Jean-Pierre Landau: Procyclicality - what it means and what could be
done
Remarks by Mr Jean-Pierre Landau, Deputy Governor of the Bank of France, at the Bank of
Spain's conference on Procyclicality and the Role of Financial Regulation; Madrid, 4 May
2009.
* * *
It is a great pleasure and privilege to be in Madrid for this conference hosted by the Bank of
Spain and the Financial Stability Institute. I would like to present a few remarks on
procyclicality, what it means, what role it played in the current crisis and which policy options
are available to mitigate its amplitude and impact on financial systems.
What is procyclicality?
Strictly speaking, procyclicality refers to the tendency of financial variables to fluctuate
around a trend during the economic cycle. Increased procyclicality thus simply means
fluctuations with broader amplitude.
Such a simple description seldom fits the behaviour of financial systems in real life. More
likely, following a shock, the path of asset prices and evolution of financial aggregates will
display various and highly irregular forms of volatility, with possible non linearities and
discontinuities (a good example being liquidity freezes). These are characteristic features of
complex systems. "Once such a system is destabilized, it moves away from the linear regime
and experience non linear behaviour such as path dependance ... sustained oscillations ...
and regime shifts"1.
Indeed, financial systems can be seen as complex systems2. They are based on
interdependence between multiple actors and counterparties. Transmissions occur through
networks whose structure and architecture is constantly changing through financial
innovation and regulatory arbitrage. Also, financial systems are "human" systems. Their
behaviour is shaped by the way human beings react to shocks in their environment. Herd
behaviour has long been known to be an essential feature of financial markets. More subtly,
individual reactions, by themselves rational, can, by the virtue of their mutual interaction,
produce strong amplification effects3.
A broader definition of procyclicality would thus encompass three components, which cannot
easily be distinguished in real life: (1) fluctuations around the trend (2) changes in the trend
itself and (3) possible cumulative deviations from equilibrium value. This points to the policy
challenges regulators face. They have to try and identify when pure cyclical fluctuations
morph into something different: either a change in the trend itself or the start of a cumulative
process.
A good operational approach to procyclicality would look at all amplification mechanisms
which provoke (or allow) the financial system to deviate durably or permanently from its
predetermined path) so that the trend itself may be affected in the short or medium run.
What are the mechanisms at work?
Analytically, it is useful to distinguish between procyclicality of capital and procyclicality of
leverage.
Procyclicality of capital is easy to understand. When conditions are good, financial
institutions are profitable and their strong capital base allows them to take larger positions in
the markets. This mechanism has been amplified by mark to market accounting4. In a mark
to market environment, an increase, for instance, in asset prices quickly translates into
stronger capital for financial institutions. This, in turn, triggers additional demand for assets
and a further increase in their prices. This kind of "inverted demand curve", where demand
increases with prices, potentially creates powerful feed back loops.
Procyclicality in leverage is more subtle. It has been shown that financial institutions' balance
sheets expand and contract with the economic cycle5. Many different mechanisms are at
work:
•
First, risk management techniques: tools used to measure and value risk, such as
VaR are naturally and strongly procyclical, especially when constructed with very
short data series. Risk management practices hardwired to valuations (such as
margin calls) strongly amplify fluctuations in leverage and may lead to fire sales and
"one sided" markets.
•
Another mechanism6 relates to the dynamics of short term money markets : when
liquidity is perceived as abundant, there is strong incentive for dealer-brokers to
engage in maturity transformation through strongly leveraged positions.
•
Finally, risk appetite itself moves along the economic cycle. Animal spirits obviously
play a role. Also, valuation gains and losses may encourage risk taking or trigger
sharp pull-backs.
Should procyclicality be avoided?
Not necessarily:
•
Financial stability is not an end by itself. It only helps if it is conducive to better
macro economic performance. Volatility may be driven by fundamentals. Sharp
movements in asset prices may help the financial system to serve as a cushion, an
"absorber" for exogenous economic shocks. This is welfare improving since it
avoids, or mitigates, adjustment in more rigid goods or labor markets.
•
By the same token, not all procyclicality is bad. It all depends on the causal link: is
the financial system the origin or the amplifier of destabilizing dynamics? Or does it
simply react to cyclical evolutions in the real economy? We should only be
concerned by "intrinsic procyclicality", which is created inside and by the financial
system.
•
Finally, cyclicality in the real economy can be beneficial to long term growth as it is
one mechanism through which "creative destruction" can take place in the
productive system.
Real and significant damages occur if and when financial imbalances are allowed to build for
a long time with two consequences: first asset prices significantly deviate from their
fundamental trend, which creates distortions in the allocation of resources; and second,
those imbalances unwind suddenly and abruptly, triggering major disruptions in growth and
the economic cycle. This is what is happening right now. And this closely resembles the
definition of a bubble.
This clearly points to one possible mandate for macro prudential supervision that, it were
feasible, would be both pragmatic and legitimate: to avoid bubbles. Bubbles are not always
triggered within the financial system. They may have roots in productivity shocks, for
instance. But cyclical fluctuations cannot develop into a bubble - like process unless some
amplification mechanisms are allowed to work fully in an overall permissive financial
environment.
What role did procyclicality play in the current crisis?
During the first phase of the crisis, it was possible to take a "short term view" of procyclicality.
It may have looked as if mark to market accounting, together with highly illiquid markets,
generated downward spirals in asset prices and created "excessive" losses, with no relation
to real underlying economic reality. Such liquidity spirals may have occurred at some critical
moments7.
However, it now seems that the disproportion between banking losses, on the one hand, and
movements in underlying asset prices, on the other, can (almost) fully be accounted for by
the extraordinary degree of leverage which accumulated in the financial system over the last
decade. Procylicality was at work, but on a much longer time horizon, and during the upward
phase of the credit cycle.
The following stylized facts describe what happened8:
• overall leverage grew strongly during the last decade
•
there was an upward break in the trend growth around 2003 / 2004
•
"inside" leverage (between financial institutions) grew faster than "outside" leverage
(in the real economy)
•
the growth in leverage was closely associated with a dramatic increase in maturity
transformation
•
risk measurement methodologies played a role in minimizing the impact of leverage
in financial and risk reporting
•
accounting methodologies also played a central role. Instant recognition of profits
led to a disconnection in time between measuring the return on an asset and
recognizing the risk; this created a powerful incentive to take risk and strongly
amplified the credit cycle.
Policy options
Addressing procyclicality clearly involves many policy actions. Those should be part of an
integrated framework of macro prudential supervision. I will briefly deal with the general
approach, then discuss the instruments available to mitigate procyclicality.
General approach
As in many matters of public policy, there is a choice between rules and discretion in dealing
with procyclicality.
The rule based approach can be built on "automatic stabilizers" which would constrain
institutions in their behaviour, regardless of their own individual situations. Examples would
include contra cyclical capital requirement, for instance, as well as dynamic provisioning.
Alternatively, discretionary action could consist in "top down" interventions from macro
prudential authorities. They would step in and impose (or relax) constraints whenever they
come to the conclusion that dangerous imbalances are building up (or unwinding).
We probably cannot dispense of this second approach. The difficulty to date cycles makes it
dangerous to rely purely on automatic mechanisms, which cannot be precisely calibrated.
Financial cycles, in particular, are driven by changes in risk appetite which are impossible to
predict. Actually, one essential objective of macro prudential supervision may be to "regulate"
(not in the legal sense, but economically) the aggregate level of risk appetite inside the
financial system. This unavoidably involves some degree of discretionary judgement. How
that judgement is made will determine the relevance and effectiveness of macro prudential
supervision.
The prudential apparatus has worked in the past on the presumption that all movements in
asset prices were based on fundamentals. This approach may prevent supervisors from
dealing with excessive procyclicality until it is too late. The existence of bubbles, for instance,
is impossible to prove until they burst. And, at least in the initial phase of a bubble, there is
no lack of "fundamental" explanations for observed movements in asset prices.
It may be useful, to better deal with procyclicality in the future, to consider some rebalancing
in the burden of the proof. Significant and lasting departures from past levels or trends in key
asset prices, risk premia or credit aggregates should trigger a macro prudential review, with
the objective of detecting amplification mechanisms at work. This seems justified when
looking at the current social costs of previous hesitation.
This is also a rational course of action. One major source of procyclicality is excessive risk
taking. Bubbles develop because investors have an incentive to ignore the "tail risk" that the
bubble may burst. Because bubbles are mostly financed by credit, most of the risk is shifted
to lenders. This asymmetry in incentives is extremely difficult to eliminate ex ante. Hence the
need, for macro supervisors, to monitor closely the financial system and preserve their
possibility to intervene by establishing the kind of presumption I just mentioned.
Instruments
The most important instrument in our current toolkit are capital requirements put on some
financial intermediaries. Capital requirements primarily act as compulsory buffers imposed on
banks and their shareholders. They also have an incentive function: to drive and limit risk
taking by bank managers. So it seems natural, when addressing procyclicality, to think of
countercyclical capital requirements.
However, capital requirements may not be binding when they are needed most. If assets
market are booming and perceived returns are high, banks will always find the necessary
capital, whatever the regulatory requirement. They will be able to both meet those
requirements and distribute profits. Conversely, capital dries up during downturns, when it is
most necessary9. There is clearly an asymmetry with strong equity outflows in boom times
and no inflows in bad times. It is not clear that Introducing counter cyclical capital
requirements will suffice to counteract this very powerful dynamic, especially in bad times.
It may be necessary to look at other tools in order to address procyclicality and pre-empt the
build up of imbalances. Those tools have to act more directly on individual and collective
incentives. This is where accounting may matter most. Economically, it will always remain
difficult, when looking at revenues drawn from a financial investment, to distinguish excess
return from additional risk taking. But financial reporting may be conceived in such a way that
this distinction is prudently introduced. There is no reasonable or practical alternative to fair
value accounting for tradable securities. This does not mean, however, that any single
valuation gain or loss should instantly be recognized as a profit (or loss) and financially
treated as such. There is a possibility to delink valuation from income / profit recognition.
Some disconnection between the valuation process - which should remain anchored on
market prices - and income and profit recognition will have to be introduced, if only to
account for risks which are there but have not yet materialized. Dynamic provisioning is one
technique for doing so, when risks are closely related to the economic cycle. Valuation
reserves may also be used when complexity or illiquidity creates additional risk linked to
valuation. Provided those adjustments are rule based and made in a fully transparent
process, they would not reduce the quantity or quality of information available to investors as
to the real health of financial institutions.
Another avenue for research would be for the regulatory system to "force" the pricing of risk
in all its dimensions. There is a clear analogy with tax theory: internalizing the risk eliminates
market failures. This approach would be best implemented to liquidity risk linked to maturity
transformation. Quantitative liquidity ratios are currently considered in a number of
juridictions to be imposed on financial institutions. However, they may not protect the system
against an aggregate liquidity shock, when, by definition, the demand for liquidity becomes
infinite and any buffer proves insufficient. Pricing liquidity ex ante in the system would reduce
the probability of such a shock and create incentives against relying too much on maturity
transformation.
Admittedly, the conceptual challenges in quantifying, for instance, liquidity risk, are
enormous. But we live in a world of second best, and even very approximate measures
would do better than nothing at all.
Thank you.
References
Adrian (T.) and Shin (H.S.) (2007): "Liquidity and Leverage". Journal of Financial
Intermediation. Forthcoming. Available on the New York Fed website as Staff Report no 328.
Adrian (T.) and Shin (H.S.) (2009): "Money, Liquidity and Monetary Policy" Forthcoming in
American Economic Review, papers and proceedings. Available on the New York Fed
website as Staff Report no 360.
Committee on the Global Financial System. CGFS Papers No 34. "The role of valuation and
leverage in procyclicality". April 2009 (available on the Bank for International Settlements -
BIS-website).
Danielsson (Jon) and Shin(Hyun Song): "Endogenous Risk ";London School of Economics
September, 2002.
Kashyap (AK), Rajan (R.G) and Stein (J.C.) (2008) "Rethinking Capital Regulation". Paper
presented at the Federal Reserve Bank of Kansas City Symposium.