Andreas Dombret: Financial systemic risk - the national and
international dimension of macroprudential policy
Public lecture by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the International Center for Monetary and Banking Studies (ICMB), Geneva,
12 February 2013.
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1. The case for macroprudential policy
Dear Prof. Wyplosz,
Ladies and Gentlemen!
Recently, The Economist reported that, more than a millennium ago, this very city was
destroyed by a tsunami which came off of Lake Geneva. Today, we are coping with the
fallout of a different storm: A financial one that took place in 2007 but has its roots in earlier
years. Ever since, systemic risk and macroprudential policy are at the top of the agenda of
policymakers, regulators and central bankers, and for good reason.
I appreciate very much having been invited today to share my thoughts on why
macroprudential policy is of such vital importance. I will touch on its broader implications at
both the national and the international level. Therefore, most of my comments are generally
applicable, but allow me to voice some thoughts on the current debate in the European
Union.
The financial crisis has made it clear that systemic risk with its implications for financial
stability was not given enough attention in the past. We have learnt the painful lesson that we
have to put the financial system on a sounder footing, and we need to draw the right
conclusions from the global financial crisis. The costs of inaction have been high, and doing
nothing is simply not an option. Thus, our approach to regulation and supervision has to
adapt to this insight and take a more systemic view. In this regard, let me suggest that one
could draw a somewhat simplifying analogy to nature.
In nature, species or populations have to adapt to their environment in order to survive. In an
evolutionary system, continuous development is vital merely in order to maintain the fitness
of an organism relative to the system with which it is co-evolving.
Similarly, the financial sector as well as regulation and supervision may be considered as a
system that is evolving over time. Its different players are continuously interacting with one
another and must adapt to change in order to succeed. In the same way as financial
institutions respond to legal constraints, the regulator has to take their reactions into account
and set the right incentives to safeguard financial stability.
All players in a functioning financial system need to respond to new developments so that a
balance can be maintained. From this angle, the financial sector can be seen to have
become more globalised, more complex and more integrated. You will agree that therefore
regulation constantly has to adapt to keep up with its changing environment.
Adopting a systemic view is paramount. With this I mean it is of paramount importance to
take due account of the external effects of individual actions and of their repercussions within
the financial sector and, ultimately, of their implications for the real economy, sovereigns and
taxpayers. In this sense, macroprudential policy provides a framework for thought and action,
for deciding how much resilience we want and how much we are willing to pay for it.
2. National dimension: goals and interactions with other policy areas
But why do we need a distinct policy? Would it not be enough to take system-wide
implications into account in other policy areas such as monetary and fiscal policy or
microprudential supervision?
There are two main arguments why a specific macroprudential policy is called for and both of
them I find important.
One is set out by Nobel laureate Jan Tinbergen in his contribution "On the Theory of
Economic Policy": achieving a number of goals requires an equal number of instruments. For
example, setting the interest rate is effective when targeting a specific goal such as inflation.
However, using one instrument to try to achieve multiple goals inevitably impairs the
effectiveness of that instrument. So even though the interest rate impacts on financial
stability, it is likely to clash with the objective of ensuring price stability. Moreover, it may be
too blunt to achieve this policy goal, especially in a monetary union when risks originate from
regions or sectors whose economies are not developing in sync.
The second argument: each policy area only should have goals that are not mutually
conflicting. Would it be wise to make the Transport Ministry responsible for environmental
protection? Or would it not be more sensible to have an Environment Ministry in charge of it?
Assigning potentially conflicting goals to different policy areas ensures that each policy area
is committed to its task.
Therefore, an independent macro-prudential policy safeguarding financial stability is needed
and should be equipped with its own instruments. More precisely, there are two main
objectives of macroprudential policy, which should be distinguished carefully.
First, it should provide a framework and rules that give the market participants appropriate
incentives. This holds true in normal times but especially when crisis management measures
have to be applied.
Second, macroprudential policy is about prevention. It puts in place instruments to keep
systemic risk from building up over time. This can happen during times of exuberance when
instruments have to be tightened. But it also can be necessary during downturns when
previously accumulated capital or liquidity buffers can be released. Other instruments are
designed to prevent spillover to other parts of the economic system.
In order to achieve these two objectives successfully, macroprudential policy has to take into
account interactions with other policy areas. This is because different policy areas might
reinforce or counteract each other. Coming back to my previous words, let the following
situation serve as an example: while environmental policy is trying to reduce traffic pollution,
at the same time transport policy is promoting enhanced mobility and infrastructure
improvements by having new roads built.
The same issue about reinforcing and counteracting effects applies to the interaction
between monetary policy and macroprudential policy.
In the short run, a potential conflict between the two policy areas cannot be ruled out. This
might be the case if real and financial developments diverge, for example when monetary
policy should be tightened but the financial system is stressed. Or it could happen when an
economy is undergoing periods of high productivity growth, which reduces inflation but at the
same time may trigger irrational exuberance in financial markets. This, for example, was the
case during the dotcom bubble at the turn of the century.
However, once a longer-term perspective is taken, tensions tend to disappear. Over such a
time horizon, price stability and financial stability are complementary. Monetary policy needs
a functioning transmission process and a healthy financial system in order to be successful,
while price stability is a key precondition for financial stability.
Similarly, there are interactions between macroprudential policy and fiscal policy. They are
interrelated because banks hold a large quantity of their own government's debt in many
countries. Unsustainable public finances have a direct impact on the rating of sovereign
bonds and thus on banks' balance sheets. As a consequence, waning market confidence,
losses and strained funding conditions can be detrimental to the resilience of the financial
system as a whole.
Fiscal policy can also impact on financial stability through tax incentives. Just think of the role
that tax incentives play in the overheating of real estate markets, for example by promoting
owner-occupied housing through overly generous tax deductions for mortgage lending rates.
Or think of the widespread preferential treatment of debt over equity. Thus, macroprudential
objectives may sometimes conflict in the short run with political objectives pursued by means
of tax policy.
Even so, by setting the right incentives, taxation also can be a useful tool for safeguarding
financial stability. Some activities, such as excessive short-term funding, represent a
systemic risk and could be curbed by an appropriate levy. This would make them more
expensive and thus less attractive for market participants.
Finally, macro- and microprudential policy can crucially impact on one another. Both aim to
enhance resilience and ensure stability. However, one focuses on single entities, while the
other looks at the system as a whole. And even if the tools employed often work in the same
direction, they may not always be perfectly aligned.
Microprudential regulation sometimes favours investment in certain "safe" asset classes.
However, this may conflict with financial stability concerns as common exposure could
involve systemic risk. Awareness of spillovers and feedback effects is a very important first
step. It also fosters the understanding that both policies should complement each other.
Achieving microprudential objectives depends on a stable financial system. Conversely, a
stable financial system builds on sound individual institutions.
In my home country Germany, a new institutional setup for macroprudential policy takes
these interactions between policy areas into account. A Financial Stability Committee has
been established; it comprises representatives from the Bundesbank, the federal Financial
Supervisory Authority and the German Finance Ministry. Together, they are in charge of
designing consistent macroprudential policies. By involving different institutions, this setup
ensures a comprehensive point of view.
Similarly, other countries will set up their own national macroprudential framework and take
decisions regarding their financial system. Thus, measures will be adopted at the national
level but will also have an impact across borders. Therefore, macroprudential policies will
have to take spillovers into account. Equally, market participants must learn about the
macroprudential policies of different jurisdictions. This thought leads me directly to my next
topic: banking union and macroprudential policy.
3. Banking union and macroprudential policy
In a financially integrated area such as the EU, spillover effects from one country to another
are especially pronounced. Any national policy that affects financial stability might have an
impact not only at home but across borders, too. This holds true not only for any measure
taken but also for measures not taken.
Furthermore, the developments of the last years have dramatically shown the perils of the
sovereign-banking nexus. The proposal for a banking union in the EU can be seen as a step
towards better addressing spillover effects and disentangling sovereign and banking risks.
The banking union will start with a single banking supervisor. With a common set of rules on
microprudential regulation, a European supervisor will be best placed to ensure a common
supervisory practice. This is to avoid forbearance or a policy of "too little too late". Inaction
can lead to severe problems in financial institutions and contagion in the financial system.
Moreover, a European supervisor helps to preserve a level playing field, which is essential to
the single market.
However, as envisaged by the banking union, a common resolution scheme should soon
complement a single banking supervisor. First of all, it will ensure that owners and creditors
bear the risk of their investment. A common resolution scheme would also avoid
inconsistencies and frictions that could otherwise arise between a single supervisor and
national resolution authorities. Ultimately, it could significantly improve the way in which we
cope with failing internationally active banks. Their orderly recovery or resolution is a key
element of financial stability and cross-border effects play a crucial part in it. A common
resolution scheme will also help to reduce negative spillover from the banking sector to
governments. Should public backstops be necessary to fund the resolution of banks
governed by the single supervisory mechanism, a burden-sharing agreement will have to be
in place.
A banking union surely contributes to financial stability. But it is not a panacea. Current
financial risks in national banking systems developed under national supervision. Thus, the
ultimate responsibility is national. Any other solution would be a fiscal transfer and should be
treated as such, including obtaining the obligatory democratic legitimacy.
Setting up a banking union and a single European supervisor also touches on institutional
questions. Furthermore, it requires us to work out how the new set-up will relate to
macroprudential policy.
Regarding the institutional framework, it must be ensured that the conferring of any
supervisory powers on the ECB does not call into question the independence of monetary
policy and the central bank's mandate for price stability. But I will not, at this point, go into
further detail about the design of the banking union. Instead, I would like to expand briefly on
the relationship between a banking union and macroprudential policy.
In contrast to the common set of rules of microprudential regulation, the essence of
macroprudential policy is to detect, assess and respond flexibly to a build-up of systemic risk
wherever and whenever it occurs. Even with a banking union, cyclical patterns in the euro
area will vary to some extent. Under a single monetary policy, regionally differentiated
macroprudential policies are vitally needed to combat systemic risk.
But who should be responsible for implementing macroprudential policies?
On the one hand, there are arguments for national authorities. Given that the
macroeconomic costs of a systemic crisis are borne largely nationally, it seems reasonable
to assign national authorities the responsibility to cope with the changing nature of systemic
risk. Furthermore, a granular understanding of the national economy and the financial system
is needed. National policies will involve implementing specific measures, such as the
countercyclical capital buffer, sectoral risk weights or capital or liquidity surcharges.
On the other hand, national authorities may sometimes be biased towards inaction. Or they
do not fully take into account spillover effects, whose potential costs have to be shared in a
banking union. This might be addressed by assigning the power to tighten national
macroprudential policies to the European level. Indeed, in December 2012, European
finance ministers agreed to confer this power to the single banking supervisor.
At present, the European Union already has an independent body responsible for
macroprudential oversight: the European Systemic Risk Board. Within its framework, there
are established rules for the interplay between European and national authorities. This
includes accountability on a "comply or explain" basis. As opposed to the single supervisory
mechanism, the ESRB comprises all 27 EU member states. It also is not confined to the
banking sector but rather addresses the entire financial system.
The responsible parties now have to figure out how to fit the macroprudential aspects of the
banking union and the ESRB together. While it is too early to know what the final setup will
look like, the ESRB will certainly not become obsolete. It plays, and will continue to play, an
important role in coordinating policies.
4. Concluding remarks
In conclusion, let me return to the analogy I used at the beginning of my speech.
Macroprudential policy can be understood as a framework for responding to needs that have
arisen because of the way the financial sector has developed. Thus, macroprudential policy
seeks to restore the balance in the financial system populated by market participants,
regulators and supervisors.
Unlike in evolution, the objective has been set. Nevertheless, to achieve the desired goals,
interactions with other policy areas as well as cross-border spillovers still have to be taken
into account. As a consequence, market participants themselves will have to adapt, to
comply with new regulatory requirements and to develop their own responses to a changing
environment.
Some responses might turn out to be unnecessary for a healthy economy. But former
Fed Chairman Paul Volcker was taking things to extremes when he said, "The only useful
banking innovation was the invention of the ATM". Other innovations, however, are beneficial
to the development of our financial system, and those should be the ones that survive.
The potential failure of the financial system can come with a huge price tag for society. For
this very reason, a stable system is essential. Macroprudential policy will have a key part to
play in this, and national macroprudential responsibilities are about to be assigned in many
countries. Appropriate instruments now need to be developed and implemented; we will have
to "walk the talk". This will be a major challenge for some time to come.
Thank you very much for your attention to the topic which is close to my heart.