Vítor Constâncio: Financial stability risks, monetary policy and the need
for macro-prudential policy
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
Warwick Economics Summit, Warwick, 13 February 2015.
* * *
The financial crisis has shown that price stability is not sufficient to guarantee financial
stability. The financial cycle and the business cycle are not synchronised, implying that risks
can emerge especially in the periods of "disconnect" between the two cycles. In the run-up to
the financial crisis, imbalances were building-up while inflation was low and stable. At
present, the search for yield phenomenon continues against the very low inflation, subdued
growth and low interest rate environment.
Monetary policy aims at ensuring price stability in the market for goods and services. It
should not be used to address pockets of instability in asset markets. This falls under the
remit of macro-prudential policy, aimed at safeguarding stability of the financial system and
containing systemic risk. At present, in advance economies, monetary policy needs to
stabilise prices and to continue supporting real activity, while macro-prudential policy needs
to tame the financial sector in asset market segments showing signs of exuberance or where
imbalances could be forming.
Financial stability objectives can only be achieved with an effective macro-prudential policy.
This requires policy interventions in a timely and bold manner, significantly affecting the
normal behaviour of financial markets or financial institutions. This poses great challenges.
First, measures would need to be admittedly intrusive, going well beyond the new capital and
liquidity regulatory framework. Secondly, the macro-prudential tool-kit that has been
legislated - including the one entrusted to the ECB/SSM - is not complete, it is centred on
banks. Instruments would need to address other financial activities and institutions, notably
pertaining to the steadily growing "shadow banking" sector. Advanced economies will only be
able to ensure financial stability with effective macro-prudential policy interventions.
***
Ladies and gentlemen,
It is a great pleasure to speak at this special conference and to discuss with young people
like you about current and potential challenges which our economies, with their ever evolving
financial systems, are facing at present or will likely be facing in the future. In my lecture
today, I will talk about policies to safeguard financial stability and in particular about the role
of macro-prudential policy in achieving this task.
The financial crisis has changed our understanding of the interactions between the real
economy and the financial system, and of the risks which these interactions may bring. In
fact, the crisis did not only require a major policy response in order to contain the damage
done to our societies. It has also triggered a re-design of our policy framework to safeguard
financial stability in the future.
In my remarks today, I will first explain why macro-prudential policy aimed at addressing
systemic risk is essential for an economy. Even more so if a country is part of a monetary
union. I will discuss the main elements of macro-prudential policy targeting the banking
sector. I will then focus on the growing importance of the shadow banking sector, the specific
risks that emerge from these unregulated activities and the challenges they pose to
macroprudential policies. In this context, I will conclude with remarks on analytical priorities for
academic research in this area.
1. Systemic risk, financial cycles and the objectives of macro-prudential policy
The financial crisis generated a big recession and had enormous costs in terms of lost output
and unemployment. In 2008, it led many to think that deep reforms of the international
monetary and financial governance would follow the acknowledged failure of the financial
regulation in place. Two well-known specialists in the field, Barry Eichengreen and Eric
Helleiner have very recently published two books explaining why a transformative reform of
the international system has indeed not occurred.1 Eichengreen explains it the following way:
"...depression and financial collapse were avoided, if barely. This fostered the
belief that the flaws of prevailing system were less. It weakened the argument for
radical action..... Success thus became the mother of failure."
This sounds perhaps too harsh because good work has been done in adopting measures in
the domains of capital, liquidity and resolution of banks in order to increase the resilience of
the banking sector, within the financial system. However, much less has been achieved
beyond banks, notably in what regards OTC derivatives or non-bank entities, including
activities of the shadow banking. Also, no changes were introduced in the international
monetary system. The G20 and the Financial Stability Board do not have the full
competences to fulfil the role of the "fourth pillar" of international economic governance,
contrary to what was initially announced by U.S. Treasury Secretary Tim Geithner.
As remarked by Helleiner, a promising innovation emerging from the crisis is the
macroprudential policy, a policy that uses regulatory measures to deal with system-wide financial
risk.
Systemic risk "refers to the risk that financial instability becomes so widespread that it
impairs the functioning of a financial system to the point where economic growth and welfare
suffer materially."2 Systemic risk may originate from three types of sources: significant
macro-economic shocks that can make the financial sector vulnerable; contagion that may
stem from default of a few financial institutions as a result of the growing interconnectedness
within the system; finally, the development of endogenous financial imbalances associated
with credit booms, excessive leverage and risk taking by financial institutions. One of the
lessons from the crisis was that a good capital and liquidity situations at the level of individual
institutions, as monitored by micro-supervision, does not guarantee the stability of the system
as a whole.
In this context, macro-prudential policy has two main objectives: to enhance the resilience of
the whole system and to smoothen the financial cycle, i.e. the fluctuation of credit, leverage
and asset prices that may lead to boom-bust episodes. The instruments available for
macroprudential policy include most of the micro-supervision instruments related to capital and
liquidity, when applied to the system as a whole, but extend to other categories, like limits to
loan-to-value ratios in housing credit, counter-cyclical capital buffers, global leverage ratios,
or haircuts and margin requirements in securities' transactions or clearing activities.
The financial cycle, which is an updated version of the old concept of the credit cycle, tends
to have larger amplitude than the normal business cycle, implying that long periods of
"disconnect" between the two cycles can materialise.3 The financial cycle refers to the
fluctuations of credit, leverage and the more relevant asset prices. The business cycle refers
basically to the fluctuations of real economic activity as measured by the GDP. In the past,
the separation between the two was not considered likely. In particular, it was thought that
price stability in the market of goods and services would be sufficient to guarantee financial
stability in the market for assets. The present situation, and the period of the so-called Great
Moderation ahead of the crisis, should be sufficient to dispel such traditional concepts.
Before the crisis, while inflation was low and stable, significant financial imbalances were
building-up as the relatively deregulated financial system engineered a credit boom and a
highly risky leverage situation. Likewise, at present, the very low inflation and subdued
growth environment is accompanied by some froth in financial asset markets resulting from
"search for yield" in an environment of low interest rates.
This "disconnect" between the financial and the business cycle creates a dilemma to
traditional macro-economic policy and especially to monetary policy. The main remit of
monetary policy refers to the relevant variables of the business cycle: inflation in the market
of goods and services and the level of real economic activity. The level of real economic
activity is a direct consideration for central banks with a dual mandate, like the U.S. Fed. It is
an indirect one in the case of a hierarchical mandate, like the one of the ECB, where the
level of economic slack in the economy is one of the drivers of inflationary (or deflationary)
pressures. The most common monetary policy framework around the world is l the inflation
targeting regime, where there is no role for any target related to asset prices. More generally,
no central bank has objectives explicitly referred to asset prices in its mandate. After the
crisis, there has been a trend, albeit without legislative expression, to attribute an explicit
goal of financial stability to central banks. Nevertheless, in order to be justified, central banks
have to be entrusted with a new set of tools of a macro-prudential nature, that can be applied
to the financial system as a whole.
There are two different reasons why monetary policy cannot, and should not, be used to deal
with financial instability in asset markets. The first relates to the fact that the priority goals of
monetary policy may require an expansionary (restrictive) stance when asset markets would
require restrictive (expansionary) measures. Monetary policy cannot abandon its priorities as
clearly stated in the mandate of central banks. More generally, as Mervyn King once stated,
it would be highly controversial if a restrictive central bank policy adopted for reasons of
asset market risks would create "mini-recessions" in real activity and unemployment, when
the level of inflation would be compliant with the defined and publicly-known target. The
second argument questions whether monetary policy, through its main policy instrument -
short term interest rates - can effectively target asset market prices. There is no theory or
model establishing a reliable relationship between interest rates and asset price targets.4
Macro-prudential policy is therefore essential in any economy as the business and financial
cycles are not synchronised. Even more so in a monetary union where vulnerabilities
identified in each country can be addressed with macro-prudential policy, allowing for the
appropriate heterogeneity, while countries remain subject to a single monetary policy.
Monetary policy simultaneously affects all sectors of the economy and can therefore be an
ineffective tool to cope with specific imbalances in the financial sector. Finally, by
independently addressing financial stability concerns, macro-prudential policy provides
monetary policy with additional room for manoeuvre to better focus on ensuring price stability.
Take the present moment. The search for yield continues in global financial markets. Flows
to high-yield bond and emerging market funds turned positive in January after recording
significant outflows in the second half of 2014. Credit spreads have narrowed. At the same
time, issuance of European leveraged finance products (high yield bonds and leveraged
loans) has surpassed pre-crisis levels. Issuance of leveraged loans has reached a
sevenyear high in the fourth quarter of 2014. Furthermore, a growing correlation of asset price
movements across market segments is reducing the investors' ability to hedge via portfolio
diversification. Nevertheless, it should be noted that the situation of froth in asset prices is
less marked in the euro area than in other parts of the world. For instance, stocks prices
reflect the historical level of price-earnings ratios and model-based valuation of normal
corporate bonds does not show indications of over-valuation.
In such a situation, monetary policy needs to stabilise prices and to continue supporting real
activity. Macro-prudential policy needs to tame the financial sector in asset market segments
showing signs of exuberance or parts of the financial system where imbalances could be
forming. Monetary- and macro-prudential policy instruments are thus two different sets of
tools, that sometimes have to adopt different stances but whereas in some situations, may
share common goals. There are anyhow important synergies and interactions between the
two policy functions. This also supports the rationale for placing the macro-prudential policy
function under the responsibility of central banks, as reflected in the macro-prudential policy
framework adopted for the ECB/SSM.
Monetary policy must prioritise the goal of price stability and not deal with the emergent
financial stability issues. The Treaty does not mention stability in asset market prices as
being included in the ECB's mandate. The separation principle implies that both fiscal
dominance as well as financial stability dominance of monetary policy should be avoided by
the central bank.
This conceptual view was behind the recent ECB decision to increase the expansionary
stance of monetary policy, thus not yielding to the voices that claimed we should first
consider the risks for asset prices and for the risk-taking transmission channel of monetary
policy.5 In order to tackle the threat to price stability created by a long period of very low
inflation, which is contradictory to our mandate, we decided to enlarge the scope of our
programme of outright purchase of assets to sovereign bonds. In the present circumstances,
the additional stimulus we are providing to aggregate demand will also help to reduce the
negative output and unemployment gaps.
The transmission channels of a Large Scale Asset Purchase (LSAP) programme include
signalling and influencing inflation expectations, exploring spill-overs resulting from investors
using the cash received to buy other assets and finally, the freeing-up of space in banks'
balance sheets to increase credit to the real economy. Therefore, the counter-argument that
the policy would not be effective on account of already low sovereign yields is not well
founded. The transmission goes well beyond the direct effect on the yields of the purchased
securities. Even less valid is the argument that sovereign bond purchases would ease the
pressure on governments to do structural reforms. It is not the task of a central bank to exert
more or less pressure on governments to adopt policies for which they are responsible. They
should implement the reforms that are necessary. In order for central banks to deserve their
independence they have to fulfil their responsibility of ensuring price stability in the
mediumterm, an objective that monetary policy has the power to achieve. To be credible, central
banks must act in a symmetric way, avoiding either too high or too low inflation.
As mentioned, monetary policy cannot cope with two different objectives and the need for
macro-prudential policy has become more acute with the realisation that advanced
economies are very likely faced with a prolonged period of low real and nominal growth. In
such an environment, monetary policy has to remain accommodative, with low interest rates,
which foster search for yield and froth in asset markets, making the use of macro-prudential
policy to tame the financial cycle and to pre-empt asset bubbles even more necessary.
The trend for lower GDP and productivity growth and for ever lower real interest rates has
continued for quite some time. For instance, the U.S. annual productivity growth was 2.36%
from 1890 to 1972. Then it declined to 1.67% from 1972 to 2004 and to 1.33% from 2004 to
2013. I use the U.S. figures because this development cannot be explained by the absence
of structural reforms, as often done by economists in relation to other countries. On the
contrary, the U.S. is normally used as a benchmark by those economists, since it is a much
liberalised and lightly regulated advanced economy. Trying to explain that trend,6 Robert
Gordon, in two well-known papers, has attributed it to the slowing down and lower economic
traction of technological innovation.
On the other hand, we have seen that 10 year sovereign interest rates in real terms came
down globally on average from 5% in 1980-1990; to 3.2% in 1991-2000; to 1.8% from
2001-2007 and 0.4% in 2008-2013.7 This reflects a worldwide tendency for planned savings
to exceed planned investment, which then depend on a host of other factors such as
demographics to differential riskiness of equities and bonds or to real investment
opportunities.
The extreme view of these two trends corresponds to what has been called the Secular
Stagnation Hypothesis that would cloud the future of advanced economies at present,
particularly Europe.8 This hypothesis has two versions. One is more related to the
supplyside, stressing technological and demographic factors behind the growth slowdown; the
other, underlines the demand-side related to excess savings and lower investment
prospects.9 The extreme view of this demand-side version points to the possibility that the
real interest rate, that would be the equilibrium rate at full employment, could turn negative
during some periods of time. This negative real rate could not be engineered by monetary
policy in view of the zero lower bound of nominal rates, leading monetary policy to use large
scale asset purchase programmes to try to stimulate the economy.
In any case, even disregarding the extreme situations, it should be acknowledged that the
monetary regime of low interest rates and large asset purchases that became necessary,
can originate search for yield in asset markets, making it essential to find other instruments,
like macro-prudential policy, to safeguard financial stability.
Without the effective use of macro-prudential policy, advanced economies would face
instability, asset bubbles and further financial crises. It is more crucial to pre-empt financial
cycle booms than to adopt a passive policy of just "mopping-up" with liquidity provision, in the
aftermath of crises because we have learned how disastrous they can be.
There is some scepticism about the possible effectiveness of macro-prudential policy. This
scepticism may be related to a reluctance to accept that a set of regulatory and
administrative measures interfering with the free functioning of financial markets became
necessary to tame the excesses of finance. Once again, the crisis convincingly showed that
finance cannot be self-regulated and its frequent, endogenous imbalances can be very
disruptive to the real economy and the livelihood of millions.
In reality, there is no alternative to making macro-prudential work effectively10 and, for that
purpose, it needs to be applied in a timely, bold and intrusive manner, affecting the normal
behaviour of financial markets or financial institutions. This brings about some big
challenges. First, the policy has to be intrusive. This can take the form of imposing caps to
loan-to-value or debt-to-income ratios in credit to housing, regulating haircuts and margins in
securities transactions, introducing limits to large exposures to specific sectors, prohibiting
proprietary trading to commercial banks, or other types of structural measures. One can
easily see how this genre of policies would confront doctrinal refusal. However, without them,
simple measures related to capital charges may indeed not be effective to contain the boom
phase of the financial cycle. Second, the macro-prudential tool-kit that has been legislated is
not complete - notably the one entrusted to the ECB/SSM - because it is mostly centred on
banks and excludes other activities and institutions, namely the so-called "shadow banking".
Let me briefly recall the set-up of the macro-prudential policy function in the euro area before
coming back to these points.
2. Macro-prudential policy in the euro area
Major steps have been made to enhance financial stability in Europe, notably the
establishment of a Single Supervisory Mechanism (SSM). In 2013, the European Council
established a set of regulations, including the Capital Requirements Directive (CRD IV), the
Capital Requirements Regulation (CRR) and the SSM Regulation, that all form the
framework for a harmonised bank micro-prudential and macro-prudential oversight in
Europe. Based on these regulations, the ECB conducted a comprehensive assessment that
was a health check of 130 banks' balance sheets, including a stress test exercise using, inter
alia, its own stress testing modelling framework.11 On 4 November 2014, the SSM became
operative and now houses bank supervision in a single European institution. An agreement
has also been reached among Member States to establish another key element of the
Banking Union - the Single Resolution Mechanism.
The SSM Regulation also confers the ECB with macro-prudential powers. The ECB may
topup specific macro-prudential measures if it considers actions by national designated
authorities as insufficient to mitigate systemic risks. As in the past, the ECB will also continue
to detect and assess systemic risks at the euro area level. However, in view of the new
macro-prudential mandate, this task is now also being enhanced by a more granular,
country-level approach.
In terms of instrument tool-kit, the ECB may use all macro-prudential instruments laid down
in the Union acts. It covers capital instruments, such as the counter-cyclical capital buffer, the
systemic risk buffer, capital surcharges of systemically important institutions as well as
liquidity instruments, such as the liquidity coverage ratio. In addition, the ECB can also
increase risk weights on real estate exposures or set higher limits on large exposures.
In a single currency area, macro-prudential policies are particularly important to deal with
sectoral and regional risks that cannot be accounted for by a common monetary policy.
Measures such as the caps on loan-to-value (LTV) or debt-to-income (DTI) ratios are
suitable instruments to address these developments. In this context, recent research
suggests that exposure-based measures, such as LTV and DTI could be more efficient than
capital-based measures.12 Indeed, the experiences of Korea, Singapore and Hong Kong
confirm that LTV and DTI are efficient tools to address local house price misalignments.13 On
the other hand, they may generate important cross-border spill-overs and leakages, and
moreover, are now solely with national authorities. Implementing them will therefore require
co-ordination and the ECB will play an active role to facilitate this in the euro area.
3. Importance of the growing market-based credit system and measures to
address its risks
With the more regulated banking system, the risks that regulation is circumvented by shifting
activity to the unregulated sector are increasing. This is even more important since the size
of this new market-based credit system has been growing almost uninterruptedly throughout
the crisis - at least partially compensating for the reduction of the credit from traditional
banks.
According to the ECB Banking Structures Report published last October,14 the size of the
shadow banking sector more than doubled over the past decade. The total assets of this
sector in the euro area amounted to €23 trillion in mid-2014 (from €19 trillion at the end of
2013), against €30 trillion for the banking sector. If the shadow banking sector continues to
grow at the same rapid pace as in the past decade and the bank credit remains stagnant, the
assets of the unregulated shadow banking sector may then become larger than the regulated
banking sector already within five years. This has actually already happened in Luxembourg,
in the Netherlands and in Ireland.
Providing credit through non-bank channels helps transform the euro-area economy into a
more U.S.-style market-based funded system. This can be beneficial as it contributes to the
wider risk diversification in the economy and may alleviate the impact of real shocks, by
providing additional source of credit in times when banks are under stress.15 Nevertheless,
non-bank credit channels can also become a source of systemic risk or contribute to the
aggravation of the initial shock.16
Let me now discuss the most important techniques through which shadow banks provide
credit to the real economy, the main systemic risks which the unregulated banking sector
may pose, and which macro-prudential tools may be used to address these risks.
Supposedly, provision of lending to the real economy via the shadow banking sector is
contained. Out of €23 trillion assets of the sector I mentioned, only €2.2 trillion were in loans
to the euro area non-financial sector. While direct lending is increasing rapidly and already
accounts for 18% of bank credit, this is not the most important technique for providing credit
to the real economy. The primary sources of funding of the real economy by the shadow
banking are securitisation, repos to finance securities transactions and funding indirectly
provided via OTC derivatives. While Financial Vehicle Corporations (FVCs) shrunk by more
than one-fifth since the crisis erupted, still more than 12% of all loans extended by monetary
and financial institutions (MFIs) granted to euro area households are secured through euro
area conduits, which hold €1.9 trillion in assets. Moreover, euro area bond funds hold almost
a quarter of all outstanding debt securities issued by euro area non-financial corporates,
while equity funds hold almost half a trillion in equities of euro area non-financial corporates.
In addition, hedge funds and mixed funds provide additional funding to the real economy via
off-balance sheet transactions, such as repos and credit commitments and OTC derivatives.
Let me put a word of caution on the numbers I quoted. They refer only to assets held by
money market funds, investment funds, financial vehicles corporations and some special
purpose vehicles that are domiciled in the euro area. The figures would be much higher if we
also had statistics on non-euro area shadow banking. They would be even higher if
offbalance sheet activities, such as securities funding transactions and derivatives were
accounted for.
The recent substantial increase in the size of the shadow banking sector in the euro area
was fostered by three factors. First, in an environment of globally low interest rates, among
other financial institutions, investment funds and hedge funds were instrumental in the
general search for yield. Second, the supply of credit has been weak due to impaired banks'
balance sheets, which led to the expansion of the unregulated credit market. Third, a more
stringent banking regulation in anticipation of the implementation of new capital and liquidity
rules under Basel III could have, in itself, induced a shift of lending to the unregulated sector.
From a financial stability perspective, a raise of the shadow banking sector may create
systemic risks that need to be better understood and measured. The sector is engaged in
maturity transformation the same way as banks are. It was the proneness of banks to deposit
runs that led the U.S. regulators, back in 1930s, to introduce deposit insurance to mitigate
that risk. What we now witness is the emergence of the shadow banking sector that is also
vulnerable to runs. Shadow banks do not hold deposits and are mostly funded via equity.
However, they are subject to the short-term redemption risk. If, for any reason, shadow
banks experience substantial redemptions, they may be forced to promptly sell assets to fulfil
their obligations, which may give rise to fire sales. This is particularly worrisome, since 98%
of almost 95 thousand non-money market investment funds operating in the euro area in
2014 are open-ended funds, which means that the investors can redeem their shares in the
funds at any time. Moreover, the funds' buffer of liquid assets that can absorb the equivalent
of a run on shadow banks has dropped in recent years increasing the illiquidity risks.
The risks stemming from the shadow banking sector are sometimes understated on the
ground that potential losses would be suffered by equity holders, who should be aware of the
risks they are taking. The systemic risk arising from the shadow banking sector cannot be
easily ring-fenced. This is because of the interconnectedness of shadow banks with the
regulated part of the financial system. Stress in the shadow banking sector can be
transmitted to the banks both through direct and indirect channels: banks' exposures to
shadow banks through equity investments, credit claims or liquidity lines. Credit claims are
often related to prime brokerage services allowing de facto non-bank financial institutions to
increase their leverage. Undrawn liquidity lines can also be activated once the redemption
risk materialises. Banks also rely on funding received from shadow banks, which often invest
in bank debt securities or provide liquidity through repo transactions or through provision of
collateral. More importantly, stress in the shadow banking could be propagated through
financial markets via common exposures to assets. The price of those assets would be
depressed in the case of a run on shadow banks, in an extreme case leading to a fire sale.
It is important to protect the border between shadow and non-shadow banks, which implies
that a macro-prudential regulator could introduce large exposures limits on exposures of
regulated institutions to shadow banks. Similarly, we could introduce margin requirements for
repo transaction with shadow banks. These are non-direct instruments and may not be
efficient in addressing the risks emerging in the shadow banking sector.
The U.S. Fed has gained the competence to transfer non-bank financial institutions to the
supervised perimeter. We do not have this powerful tool implemented in Europe. Certainly,
some shadow banks grew too-big-to-fail and hence, they should be subject to the same
surveillance as Global Systemically Important Banks (G-SIBs). In fact, the Financial Stability
Board is preparing a methodology for identifying Global Systemically Important Non-bank
Financial Institutions (G-SINFIs).
Another possible macro-prudential tool to address excessive leverage in conducting
securities funding transactions and not-centrally-cleared OTC transactions could be to
introduce margin requirements for these transactions. Shadow banks could in principle be
subject to direct regulations. In this context, cash buffer requirements and redemption fees or
gates have already been discussed by expert groups and cannot be excluded.
Finally, in order to mitigate the risk of regulatory linkages, any macro-prudential instrument
operating via the demand for loans, such as the LTV or DTI ratios should be imposed at the
borrower level, possibly by introducing restrictions in the consumer protection legislation and
not via the bank regulations. This would allow for the extension of the perimeter of these
macro-prudential instruments to beyond the regulated banking sector.
4. Challenges for macro-prudential policy with an ever-evolving financial sector
I have argued that central banks should be given a strong macro-prudential policy mandate
and an adequate set of tools to address the build-up of financial risks, in particular in
situations when monetary policy is accommodative. CRD IV and CRR provide the necessary
framework for regulating the banking sector. Nonetheless, as I mentioned, risks may develop
outside the banking system. Macro-prudential policy is a new field for research that should
attract young economists.
Addressing those risks is challenging. Firstly, because shadow banking is an elusive concept
that is hard to quantify with available statistics. Secondly, as I have argued, the tools needed
to prevent the building-up of excessive risks in that sector are currently not in the set of
instruments available to the ECB or to macro-prudential authorities at large - and some need
yet to be devised.
An important role of research is to break frontiers by providing underpinnings for policies that
have not been used before. At the ECB, we realised the need for deep analytical foundations
of macro-prudential policy already in 2010, when the Macro-prudential Research Network
was established for this purpose. One of the network's key contributions was the
development of a series of macro-economic models featuring financial instability and apt to
the evaluation of bank regulation, something that was virtually