Lorenzo Bini Smaghi: Macro-prudential supervision
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the CEPR/ESI 13th Annual Conference on "Financial Supervision in an Uncertain
World", European Banking Center at Venice International University, Venice,
25-26 September 2009.
* * *
Introduction1
The recent financial crisis has produced a broad consensus on analysis and policy action in
at least three areas, namely the need: i) to gain a better understanding of systemic risk; ii) to
strengthen the macro-prudential aspects of financial supervision; and iii) to deepen central
banks' involvement in it. The establishment of a new body to conduct macro-prudential
supervision at EU level - the European Systemic Risk Board (ESRB) - is one element in a
comprehensive set of initiatives and responses in this field.
My remarks today focus on the future work of this body and consist of four parts. I'll first
consider the origins, purpose and structure of the ESRB. In second place, I'll discuss the
concept of systemic risk, and how it can be monitored and assessed effectively. I'll examine
some analytical tools for systemic risk analysis in the EU and look at how these tasks could
be organised in the context of the ESRB. In the third part, I'll cover the ECB's experience in
conducting financial stability surveillance in the euro area and reflect on the vulnerabilities
that we (and other authorities) identified before the crisis. I'll ask why the communications
what if?
about the risks that built up were insufficient to prevent the crisis. The fourth part is a
What if the Risk Board had existed in the early 2000s - could the factors that led to the crisis
have been identified and averted? The answer should point to some of the key advantages
of (and reasons for) the EU's new macro-prudential function.
1. The setting-up of the European Systemic Risk Board
The idea of establishing a body to monitor and assess systemic risk at European level was
first mooted in the late 1990s.2 It took over a decade and a financial crisis to implement it. Let
me recall the milestones of the setting-up of the ESRB institutional framework. Following the
recommendations of the de Larosière Report, in February this year, the main features of the
institutional framework for macro-prudential supervision were defined by the Communication
published by the European Commission on 27 May as well as the Conclusions approved by
the ECOFIN Council on 9 June and by the European Council on 18 and 19 June.
The European Systemic Risk Board will be responsible for the macro-prudential oversight of
the financial system within the European Union. It will seek to prevent or mitigate systemic
risks within the financial system, so as to avoid widespread financial distress, and it will
contribute to a smooth functioning of the Internal Market and ensure a sustainable
contribution of the financial sector to economic growth. Its tasks will be to identify and assess
risks to systemic stability in the EU, issue risk warnings where risks appear to be significant
and, where necessary, give recommendations on measures to be taken to contain such risks
and follow up on their implementation.
The Risk Board will have 33 full members: the 27 EU central bank Governors, the ECB
President and Vice-President, a Commission member and the three Chairs of the new
European Supervisory Authorities. To ensure close cooperation with supervisors, a
representative from one national supervisory authority for each EU country may attend the
meetings of the ESRB, but will have no voting rights. In addition, the President of the
Economic and Financial Committee (EFC) will participate, but likewise will have no voting
rights.
The ECB was requested by ECOFIN to provide the necessary analytical, statistical,
administrative and logistical support, and to draw on technical advice from the national
central banks and supervisors. This is a clear recognition of the important role that central
banks have gained over time in monitoring financial stability.
The Commission proposals specify in detail the new institutional arrangements concerning
the establishment of the ESRB and the involvement of the ECB. The ECB/Eurosystem will
provide its views when formally consulted according to the Treaty provisions. Indeed, further
work is needed to clarify and optimise the details of the institutional framework for the ESRB
as well as for the new European Supervisory Authorities for micro-prudential supervision.
Sound institutional arrangements are a crucial pre-condition for the effectiveness of these
supervisory reforms in general and the establishment of the Risk Board in particular. In this
context, let me mention two key elements to be defined by the forthcoming legislation.
One is the arrangements for the exchange of micro-prudential information among national
supervisors, the new European Supervisory Authorities and the ESRB (subject to specific
confidentiality agreements). In order for the ESRB to perform its functions, it should have the
power to request any information it deems necessary (for example, exposures of large and
complex financial institutions to structured products).3
The other key element is that a risk warning needs to be translated into appropriate
supervisory action. An institutional mechanism should exist to ensure that the
recommendations adopted by the ESRB as regards the actions to address the systemic risks
identified by the macro-prudential assessment would be followed up by the competent
national authorities. However, as the recommendations will not be binding, there should be
institutional mechanisms to ensure that they are implemented. And if they are not
implemented, an explanation has to be provided.
The ESRB may decide to make the recommendations public. As the recommendations aim
to address systemic risks, their publication will increase pressure on the Member State to
implement such recommendations.
A peer review mechanism should be set up. In particular, the ECB, on behalf of the Risk
Board, would closely monitor the implementation of the recommendations by Member States
and national authorities. Cases of non-compliance could be reported to the Council and,
where relevant, to the European Supervisory Authorities for appropriate follow-up.
2. The concept of systemic risk and its analysis by the ESRB
How well this institutional framework will enable the ESRB to perform its tasks will depend on
its understanding of systemic risk, the amount of relevant information at its disposal, the
analytical tools that are available to assess the risks, and the framework used to distil the
most important results from all these elements. Let me comment on some of these four
aspects and touch on how we intend to fulfil our mandate to support the ESRB.
Conceptual issues of systemic risk
Systemic risk analysis is nothing new to the central banking community, including the ECB.
One reflection of this fact is the series of triennial central bank conferences held under the
G10 Committee on the Global Financial System between the mid-1990s and early 2000s.
Even the European Monetary Institute, which was the forerunner of the ECB, contributed to
systemic risk work in this context, alongside the US Federal Reserve, the Bank of England,
the Bank of Japan and many other central banks.4 For instance, from the outset, the ECB
drew up a research agenda on financial stability and systemic risk.5 In addition, in 2004 we
started to publish a Financial Stability Report (FSR) twice a year. The main objective of this
Report is to help identify, at an early stage, potential vulnerabilities and to raise awareness
among market participants with a view to promoting preventive and remedial policies. Each
issue also contains several special features offering a wealth of further insight into financial
stability and systemic risk.
This background suggests that the ECB is a logical choice as a provider of analytical support
to the ESRB, but it should not obscure two major challenges we are facing. First, the
phenomenon of systemic risk is extraordinarily complex. Second, despite the steps reported
above and some lively academic literature on financial contagion over the last two decades,
systemic risk analysis and research is far less advanced than that of monetary policy, for
example. There are no established frameworks that can be taken "straight off the shelf".
Having said that, let me describe briefly the concept of systemic risk. Systemic risk was
defined by the G10 in 2001 as "... the risk that an event will trigger a loss of economic value
or confidence in, and attendant increases in uncertainty about, a substantial portion of the
financial system that is serious enough to quite probably have significant adverse effects on
the real
economy."6 In simpler terms, it is the risk that the failure and distress of a significant
part of the financial sector reduces the availability of credit, which in turn may adversely
affect the real economy. Interestingly, this notion of systemic risk is quite similar to the
definition of financial stability that the ECB uses in its Financial Stability Report, underlining
the fact that our financial stability work has always had a macro-prudential orientation. Our
working definition describes financial stability as a "condition in which the financial system -
comprising of financial intermediaries, markets and market infrastructures - is capable of
withstanding shocks and the unravelling of imbalances, thereby mitigating the likelihood of
disruptions in the financial intermediation process which are severe enough to significantly
impair the allocation of savings to profitable investment opportunities".
4
Risk Measurement and
See, for example, de Bandt and Hartmann (1998), "What is systemic risk today?", in
Systemic Risk, Proceedings of the Second Joint Central Bank Research Conference, hosted by the Bank of
Japan, Tokyo, 1997.
5
In this regard some of the ECB outputs (partly in collaboration with academics and researchers from other
central banks and international organisations) include: Fell and Schinasi, (2005), "Assessing Financial
Stability: Exploring the Boundaries of Analysis", National Institute Economic Review, Vol. 192, No. 1; de Bandt
and Hartmann (2000), "Systemic risk: A survey", ECB Working Paper, No 35, November; Hartmann,
Straetmans and de Vries (2004), "Asset market linkages in crisis periods", Review of Economics and
Statistics, 86(1); Hartmann, Straetmans and de Vries (2005), "Banking system risk: A cross-Atlantic
perspective", NBER Working Paper, No. 11698, October; Cappiello, Engle and Sheppard (2006), "Asymmetric
dynamics in the correlation of global equity and bond returns", Journal of Financial Econometrics, 4(4); Gropp,
Lo Duca and Vesala (2009), "Cross-border bank contagion in Europe", in Shin and Gropp (eds.), Banking
Integration, Bank Stability, and Regulation, special issue of the International Journal Central Banking, 5(1);
Iyer and Peydró-Alcalde (forthcoming), "Interbank contagion at work: Evidence from a natural experiment",
Review of Financial Studies.
6
Group of Ten, (2001), "Report on Consolidation in the Financial Sector", Basel.
BIS Review 115/2009
Following de Bandt, Hartmann and Peydró-Alcalde (forthcoming), we can distinguish three
broad and interrelated ways in which systemic risk can materialise.7 The first one is
commonly called contagion and is closely studied in the research literature. For example, a
supposedly idiosyncratic failure of a financial intermediary leads to the failure of other
intermediaries. The second one emerges from imbalances that build up over time, such as
credit booms or concentrations of lending in certain regions or sectors. These "bubbles" can
go on profitably for most participants who "ride" them for quite a while. Then relatively small
events or changes in expectations can lead to their breakdown, simultaneously bringing
down a wide range of intermediaries and markets.8 The third way in which systemic risk can
materialise relates to economic downturns or other aggregate shocks that cause the collapse
of a wide range of intermediaries and markets simultaneously.9
Other important elements in systemic risk include the strong information intensity of financial
contracts and transactions, and a high degree of connectedness between financial
intermediaries and markets as well as a strong reliance on debt financing (leverage) and on
maturity mismatches between assets and liabilities. These factors imply feedback
mechanisms that amplify shocks and can lead to non-linearities in the financial system that
then are easily transmitted to the real economy.
Systemic stability, or the absence of systemic risk, can be seen as a public good, thereby
legitimising the role of governments and other authorities in addressing it.10 Like pollution,
systemic risk involves externalities, in the sense that each financial intermediary manages its
own risks but does not consider its impact on the risk of the system as a whole. The financial
crisis contributed considerably to a better understanding of the phenomenon of systemic risk,
which is also reflected in aspects of regulatory reforms. In particular, the possibility of
aligning capital requirements to a measure of firms' systemic risk contribution is being
contemplated by regulators, e.g. the Basel Committee on Banking Supervision.11
How could the ESRB then structure its supervisory work on systemic risk? In broad terms,
systemic risk analysis can be broken down into two core components: i) surveillance, or risk
detection, and ii) risk assessment, each of which I will address in turn.
Risk detection
Financial stability surveillance concerns risk identification. This kind of surveillance mainly
aims to detect potential sources of risk, especially financial vulnerabilities - that is
weaknesses which, if unearthed, could lead to a disruption or failure in part of the financial
7
De Bandt, Hartmann and Peydró-Alcalde (2009), "Systemic risk in banking: An update", forthcoming in the
ECB Working Paper series, and Berger, Molyneux and Wilson (eds.), Oxford Handbook of Banking, Oxford
University Press. This paper surveys all the relevant academic research with respect to the three categories
and relates them to the present crisis where applicable.
8
This tendency of financial systems towards boom-bust cycles goes back, for example, to the work by Minsky
Financial
(1977), "A theory of systemic fragility", in Altman and Sametz, Crises, Wiley. Notably, observers from
the Bank for International Settlements, such as Bill White and Claudio Borio, warned before 2007 that such
imbalances were building up.
9
For example, Gorton (1988), "Banking panics and business cycles", Oxford Economic Papers, 40, observes
that most US banking crises during the national banking era could have been predicted with a simple business
cycle model.
10
See, for example, Acharya, Pedersen, Philippon and Richardson (2009), "Regulating Systemic Risk", in
Acharya and Richardson (eds.), Restoring Financial Stability: How to Repair a Failed System, Wiley; Lo
(2008), "Hedge Funds, Systemic Risk, and the Financial Crisis of 2007-2008", Written Testimony prepared for
the US House of Representatives, Committee on Oversight and Government Reforms, Hearing on Hedge
Funds, November.
11
Basel Committee on Banking Supervision, "Comprehensive response to the global banking crisis", press
release, 7 September 2009.
BIS Review 115/2009
system and potentially to a financial crisis. It would have to pay attention to the sources of
the three forms of systemic risk discussed earlier - contagion, imbalances and macro
shocks.
Risk monitoring should identify sources of risks and vulnerability coming from within the
financial system - i.e. stemming from financial institutions, markets or market infrastructure -
and also those present in the macroeconomic environment and non-financial related events.
These would include vulnerabilities resulting from global imbalances, growth prospects,
developments in housing markets, creditworthiness of borrowers, to name a few.
The monitoring involves processing large amounts of (often disparate) information of a
statistical nature and is based on market sources. In addition, continuous market intelligence
efforts are essential for effective risk monitoring and the early detection of new financial
instruments, practices or business strategies which could create vulnerabilities and risks in
financial markets.
In the case of the Risk Board, market intelligence will be complemented by what could be
called "institutional intelligence" and "policy intelligence", given the qualitative information and
expert knowledge available to central banks and supervisory authorities represented in the
ESRB. The Board's independent, impartial status could prove to be invaluable in the
surveillance and identification of risks viewed as material.
Risk monitoring is facilitated by a large set of tools, including contemporaneous financial
stability indicators and forward-looking early warning indicators and models. These tools
need to be regularly revised and updated in order to capture innovation in financial markets,
fuelled by new products and business models.
Macro-prudential indicators comprise a vast set of indicators - on the macroeconomic
environment, financial markets, financial institutions and financial system infrastructures.
More specifically, they include macroeconomic aspects, financing conditions, monetary
conditions, asset valuations, risk appetite, market liquidity, funding liquidity, credit risk,
financial strength of institutions, and others. Some of these indicators may contain
information relevant to early warnings as they may draw attention to rapidly increasing
exposures to specific asset classes, broad-based increases in financial leverage and
dynamics in the maturity profile of financial institutions' debt which could indicate roll-over
problems.12
In the ESRB context, early warning indicators and early warning signal (EWS) models should
play an important role in both the risk surveillance phase and in the lead-up to the risk
warning phase. EWS models are designed to indicate when a financial system, market or
intermediary reaches a "danger zone", which usually points to a crisis ahead. In the past, a
number of forward-looking stability indicators were used by most central banks, but these
were not necessarily comprehensive frameworks of developed EWS models covering most
financial systems. One reason for this may have been that the older generation of these
models performed well in the sample but they typically failed to predict future crises. Recent
research suggests that their out-of-sample performance can be improved, in particular with
respect to credit cycles and asset price bubbles.13 A caveat that remains is that it seems
difficult for them to improve their predictions on the timing of credit booms and asset-bubble
bursting.
Risk assessment
Risk assessment relates to the evaluation of the relevance and potential severity of each risk
identified as material in the surveillance phase. It should therefore include a quantitative
evaluation of the likelihood that the potential risk scenarios could actually materialise, as well
as an evaluation of the ability of the financial system to absorb the shocks (for example,
through existing capital buffers or through the potential to increase buffers in the future
through profit retention). It should also include cost estimates in terms of the failure of
institutions, costs deriving from the malfunctioning of financial markets or impairment of the
real economy. The product of these factors forms the basis for the ranking of risks.
Quantitative methods and analytical tools (for example, macro-stress testing models) should
support, together with expert judgement, the prioritising or ranking of these risks. The models
will help in the conduct of quantitative impact assessments on the financial sector as well as
in the assessment of the potential costs for the real economy, and thereby offer information
about the relevance and severity of the risks detected in the surveillance phase.
Macro-stress testing models have become the workhorse of macro-prudential stability
analysis in the last decade, notably including quantitative impact studies for specific
scenarios. Their main purpose is to assess the resilience of the banking and financial
systems against extreme but still plausible events. One problem with these models in the
past was that even for large shocks they generated hardly any bank failures. This can
probably be improved by using appropriate data, more granular than previously available,
and by capturing better and a larger number of adverse feedback loops that can play a role
in amplifying the transmission of instability in the financial system. These feedback loops
could include contagion effects across banks, market liquidity and funding liquidity
problems.14 Another difficulty for these models is whether they should be extended to also
capture feedbacks from real economy outcomes to financial stability variables.
The assessment task is currently much less developed than the surveillance one. This is not
only because it involves considerable analytical sophistication, but also and mainly because
there are significant gaps in the information on the financial intermediaries themselves and
on inter-linkages between the various parts of the financial system.
Viewing the financial system as a network, more information is needed on the key network
nodes, and well as on the links between those nodes.15 The degree of interconnectedness in
the system may be determined by common exposures to specific asset classes, such as
specific sectors in the economy, for example, commercial property, or to specific regions
such as emerging Europe, via granted loans or securities holdings. Inter-linkages may also
derive from intra-bank and intra-group exposure, as well as from trading and other correlated
positions in the financial markets, such as in the credit derivatives market, which may lead to
crowded trades, should they need to be unwound simultaneously. They may derive from
cross-ownerships and capital participations among institutions, from similarities in business
models, or from reliance on the same external sources for funding, for example.
While it is unrealistic to think that it would be possible to characterise the degree of
interconnectedness of the financial system by taking into account all possible channels for
contagion, a great deal of invaluable information exists in a scattered form (at the disposal of
supervisors, trading platforms or the institutions themselves).
At present, these information gaps imply that most modelling techniques for risk assessment,
including macro stress-testing and contagion models, are highly dependent on market-
inferred data based on stock prices or credit default swap spreads that, in particular, might
not behave reliably at times of turmoil or stress in financial markets.
It is important to note that the complexities of systemic risk and macro-prudential supervision
and the state of current research do not allow the analytical tool kit to be limited to just one or
two major models. Given that the framework for macro-prudential analysis is at an early
stage of development compared with other areas of economics, there is a need to look at a
wider range of models and thereby include relevant risks, imbalances and transmission
channels.
Systemic risk analysis needs to be supported by a suite of state-of-the-art analytical models
and tools, and a conceptual framework for using them. The complex and intertwined
economic and financial linkages call for a constant cross-checking of several indicators or
measures. In addition, the evolving nature of finance and the pace of innovation also require
that the set of tools for systemic risk detection and assessment are constantly adjusted or
revised. Many central banks, including the ECB, have in the past developed such models
and tools in order to support their regular financial stability analyses and reports. The
experiences with the crisis and the decision to establish a macro-prudential stability function
in Europe suggest that, even when building on existing structures, significant efforts are
called for in order to extend and further improve models and tools. While it would be
desirable for the risk assessment exercise to be increasingly quantitative, it should never
become mechanistic or fully model-based. Expert judgement and qualitative assessments
will always be crucial to understand the messages coming from various analytical tools, also
taking into account overall intelligence efforts.
Comprehensive information base
Irrespective of their level of sophistication, models need to be fed with the appropriate data in
order to produce results that, in addition to their analytical interest, can support policy
messages. A comprehensive information base is also key in the risk surveillance phase that
precedes the actual risk assessment. This is because the establishment of a wide radar
screen supporting rigorous monitoring is only possible if the critical information is available.
The current crisis has convincingly shown that a significant part of credit intermediation was
channelled outside the banking sector and the regulated financial sector. The non-regulated
or "shadow" banking system was almost totally off any surveillance radar screen. Not enough
was known about special investment vehicles, conduits, securitisation markets and
instruments, or about all the financial intermediation that takes place outside the traditional
banking system. Moreover, little was known about the direct and indirect exposures between
this shadow banking system and the regulated one, which turned out to be substantial.
Information on non-banking institutions, potentially of systemic importance, such as hedge
funds, was scattered, not quality-checked and typically provided on a voluntary basis. A
tendency to create a bias towards the best performers was the result. Even for the banking
sector, for which data is abundant - and, what's more, there is substantial expertise in
conducting risk assessments - the information available to bodies entrusted with financial
stability functions but without a supervisory mandate is far from satisfactory. The information
on the degree of interconnectedness that I previously mentioned is critical, even if only to
identify the key nodes of the financial system network which would need to be closely
monitored. So far, for the case of the ECB, systemic risk analysis is conducted solely on the
basis of publicly available information, mostly gathered from individual financial reporting.
The failure of Lehman Brothers just over a year ago illustrates well the relevance of such
inter-linkages between financial institutions. They may matter more than the size of their
balance sheets. And if those linkages are impaired, they can affect the functioning of the
entire financial system. In fact, before the crisis an increasing amount of overall risk in the
economy was perceived to exist, but there was little certainty as to where the risks lay. Few
suspected that the vast majority of them would be held directly or indirectly at key nodes of
the financial system network.
The spectacular growth in the securitisation and credit risk transfer market in the years up to
the crisis increased discussion of the potential vulnerabilities, in particular about who were
the ultimate holders of the risks originating in the banking system, and their capacity to
withstand shocks. These risks were transferred from the originators to various investors
outside the banking sector, from institutional investors to hedge funds, but also within the
banking sector itself. In fact, weaknesses in the so-called originate-to-distribute model
followed by most large banks, and fragilities in the funding of special investment vehicles and
conduits resulted in some of those risks backfiring and ending up consolidated on the banks'
balance sheets. The eruption of the turmoil left banks sitting on unwanted risks, such as
leveraged loans related to leveraged-buy-out transactions, (often referred to as warehousing
risk in the financial jargon), which were intended to be sold on to the market. Likewise, in the
structuring of collateralised debt obligations (CDOs), which were an extremely profitable
business for banks in the years before summer 2007, the banking system ended up
accumulating a considerable proportion of CDO tranches. As the crisis broke, these tranches
rapidly became a significant fraction of banks' impaired or so-called toxic assets.
Risk warnings
Let's get back to the European Systemic Risk Board. In addition to risk surveillance and risk
assessment, the ESRB will be entrusted with a third task - issuing risk warnings and policy
recommendations. This is somewhat new to the central banking community. The issuance of
risk warnings, in the context of safeguarding financial stability - where the analysis is centred
on the downside risks and thus on highly improbable events - differs substantially from other
types of analysis focused on a central, most probable, baseline scenario (such as the one
supporting monetary policy). The translation of systemic risk assessments into proposals for
concrete policy actions - of a prudential or supervisory nature - is also, to a large extent,
new to the central banking community.
3. What went wrong?
Confronted with the question of whether central banks and international bodies with financial
stability competencies saw the financial crisis coming, it would be fair to answer "Yes, to
some extent". Prior to the summer of 2007, in a number of official publications16, attention
was drawn to a number of growing vulnerabilities and potential risks such as:
•
the (then incipient) crisis in the US sub-prime mortgage market and its potential to
deepen and spread to other markets;
•
the fact that financial market liquidity could vanish abruptly when investor uncertainty
and risk aversion rose;
•
the role of hedge funds as key players, over the years, in fuelling liquidity in financial
markets, implying that a shock to the hedge fund industry would severely affect the
smooth functioning of some markets;
•
the excessive reliance of investors on the risk assessment of structured products
made by rating agencies;
•
the concentration of risks in the financial system, which was becoming increasingly
difficult to identify due to the proliferation of structured finance products and credit risk
transfer instruments;
•
the risk-bearing ability of the ultimate risk-holders in these chains.
However, it would be fair to say that few, if any - including market participants and public
authorities - were able to foresee the magnitude and severity of the crisis. In retrospect, it
became clear that the crisis was greatly intensified by a myriad of unknown connections and
interdependencies between financial intermediaries, within and outside the banking system,
including some non-regulated financial sectors. Sophisticated market participants and
investors were also apparently unaware of the degree of interconnectedness in the financial
system. Otherwise, their behaviour in the months leading up to the summer of 2007 might
have shown some anticipation of the developments (e.g. they might have seized some
contrarian investment opportunities).
In particular,
•
the magnitude of the large off-balance-sheet exposures of banks to the US
subprime-related structured finance products was widely unknown;
•
little information existed about the extent and implications of the activities of new
financial entities - conduits and other structured investment vehicles - which are
linked through management and liquidity arrangements to banks;
• the probability that the various intertwined vulnerabilities could materialise
simultaneously and combine in the way they eventually did was perceived as being
very close to zero;
•
the extent of inter-linkages between financial intermediaries and across markets was
not fully appreciated, and the possibility of tensions in one specific segment of the
credit market spreading rapidly to other markets and continents was not foreseen.
For more than two years now, we have been discussing the need for major improvements in
supervisory and regulatory frameworks to respond to the weaknesses that came to light as
the crisis unfolded. I will not address these issues again today. I will approach the question
from the point of view of central banks and ask: what inf