banks. Since then similar measures have been adopted in Estonia,
Denmark and Sweden. The latest country to announce measures was Austria, applying the
systemic risk buffer to a total of 12 banks.7
There are however several well-known problems with relying on such instruments to smooth
the financial cycle. For one, aside from the counter-cyclical capital buffer, capital-based
measures tend to be focused on building resilience and are hence applied in a static way.
This is the case for the implementation of the systemic risk buffers in various countries that I
just described. Moreover, the evidence suggests that, even if applied in a more time-varying
way, such measures have more indirect and possibly limited effects on cyclical adjustments
and the costs of loans.8 This may make them less effective in restraining excessive credit
demand in an environment of exuberant expectations of house price appreciation.9
The second way in which the boom-bust cycles can be tempered is on the borrower side -
that is, by limiting households' or non-financial corporations' leverage. Borrower-based
instruments, such as loan-to-value (LTV), loan-to-income (LTI) or debt service-to-income
(DSTI) limits, are on the whole thought to be among the most effective macroprudential
instruments in curtailing excessive credit growth.10 It should be highlighted that using
indicators related to income is preferable to taking housing values in the denominator of such
indicators. In an undesirable boom, the value of houses goes up and the Loan-to-Value may
provide a misleading indication of what is happening. In any case, an increasing number of
euro area countries are introducing such measures to address the impact of low interest
rates on housing market developments.
For example, Estonia has introduced limits on LTV, DSTI and maturity restriction
requirements for commercial banks issuing housing loans. Ireland has taken the decision to
place ceilings on the proportion of mortgage lending with a high LTV and LTI ratios. The
Netherlands has introduced a gradual tightening of its LTV caps, decreasing by 1 percentage
point each year until the LTV reaches 90% in 2028. Slovakia has progressively tightened
share of loans with LTV ratios and introduced recommendation on maximum maturity and
requirement for income verification and internal borrower repayment assessment for banks.
And Lithuania, as you know, has been implementing its Responsible Lending Regulation
since autumn 2011.
To effectively temper the financial cycle, however, a time-varying dimension is crucial in the
design of such instruments - that is, the relevant ratios must be able to be adjusted over the
cycle. Otherwise, especially in the case of LTV, there is a risk of pro-cyclicality due to the fact
that leverage constraints decrease as asset prices rise. In order to adjust the LTV or DSTI
ratios in this way, borrower stress tests either against future changes in interest rates or in
house prices should, in my view, become a common standard.
In this context I note that Lithuania has recently made its DSTI legislation more sensitive to
the financial cycle by requiring credit institutions to check whether customers would be
financially able to withstand future increases in interest rates, while also reducing the
maximum maturity of credit. This is a good example of using macroprudential policy in a
preventive way. However, not all countries in Europe can follow this rule in similar
circumstances, given more limited legal possibilities. It also relies wholly on the foresight of
the national competent authorities. The fact that borrower-based instruments do not fall
under European legislation means that there is little coordination in how and when they are
used across countries. This in turn means that their implementation mode varies strongly
across individual countries.11
For example, in some countries, such as here in Lithuania, borrower-based measures are
codified in the context of financial stability, while in others they fall under consumer protection
law, as for the Netherlands and Latvia. The range of lending institutions covered by
borrower-based measures also varies according to the national legal basis. Hungary, for
example, is one of the few countries where loan-to-value limits are implemented by the
central bank for financial stability purposes with coverage by activity, which implies that any
institution extending credit for house purchases needs to comply with the imposed LTV
limit.12
Heterogeneity also extends to the competent authorities for implementing the measures. In
some countries it is the central government, in others it is the central bank, and in still others
authority is in the hands of a committee that involves different national bodies
(crossinstitutional committee). This requires coordination among different types of institutions with
different mandates and time horizons, and given the high political and social sensitivity of
implementing borrower-based measures, can lead to an inaction bias. We see this today in
several European countries. The result is that, insofar as such measures are deployed, the
crucial time-varying dimension is often lost.
These implementation issues have clear area-wide consequences. First, they raise the risk
of regulatory leakages - be they between countries or between banks and other financial
institutions, especially relevant also for the commercial real estate sector. Second, they blunt
the effectiveness of what is one of the key instruments to address the systemic risks for the
Union as a whole emanating from excessive credit flows and house price bubbles. Indeed,
what we confront in the euro area is a somewhat paradoxical situation where the instruments
that could most effectively address the risks of a low interest rate environment are the ones
governed by the weakest common framework.
There is some capacity to use the current framework more effectively, but it is limited within
the existing legal setup. To promote consistent implementation of borrower-based
instruments across the EU, the ESRB can issue recommendations that are to operate
through a comply-or-explain mechanism. Up until today, no such recommendation exists for
the real estate market. When it comes to the implementation of borrower-based instruments
in euro area/SSM countries, the ECB can play a key coordinating role for SSM countries.
Interaction between national authorities, represented by national central banks and
supervisors, takes place within the Financial Stability Committee (FSC). It is our duty to make
best use of this forum to encourage a consistent application of instruments. Yet it may not be
sufficient given that the competent institution for deciding on borrower-based instruments is
not always represented in the FSC.
In my view, therefore, we have to give serious consideration to strengthening the legal basis
of the macroprudential framework for borrow-based instruments, especially within the SSM
area. The potential risks from the housing market are too important, and play too pivotal a
role for a number of financial markets and for the European financial cycle, to be addressed
in such an uncoordinated way. We need the relevant instruments to be based on European
law. I therefore strongly support initiatives to establish a consistent minimum set of
borrowerbased instruments in the European macroprudential framework. Indeed, the review of the
CRR/CRDIV legal framework should be seen as an opportunity to achieve this.
Systemic risks in the shadow banking sector
This discussion so far has dealt predominantly with bank credit. As I indicated earlier,
however, financial activity and the financing of the economy in the euro area has been
shifting to non-banks. We are seeing an ever greater involvement of insurance companies
and pension funds in mortgage and private placement markets and investment funds in
equity markets. To give just one figure, non-money market investment funds' holdings of
non-financial corporate bonds have risen from 14% of the outstanding volume in 2008 to
27% by the first quarter of this year.13 This shift has undoubtedly been beneficial by acting as
a buffer for the real economy while bank credit has been contracting.
However, as the sector continues to expand and increase its role in lending to the real
economy, as its interlinkages with the wider financial sector deepen, and as the footprint of
large institutions grows, non-banks will only gain in systemic importance. Moreover, the more
policymakers are effective in using macroprudential tools to constrain excessive credit
growth in the banking sector, the more likely it becomes that there will be excessive
adjustments in the non-bank sector through leakages. For these reasons, the coverage of
the macroprudential framework needs to start being extended to the shadow banking sector.
In this context there are four issues in particular that I would like to highlight.
First, there is the need to improve the information available to policymakers on the build-up
of leverage within the shadow banking sector. Typically the issue of leverage has been seen
as less relevant for shadow banks than for banks, as they receive the bulk of their funding by
issuing shares. As a result, the aggregate ratio of assets to equity for euro area investment
funds is only 1.1, over ten times smaller than that of euro area credit institutions. However,
this figure is misleading as most of the equity in investment funds is demandable, meaning it
can be withdrawn at any time by investors.
In addition, derivatives positions in particular can embed sizeable leverage, potentially
adding to deleveraging pressures when financial stress emerges.14 Such "synthetic leverage"
can stem from derivative instruments or securities financing transactions that create
exposures contingent on the future value of an underlying asset.15 For example, taking the
financial reporting of a large alternative fund, and calculating leverage using a gross measure
that includes the above underlying exposures, it can be found that leverage goes up to a
level of 700% of NAV. At the same time, the fund's prospectus indicates that it could go up to
900%. When using the commitment approach, however - i.e. taking into account netting and
hedges - leverage could be expected to reach a maximum level of 170% of NAV. In other
words, "synthetic leverage" can be many multiples higher than the leverage suggested by
headline ratios.
Data availability however still limits the ability of authorities to monitor synthetic leverage from
a financial stability perspective, i.e. taking into account both on-balance-sheet and
offbalance-sheet exposures. The European Securities and Markets Authority (ESMA), which is
tasked with harmonising reporting practices, can request access to supervisory data from
national authorities. But for various reasons statistical data on synthetic leverage are not
systematically collected at the European level. In my view this needs to be addressed. In
time, I also see a need to develop dedicated instruments to address leverage in the shadow
banking sector that adequately account for derivative positions.
Second, our framework for managing non-bank leverage needs to encompass not only
intermediaries, but also securities financing transactions through haircuts or margins.16
Important work is being done here at the international level. For repurchase agreements, for
example, the FSB has developed minimum haircuts for OTC transactions for not centrally
settled transactions.17 I see scope however for further reflection in this area. For instance,
these minima do not yet apply across the board. And as has been shown in the past, market
imposed haircuts during crisis times are many times higher than any of the static haircuts
that are currently discussed, which could mean that margining practices remain procyclical if
they cannot be changed in a time-varying way. I see scope however for further reflection in
this area. For instance, these minima do not yet apply across the board. And as has been
shown in the past, market imposed haircuts during crisis times are many times higher than
any of the static haircuts that are currently discussed, which could mean that margining
practices remain procyclical if they cannot be changed in a time-varying way.
Third, liquidity stress poses an equally important source of systemic risk for the non-bank
financial system and requires appropriate macroprudential tools. Liquidity spirals can be
triggered if funds are confronted with strong redemptions or increased margin requirements
which force them to sell into markets with low liquidity. This amplifies asset price adjustments
and triggers further redemptions and margin calls. Key to countering such liquidity risks is to
develop and apply liquidity buffers to the shadow banking sector, in the spirit of the Liquidity
Coverage Ratio for the banking system. This would serve as a first backstop should liquidity
shocks curtail funding liquidity temporarily.
However, liquidity risk is a somewhat more complicated phenomenon for non-banks than for
banks, as simply comparing the maturity of the asset side with the term funding on the
liability side does not give an accurate picture of maturity mismatch. That is because, as
already mentioned, their larger share of equity funding is itself redeemable, which gives
nonbank equity a fire-sale property. Therefore, addressing liquidity risk would also have to
involve countering such risks from capital. This could involve measures such as redemption
gates and loading fees to provide additional safeguards.
Fourth, if we are to deploy macroprudential tools more effectively in the shadow banking
sector, regulators need a clearer picture of the resilience of individual institutions and the
system as a whole to shocks. In this context I would support developing guided stress-tests
designed by regulators themselves, which can shed light on the true loss absorption capacity
of non-bank institutions. Such stress-tests - which would need to fully incorporate the
derivative positions of institutions and their exposure to liquidity shocks - would offer a more
comparable assessment of the health of individual institutions and, when considering
feedback loops within the financial system and the economy, of the resilience of the system
as a whole.
Remember that the risk of spillovers from non-banks to the real economy is not only via their
direct role in credit intermediation and capital markets. Since almost all large asset
management companies in the euro area are owned by banks or bank holding companies,
reputational problems in the asset management arm could spill over to the parent company,
or vice versa.
New macroprudential tools, be they leverage limits, guided stress tests, or redemption gates,
would need to be placed in the hands of the regulators to be effectively deployed. And just as
for the banking sector, to be successful in countering the build-up of systemic risks over the
cycle they would need to be applied in a time-varying fashion. However, it is important to
stress that, when determining the appropriate policy responses to mitigate growing risks in
the sector, consideration should be given to its growing role in credit intermediation. We need
to ensure that the impact on supply of credit to the real economy is limited.
There is of course much we still have to learn about the design and implementation of such
instruments; indeed, we are still only beginning to discover the mechanisms through which
macroprudential policy works in the banking sector. Still, I am convinced that these additional
instruments are essential - and starting work on them is urgent - if we are to have a holistic
view on systemic risk and financial stability.
Conclusion
Let me conclude.
What I have argued today is that we are entering into an environment where monetary policy
cannot be responsible for managing the financial cycle. And this fact, while acknowledged in
principle, has not yet been fully reflected in our policy frameworks in practice.
A comprehensive approach to macroprudential policy means two things.
First, making efficient use of macroprudential tools that can constrain excessive credit growth
towards the real estate sector, which is the main driver of the financial cycle. Borrower-based
measures therefore come to the forefront. Given their importance, they deserve to be
properly embedded in European legislation and effectively coordinated within European
institutions.
Second, broadening the coverage of the macroprudential toolkit to reflect changing patterns
of intermediation - i.e. to the shadow banking sector. It may be the case, as Jeremy Stein
famously argued, that monetary policy is the best tool to "get in all the cracks" of the financial
system. But as that option may not be available to us for some time, it is incumbent on
policymakers to put more attention into developing instruments that can reach into all the
corners of the financial system.
I trust that our conference today will provide many useful insights on how we can proceed
with this agenda.