Vítor Constâncio: Macro-prudential policy - strengthening the
foundations, enhancing the toolkit and taking action
Keynote address by Mr Vítor Constâncio, Vice-President of the European Central Bank, at
the First conference of the Macro-prudential Research Network (MaRs), Frankfurt am Main,
5 October 2011.
* * *
Ladies and gentlemen,
It is a great pleasure to speak to you at the first conference of the Macro-prudential Research
Network (MaRs). I would like to thank the organisers for this very important and timely
gathering, which marks the first year of the network.
The sources and the propagation of the financial crisis have proven the need for
macroprudential policies to address systemic risk, as well as take account of the interplay between
the financial system and the real economy. New institutions have been put in place, such as
the European System of Financial Supervision and the Financial Stability Oversight Council
in the United States, and regulatory reforms are taking shape, notably Basel III and a host of
other initiatives under the leadership of the Financial Stability Board. However, it is also very
clear that in the macro-prudential field we are in a much less comfortable position than in the
monetary policy field, in particular concerning widely accepted scientific foundations and long
experience with tested policy instruments.
Against this background, I will start by providing a brief overview of the research that has
been carried out in the MaRs network. I will then focus on one important operational tool that
we are pushing forward at the European Central Bank (ECB) to assess systemic risks: our
top-down stress-testing framework. I will conclude by referring to a key aspect of our future
regulatory framework in Europe, namely the set of macro-prudential policy instruments
embedded in the Capital Requirements Directive (CRD) IV, and how these instruments
should be made compatible with the requirements for both safeguarding financial stability
and further developing the Single Market for financial services.
1. A snapshot of progress in macro-prudential research
The rudimentary state of the scientific foundations in the macro-prudential field led the 27 EU
national central banks and the ECB, which constitute the majority of the member institutions
of the European Systemic Risk Board (ESRB), to establish a network of researchers working
on macroprudential issues called MaRs - standing for Macro-prudential Research, but in a
way also referring to a journey into unknown territory. The objective of MaRs is to develop
core conceptual frameworks, models and tools to improve macro-prudential supervision in
the EU. Through MaRs, we hope to fill some of the identified analytical gaps ourselves and
also to act as a catalyst for more and better-targeted academic research in this field.
This conference today is the first public event organised by MaRs. The papers presented
here are only a small sample of the research conducted. Many more projects are under way
and we envisage publishing all papers produced in the ECB Working Paper Series.
The network has been charged with conducting research in three areas where gaps were
identified and the need for analytical support for policy choices seemed greater.
The first MaRs work area deals with the development of macro-financial models linking
financial instability and the performance of the economy. A large part of this workstream is
aimed at providing relatively fundamental research and therefore not immediately operational
policy tools. The first three sessions of the conference feature papers from this workstream.
The modelling of bank defaults is crucial to characterising financial instability. In the paper by
Eichberger et al. the authors analyse the endogenous and interconnected nature of default
risk, therefore implying that models that treat default risk as exogenous may be subject to
significant biases and mistakes. Another fundamental topic is the shadow banking sector.
The model by Goodhart et al. includes the presence of a shadow banking system, which
holds securitised assets issued by the traditional banking system that are subject to default.
The analysis explores how different types of financial regulation would perform in the event
of many of the phenomena that were observed during the financial crisis.
A lot of attention has been devoted recently to the debt and leverage ratios of financial
intermediaries and to their variation over the business cycle. The dynamic stochastic general
equilibrium (DSGE) model proposed by Rannenberg shows that in presence of a costly
bankruptcy and moral hazard between banks and their depositors, the yield requested on
loans is affected by the leverage of both the borrower and the lender. This set-up is helpful in
understanding the sources of the leverage cycle, since the response of the external finance
premium and the overall economy to monetary policy and productivity shocks is greatly
amplified.
Another area of particular interest is the analysis of the interactions between monetary and
macro-prudential policies. The estimated DSGE model with financial frictions by Beau et al.
shows that the combination of an independent macro-prudential policy leaning against
"excessive" credit growth and a monetary policy focusing on inflation is the best response to
asset price or credit supply shocks to maintain price stability. In addition, a monetary policy
taking into account any macroeconomic effects resulting from macro-prudential policies will
optimise general welfare.
The paper by Lambertini et al. examines in particular the effects of monetary and
macroprudential policies that lean against boom-bust cycles in housing and credit. They show that
counter-cyclical -loan-to-value rules responding to credit growth do not increase inflation
volatility and are effective in maintaining financial stability. However, a welfare comparison
between the impact of an extended interest rate rule - including financial variables - and
counter-cyclical loan-to-value ratios leads to ambiguous results, as lenders and borrowers
are affected in opposite ways. This suggests a strong need for cooperation between
monetary and macro-prudential authorities to avoid conflicting policies.
Let me now turn briefly to the area of MaRs dealing with early warning models and systemic
risk indicators, which is the theme of sessions V and VI. The results of this workstream
suggest that the value of early warning indicators has increased thanks to improved
methodologies and the use of less exploited data sources. It should also be added that the
focus has been shifted somewhat from predicting crises to predicting growing imbalances,
which has most likely contributed to the greater effectiveness of new early warning tools.
A number of studies examine the variables to be included in estimated models in order to
improve forecasting ability. Fornari and Lemke, and Abildgren examine the predictive value
of financial variables. More generally, the work carried out by MaRs researchers shows how
the predictive information can be improved by using individual balance sheet data of financial
firms combined with traditional macro-financial variables. Concerning specific indicators, the
merit of private credit gaps and the role of global variables in early warnings has been
confirmed, while the performance of bank solvency and liquidity ratios in this regard is still
under debate.
Very valuable information for policy-makers comes from the measurement of the current
level of systemic financial stress. Again, it seems that valuable indications arise from the use
of firm balance sheet data combined with financial market data, as is the case for the
indicator given by Louzis and Vouldis. Other studies emphasise that, for example, the
decoupling of credit risk conditions of financial firms from the macro-financial environment
can serve as an early warning indicator of systemic stress.
The third area in which the MaRs network seeks to achieve progress is the assessment of
contagion risks, addressed in Session IV. In this context the analysis of the interbank market
is crucial, and the paper by Memmel and his co-authors provides very useful insights. They
confirm previous evidence of tiering in the case of Germany, where some banks distribute
liquidity to others. Moreover, a relatively large share of default cases result either in a tiny
loss or in a very large loss. This stands in contrast to the usual assumption that
loss-givendefault averages about 40% and adds an element of fragility to the interbank system.
Overall, more extensive research on risks from cross-border bank contagion in Europe is still
held back by data limitations, which we hope will continue to relax over time. A large project
assessing cross-border financial links using TARGET2 data and involving researchers from
several central banks is just starting under MaRs.
2. The ECB's top-down stress-testing framework
Beyond MaRs' research in a cross-institutional context, a lot more analytical
macroprudential work is undertaken here at the ECB, as at other central banks. Our main aim with
this work is to be in a position to carry out systemic risk assessments in real time, directly
and regularly supporting policy discussions. For this we have at our disposal a number of
tools and techniques which help to assess and quantify the impact of systemic risks on the
banking sector and ultimately on the real economy. This enables us to rank, according to
their severity, the systemic risks we have identified at any point in time.
I will now specifically focus on the top-down stress-testing framework developed by the ECB,
which is one of our major tools. This toolkit has proven particularly valuable during the recent
financial crisis and the ongoing sovereign debt crisis. Systemic risks emerged, intensified
and evolved rapidly, calling for a flexible and operational tool that could deliver quantified
impact assessments in a timely fashion. The tool is comprehensive enough to cover
individual banks and it incorporates real-financial interactions.
The ECB top-down stress tests are a regular contribution to ESRB meetings. The analysis
provided by the tests is also used to support the financial stability assessments in the ECB's
Financial Stability Review and also for background policy analyses. Importantly, our
topdown stress test results were used as an input for the "peer review" process of the European
Banking Authority (EBA) 2011 EU-wide stress testing exercise. The top-down analysis
provided a basis for benchmarking and, where necessary, to challenge the results of the
bottom-up exercise. For instance, the top-down stress test uses common methodologies and
assumptions across all banks, whereas the bottom-up approach allows for some
heterogeneity across banks with respect to certain assumptions and applications, such as
the use of banks' own internal credit risk models. The top-down assessment can therefore be
employed to capture outlier results of individual banks in the bottom-up stress test.
The current ECB top-down macro stress testing consists of a number of distinct but
interrelated building blocks. They can be grouped into four broad areas reflecting different
stages of the process.
First, a macro-financial scenario building block. The identified sources of systemic risks
facing the EU banking sector need to be translated into specific shocks that drive macro and
financial variables. Subsequently, an adverse macroeconomic scenario is derived, by
computing the effects on the economy of these, exogenous, shocks. A topical example of
such exogenous shocks could be contagion in the euro area sovereign debt market tensions.
This could be simulated through increases in government bond spreads of different euro
area countries, which in turn would have adverse effects on the general macroeconomic
outlook, resulting in a decline in GDP compared with a baseline scenario. This translation of
shocks to macro-financial scenarios is done using a variety of tools, ranging from in-house
large-scale macro models to smaller time-series models. An especially useful and flexible
multi-country, EU-wide, macro simulation tool is our set of "stress test elasticities" (STEs).
This provides impulse response functions of endogenous variables to a set of pre-defined
exogenous shocks.
For example, a shock to EU external demand - perhaps arising from confidence-driven
developments in the United States - would lead to differentiated effects on GDP and other
domestic demand variables across EU countries, with the impact depending on
countryspecific factors, such as the degree of trade openness. However, we do not have a single
preferred choice for the macro-financial scenario simulation tool, but rather select from the
wide menu of models available at the ECB, depending on the specific scenario we want to
construct. Over time, models developed by researchers in Workstream 1 of MaRs could also
be applied to inform our macro-financial scenario design.
Second, a benchmark parameter block. The macro-financial scenario will in turn affect the
banking sector through a number of channels including the impact on banks' credit portfolios,
their trading book and the various components of profits. In practice, this transmission is
performed via a number of satellite models. The impact is three-fold, affecting credit risk,
market risk and bank profitability.
 Our efforts so far have focused on deriving properly modelled credit risk parameters
(that is, probabilities of default and loss-given-default rates from which loss rates are
calculated). We have invested heavily in this area because credit risk still is the main
risk component for most European banks.
 Regarding market risk, the benchmark parameter calibration techniques we have
developed have mostly concerned the computation of haircuts on banks' sovereign
debt holdings. (This uses a model that was specifically constructed for and used in
the last two EBA EU-wide stress testing exercises.).
 Finally, regarding the modelling of bank profitability, we currently focus much of our
efforts on simulating net interest income, because this remains the most important
profit component for the majority of EU banks. Other items affecting bank earnings,
such as trading income, fees and commissions, taxes and dividend policies, are
generally based on judgemental assumptions or extrapolations.
Third, the balance sheet part of the framework. This third module includes models to
estimate loan losses and tools to simulate banks' balance sheet items (accounting and
regulatory) as well as their profit and loss statements to calculate the impact on banks'
capitalisation. As the modelling framework is based on a bank-by-bank assessment of
individual banks' balance sheets, it is flexible with respect to the geographical coverage in
the EU or euro area.
Fourth, contagion and feedback effects. Typically, stress tests (including the EBA
EU-wide exercise) do not look beyond the first-order impact on banks' solvency positions.
However, identified capital shortfalls likely have repercussions beyond such immediate
effects at the individual bank level. Hence, our fourth building block, which is still the least
developed, concerns the modelling of contagion from banks failing the stress test to other
banks (via various forms of counterparty exposure) and, more broadly, also to other
economic sectors (using a flow-of-funds-based propagation tool). In addition, real economic
feedbacks are modelled via reductions in loan supply by capital-constrained banks.
Operationally, this is typically done by feeding our stress test results into some of our
largescale macro models that include an active banking sector and thus can adequately capture
the real-financial linkages. Nonetheless, further modelling enhancements are warranted in
this fourth building block, and for this purpose we will continue to closely monitor the
progress in the tools developed in Workstreams 1 and 3 of MaRs.
Having described the various building blocks, let me furthermore emphasise that our
framework is based entirely on publicly available consolidated bank-level data; no
supervisory information is employed in our set-up.
Our analytical framework should also not be mistaken for the constrained "bottom-up"
approach adopted by the EBA for its annual EU-wide stress test. The EBA stress testing
exercise is carried out at the bank level and applying granular bank level data only available
to the banks and their national supervisors. Compared with supervisory stress tests carried
out between banks and their home supervisors, the EBA bottom-up stress test is
"constrained" in the sense of using a common scenario across all banks and to a large extent
also relies on common methodologies.
Bottom-up and top-down stress tests should not be directly juxtaposed, as a one-to-one
mapping of their results is not possible. Rather they should be seen as complementary tools
to assess the resilience of the financial sector; they are characterised by different strengths
and weaknesses. Importantly, although top-down stress tests are far from perfect and suffer
from many deficiencies, they are a useful tool to challenge the more granular bottom-up
approaches and especially to detect outlier responses by individual banks in the latter case.
3. The use of macro-prudential policy instruments in the Single Market
I would like to conclude by turning to the design of policy instruments that authorities may
use to address the risks identified by various analytical tools.
As a consequence of the lessons learned from the crisis, the focus of financial regulation has
gradually shifted towards a macro-prudential approach, a key element of which is the
establishment of authorities with macro-prudential mandates at both the national and the
international level. In the EU context, the ESRB has been operational since the beginning of
this year. The ESRB is currently working on developing a macro-prudential toolkit of policy
instruments that authorities can use to address systemic risks.
Moreover, the Basel III regulatory framework - considered the cornerstone of the global
regulatory reform for banks and endorsed by the G20 leaders last year - already includes
some elements of a macro-prudential toolkit. Indeed, the counter-cyclical capital buffer can
be considered as a predominantly macro-prudential tool. The capital buffer will be built up in
periods of excessive credit growth and released in stress situations, thus introducing a
counter-cyclical element in financial regulation.
Other elements of a macro-prudential toolkit fall primarily in the domain of what is traditionally
micro-prudential supervision. We have capital and liquidity rules which aim to mitigate risks
at the level of individual institutions, but which could, in principle, be recalibrated to address
macro-prudential concerns as well.
With the aim of implementing Basel III, the European Commission recently published a
rulebook, known as "CRD IV". This includes a proposal for two new legal acts: a directive,
which needs to be implemented in each Member State, with provisions on the authorisation
and supervision of credit institutions and investment firms; and a regulation laying down the
prudential standards which will have direct application across the EU.
Recently, concerns have been raised with regard to the ability of authorities to use
microprudential tools for macro-prudential purposes if the capital and liquidity rules are introduced
as a directly applicable regulation in the EU. This would imply not only a minimum but also a
"maximum harmonisation" of prudential requirements, in that a country could adopt neither
more nor less stringent implementations of the policy instruments.
The maximum harmonisation approach aims to ensure a consistent implementation of
prudential measures in the Single Market. It ensures that a level playing field for financial
institutions will be established through a single rulebook, thus avoiding regulatory arbitrage
and distortions to competition. Furthermore, the harmonised rules also support financial
integration and improve transparency. Finally, this approach also reduces regulatory costs as
well as banks' compliance costs. Given the substantial benefits of greater financial
integration, the ECB has consistently supported the "single rulebook" approach for financial
regulation, with the aim of promoting the smooth functioning of the Single Market.
At the same time, however, let me underline that, for financial stability reasons, it is desirable
that national authorities have the possibility to impose a more stringent calibration of capital
requirements and a few other requirements than those proposed in the regulation.
The need for such a macro-prudential framework overlay is justified by the fact that different
countries are at different stages of the cycle within Europe, potentially facing different types
of systemic risk. Authorities therefore need a certain degree of national discretion to calibrate
the given set of macro-prudential policy instruments to their specific cyclical situation, i.e. to
address the time dimension of systemic risk. There are also significant differences in the
structural importance of the financial sector or the size of the banking sector relative to GDP
across EU countries, which may translate into different levels of systemic risk at a given point
in time. Authorities may thus need appropriate tools with which to address the
crosssectional dimension of systemic risks as well.
However, given that regulations are directly applicable and Member States cannot modify
them or add provisions unless this is explicitly provided for in the regulation itself, I am of the
view that the establishment of a general macro-prudential regime in the Capital Requirement
Regulation is warranted. This macro-prudential regime should have three main features:
First, adjustments should only be possible in the direction of strengthening the harmonised
minima.
Second, and as mentioned earlier, only calibrations should be subject to upward adjustment.
Definitions should be maintained, thus respecting the principle of an EU rulebook.
Third, this macro-prudential regime should be subject to strict safeguards, under the ex ante
coordination of the ESRB. The purpose of this coordination before new calibrations are
introduced by individual countries is to guard against possible unintended consequences and
spillover effects. These safeguards could include the identification of the macro-prudential
concerns in the respective countries and confirmation by the ESRB. Deviations should be
subject to close monitoring by the ESRB as well as to disclosure requirements. Finally, when
the macro-prudential concerns cease to exist, the calibrations should return to the
harmonised minimum in the EU rulebook.
This should provide macro-prudential authorities with the flexibility required to preserve
financial stability while including safeguards against adverse side-effects on other countries
and, ultimately, possible impairments of the Single Market for financial services in the EU.
More generally, let me highlight that, while most of the arguments put forward against a more
stringent national calibration tend to stress the potential trade-offs between financial
integration and financial stability, this may not always be the case. The occasional
introduction of more stringently implemented macro-prudential measures by specific
countries under the aegis of the ESRB may actually enhance both financial stability and
financial integration by protecting the Single Market from excessive boom-bust cycles. By
avoiding, or at least mitigating, such cyclical swings, macro-prudential authorities may
effectively contribute to the smooth functioning of the EU financial system and the Single
Market in the medium to long term.
The work of the MaRs is an important contribution to a new pillar of policies that the crisis
showed to be indispensable. As you can see, the ECB follows your work with great interest. I
wish you a very fruitful conference.
Many thanks for your attention.
References
Abildgren, K., "Business cycles, Monetary Transmission and Shocks to Financial Stability -
Empirical evidence from a new set of Danish quarterly national accounts 1948-2010".
Danmarks Nationalbank Working Paper No 71, 2010.
Beau, D., L. Clerc, and B. Mojon, "Macro-Prudential Policy and The Conduct Of Monetary
Policy". Banque de France, Occasional Papers No 8, 2011.
Eichberger, J., K. Rheinberger, and M. Summer, "Credit Risk in General Equilibrium".
University of Heidelberg, University of Applied Sciences Vorarlberg and Oesterreichische
Nationalbank, mimeo, 2011.
Fornari, F., and W. Lemke, "Predicting Recession Probabilities With Financial Variables Over
Multiple Horizons", ECB Working Paper Series No 1255, 2010.
Goodhart, C. A. E., A. Kashyap, D. P. Tsomocos, and A. P. Vardoulakis, "Financial
Regulation in General Equilibrium", London School of Economics, University of Chicago,
University of Oxford and Banque de France, mimeo, 2011.
Lambertini, L., C. Mendicino, and M. T. Punzi, "Leaning Against Boom-Bust Cycles in Credit
and Housing Prices", Working Paper 8/11, Banco de Portugal, 2011.
Louzis, D., and A. Vouldis, "Financial Stress Index for the Greek Banking System", Bank of
Greece, mimeo, 2011.
Memmel, C., A. Sachs, and I. Stein, "Contagion at the interbank market with stochastic
LGD", Deutsche Bundesbank Discussion Paper Series 2: Banking and Financial Studies,
No 06, 2011.
Rannenberg, A. "Asymmetric Information in Credit Markets, Bank Leverage Cycles and
Macroeconomic Dynamics", Nationale Bank van België/Banque Nationale de Belgique,
mimeo 2011.