27.04.2021
Financial stability and macroprudential policy: objectives, tools and
challenges*
Universidad de Zaragoza
Pablo Hernández de Cos
Governor
*English translation of the original speech in Spanish
Distinguished Rector of the University of Zaragoza, Distinguished Dean of the Faculty of
Business Economics, academic and other authorities, ladies and gentlemen. Good morning.
It is an honour and a pleasure to be able to participate in this event organised by the
University of Zaragoza. I should like to begin by expressing my gratitude to Vicente Salas,
Chair of Business Economics at this University and the promoter of this meeting, who was
linked for many years to the Banco de España in various capacities, as an economic adviser
and as a member of our Executive Commission and our Governing Council. Over these
years of intense collaboration, he played a pioneering role in theoretical and empirical works
on the subject to which I wish to devote my address today: financial stability and
macroprudential policy. In these papers he did not confine himself solely to studying
various aspects relating to the financial system, but also devoted much of his research to
analysing the interaction between the financial sector and the real economy, especially as
far as firms are concerned. As I shall attempt to convey in my address, this interrelation is
one of the key distinguishing characteristics that warrant and condition macroprudential
policies.
Financial stability is of fundamental significance for society's well-being. This is why all
countries have institutions entrusted with ensuring financial stability is maintained and, in
particular, with taking macroprudential policy decisions. In Spain's case, and in relation to
the banking system, it is the Banco de España -as part of the related European
mechanisms- that performs these functions.
Financial stability and macroprudential policy
The financial system plays a key role in the economy - namely financial intermediation -
which, moreover, affects all sectors: households, firms, government, financial firms
themselves, etc. The markets and intermediary companies that comprise the financial
system raise funds from economic agents with surpluses (savers) and distribute them
among those that need to finance investment projects or consumption decisions (debtors).
Hence the name financial intermediation, since the financial system acts as a bridge
between savers and debtors.
Hence, by "financial stability" we understand that situation in which the financial system is
capable of withstanding shocks without disruption to the financial intermediation process
on a sufficiently serious scale as to adversely affect real economic activity.
Given the importance of this intermediation, our modern societies have equipped
themselves with a regulatory and supervisory framework for banks and financial activities
that seeks to ensure financial stability.
In this respect, before the global financial crisis that struck the world economy more than a
decade back, it was considered that, to achieve the objective of a sound, safe and stable
financial system, it sufficed to ensure the solvency of each financial institution individually.
That is to say, financial regulation and supervision remained within the domain of so-called
"microprudential policies", decided upon and applied to each individual bank. Monetary
policy (pursuing price stability) and fiscal policy (seeking budgetary stability) were, for their
part, entrusted with managing the economic cycle.
However, the global financial crisis and its high cost in terms of economic activity,
employment and public debt prompted the reconsideration of this paradigm. It should be
borne in mind that the crisis came about owing to the build-up of previous imbalances,
whose correction entailed a considerable loss of well-being for society. There was a
macroeconomic dimension to these imbalances, which were concentrated in the financial
sector, highlighting how the microprudential approach, bank by bank and market by market,
was clearly insufficient to ensure the stability of the system as a whole.
This is what is known as the "fallacy of composition".1 Indeed, on occasions, bank
managers' decisions can be optimal from an individual perspective, but are not so once the
effects on the system as a whole through the numerous interconnections between the
different intermediaries and financial markets are taken into account. It was thus deemed
necessary for economic policymakers to have an additional set of instruments for attaining
the goal of (macro-) financial stability enabling them to incorporate this aggregate view.
As to their specification, a key principle that should be followed in economic policy design
is that each of the authorities' targets should have a differentiated instrument to avoid any
clash between them (the so-called "Tinbergen principle"2). The aim of maintaining financial
stability with this aggregate perspective therefore demanded having one's own tools.
And, given that financial conditions can amplify the fluctuations of the economic cycle (e.g.
more extreme and volatile movements in output prices, making it more difficult for agents
to foresee their future economic situation) and also macroeconomic imbalances (e.g. activity
highly concentrated in sectors that are not the most productive), a macroprudential
approach to financial system regulation and supervision can conceivably mitigate the
accumulation of these types of risks or reduce the cost of their subsequent materialisation.
Specifically, macroprudential policy is entrusted with ensuring the soundness of the financial
system in the face of systemic risk. This is, namely, the risk that financial instability becomes
so widespread that it hampers the functioning of the system to the extent that economic
growth and the welfare of the population are adversely affected.
The "macro" prefix to this policy thus refers, on one hand, to the fact that it adopts an
aggregate approach for the financial system as a whole; and, on the other, that it seeks to
regulate the financial cycle, since this may amplify the economic cycle. The "prudential"
suffix, for its part, refers to the fact that it has to act pre-emptively; it will seek firstly to
mitigate the accumulation of systemic risk or its potential materialisation, and secondly to
generate buffers (mainly capital buffers in the case of banks) enabling the impact of systemic
risk, should it materialise, to be cushioned.
The multi-dimensional nature of systemic risk
One characteristic of macroprudential policy is the multi-dimensional nature of its objective:
to prevent systemic risk. Theoretical and empirical research appear to concur that there are
at least two dimensions to this risk which, moreover, can interact with each other.
The first is the time dimension, which is related to how systemic risk evolves over the course
of the financial cycle. A good example of this dimension can be found in the run-up to the
global financial crisis. During those years, there was strong growth in credit to the
nonfinancial private sector in Spain (in particular to real estate development and construction
activities), attaining levels far above those considered sustainable. This situation was
accompanied by price rises and increases in real estate market activity, also to
unsustainable levels.
Against this background, household and corporate debt associated with real estate
transactions mounted to such an extent over time that, when its sustainability was
questioned and financing ground to a halt, there was a sharp correction to these financial
imbalances. This correction had a considerable cost in terms of GDP and employment,
directly affecting the losses the financial system would have to address and which had only
been but partly expected in the prior expansionary phase.
The second is the cross-sectional dimension, through the various intermediaries making up
the financial system. This dimension derives from specific structural characteristics of the
financial system that may amplify the impact of any shock to it. Indeed, the financial system
is made up of highly heterogeneous institutions, in terms both of size and complexity. In
turn, these institutions are very closely interconnected, both through direct exposures in the
interbank market and indirect exposures: exposure to the same economic sectors or even
to the same agents (firms or the public sector).
Both the diversity of the players and their close interconnectedness notably improve the
efficiency of the system, since they provide maximum specialisation in risk management.
But they are also a cause of vulnerability, since the potential difficulties of one institution
can swiftly pass through to the rest. This is particularly the case for banks of greater
systemic importance, whether because of their size, their complexity or their central position
within the system.
One of the best examples of the importance of this dimension for systemic risk is also to be
found in the global financial crisis. The US insurance company AIG had not been a major
originator of sub-prime mortgage loans. However, it had sold financial insurance
instruments against the potential default of the securitisations of these loans (CDSs) to its
clients, who were, above all, other financial institutions. The contagion effect to the rest of
the financial system that the bankruptcy of AIG would have caused was on such a scale
that it led to its bailout by the US authorities. But the mere expectation of this type of bailout
can affect managers' risk-taking decisions in periods of expansion, which may be excessive
precisely because they expect to be bailed out in the event of difficulties. This is the
wellknown "too big to fail" problem.
The multi-dimensional nature of systemic risk means that macroprudential policy needs an
extensive range of tools (or instruments) to allow it to tackle each of those dimensions as
efficiently as possible. Moreover, given that a wide variety of institutions with greatly diverse
characteristics operate in the financial sector, these instruments should be adjusted to their
particularities.
In this respect, the significant interconnectedness of these financial system players calls for
an all-encompassing overview when taking macroprudential policy decisions. And this
requires close coordination among key institutions if, as in Spain, the oversight of the
financial system is shared by different national [Banco de España, CNMV (National
Securities Market Commission) and the Directorate General of Insurance and Pension Funds
of the Ministry of Economic Affairs and Digital Transformation] and European authorities.
No less important is the need for international coordination. In Europe, we are moving
towards the Banking Union and the Capital Markets Union, with ever-increasing financial
interconnectedness. Worldwide, the importance of global financial flows is very high and
growing. Indeed, some researchers have noted the presence of a global financial cycle that
may condition decisions taken at the national level [Rey (2015)].
The institutional design of macroprudential oversight
The starting point for talking about macroprudential policy is the regulatory reform in the
banking sphere, which was launched globally by the G-20, the Financial Stability Board
(FSB) and the Basel Committee on Banking Supervision (BCBS) between 2008 and 2014,
and which culminated in the regulatory framework known as" Basel III".
Against this background, the Banco de España was designated as the authority entrusted
with defining macroprudential policy in relation to Spain's banking sector. Spain has,
moreover, another two sectoral prudential supervisory authorities: the National Securities
Market Commission (CNMV) - whose remit covers financial markets, investment services
companies, investment funds and other collective investment vehicles, among others - and
the Directorate General of Insurance and Pension Funds of the Ministry of Economic Affairs
and Digital Transformation. The General Secretariat of the Treasury and International
Financing, which reports to this latter Ministry, is responsible for the implementation of
financial regulation in Spain, including that stemming from the transposition of European
Union (EU) directives in this area.
To coordinate all these institutions, the Spanish macroprudential authority (AMCESFI) was
created in 2019. AMCESFI is structured as a collegiate body in which the senior officials
from the aforementioned institutions participate. It is entrusted with the oversight of the
financial system as a whole, acting in an advisory capacity with respect to the proposed
macroprudential measures put forward by the sectoral authorities.
The need for coordination in this field is also very necessary at the supranational level, and
in particular in Europe since the creation of the Banking Union, which centralises at the
European Central Bank (ECB) the supervision of the significant banks in the 21 EU
countries.3
In this respect, although decisions on macroprudential instruments in Europe are in the
hands of national authorities, the ECB scrutinises these national banking authorities'
proposed macroprudential policy measures to ensure that they are consistent across the
euro area countries. In particular, the ECB is empowered to tighten the measures applied
by national authorities to specific instruments envisaged in Community banking legislation.
The European Systemic Risk Board (ESRB), on which the heads of the EU central banks
and regulatory and supervisory authorities for banks, securities, insurance and pension
funds sit, has been in place since 2011. The ESRB, whose Advisory Technical Committee it
is my honour to chair, has macroprudential oversight functions and is empowered to issue
opinions, warnings and recommendations on matters relating to the emergence of systemic
risks, and the suitability of macroprudential measures proposed at the national level.
At the global level, the BCBS (in the banking sphere) and the FSB (in relation to the financial
sector as a whole and its interconnections) play a crucial role as promoters of regulatory
standards that the relevant authorities of the main jurisdictions in the G-20 area undertake
to adopt so as to have common rules in place for the international financial system.
In the macroprudential realm, under the coordination of the FSB, the BCBS developed the
countercyclical capital buffer in 2010 and the framework for identifying and setting
macroprudential buffers for global and national systemically important institutions (2011 and
2012, respectively). These were included under the Basel III regulatory framework, which is
the basis for the banking prudential regulations in force in Spain and in the EU. These tools
are currently the backbone of macroprudential policy.
The Banco de España participates actively in these institutional arrangements, as a member
of the various national and international bodies and fora that I have described. Further, it is
responsible for identifying the risks to the financial stability of the Spanish financial system
and deciding how and when to use macroprudential tools at credit institutions.
Macroprudential tools and credit institutions
As indicated, the multi-dimensional nature of systemic risk calls for various macroprudential
tools so as to be able to address each of these dimensions as efficiently as possible. I shall
now describe these tools distinguishing, for the purpose of my address, between those that
affect the capital requirements on credit institutions and those that fall on borrowers.
Macroprudential tools that affect the capital requirements on credit institutions
The banking regulations in force require banks to have sufficient capital set aside to cover
unexpected losses and to maintain their solvency in the event of a crisis. The amount of
capital required depends on the risk linked to a specific bank's assets and, in fact, is
expressed as a percentage of risk-weighted assets. The concept of risk-weighted assets
basically means that a lower capital allocation is attributed to the safest assets, while the
riskiest assets are assigned a greater risk weighting. In other words, the riskier assets are,
the more capital the bank will have to hold in reserve. In parallel, specific grades are
assigned to capital, depending on its quality and on risk.4
First among the macroprudential tools made available to the authorities is the possibility of
directly influencing credit institutions' capital by means of requirements additional to the
traditional microprudential capital requirements. This greater requirement of capital
increases banks' loss-absorption capacity and, moreover, influences their appetite for risk,
given that the losses that shareholders must bear in the event of difficulty ("skin in the
game") increase as a result.
If they are to function correctly, these additional capital requirements must be activated
when banks begin to build up risks, and they must be drawn down when risks abate or when
they materialise.
In short, when a macroprudential capital buffer is activated or increased, banks5 might
consider the following options to comply with these new requirements:
a) increase the net interest income arising on customer charges, generate more
profits and retain a portion of them;
b) maintain profits, but reduce dividend payments;
c) issue new shares and raise additional funds, or
d) reduce risk-weighted assets.
The first three alternatives would tend to exert upward pressure on the interest rates on
loans granted by banks. These higher interest rates mean that fund-seekers will resort to a
lesser extent to financing in their spending decisions, whereby the volume of lending and,
therefore, the risks borne by the financial system will diminish. Moreover, this increase in
interest rates will reduce household consumption, and firms will also invest less, which will
further reduce the demand for credit. In parallel, real and financial asset prices will adjust
downwards, reducing the value of the collateral for credit transactions.
Under the fourth option (the reduction of risk-weighted assets), it is the volume of credit
made available by banks that is directly and adversely affected, moderating once again
consumption and investment, and asset prices. Logically, the reduction in or release of
these requirements would have the opposite consequences.
Depending on the intensity of the increase in capital adopted, and on the economic
environment into which it is introduced, banks might choose one or another option, or a
combination thereof. For example, the empirical evidence suggests that banks resort to the
first three options especially in expansions, when available liquidity and financing are
abundant and, in general, when risks are being built up. The fourth option is chosen
especially in recessions, crises or situations in which systemic risk is materialising.
Consequently, the activation of capital tools in phases in which risks are accumulating will
influence credit institutions especially via the increase in the cost of lending. By contrast,
the deactivation of these tools when systemic risk is materialising or being mitigated might
help sustain the supply of credit by banks.
When these tools are used to tackle the time dimension of systemic risk, they are normally
applied countercyclically to the entire banking system. Thus, capital requirements would
rise in expansionary phases of the credit cycle and fall in recessionary periods, using a series
of benchmark financial cycle indicators. In fact, this tool is known as the "countercyclical
capital buffer" (CCyB) and, as with the other two I will now describe, it was introduced into
Spanish banking regulations further to the transposition of the European capital
requirements legislation which, in turn, is the application of the Basel III Accord in the EU.
The tools designed to address the cross-sectional dimension of systemic risk are more
geared to last over time, whereby they tend to be more stable throughout the financial cycle.
The first is the buffer for systemically important institutions (at the global or national
level), which is applied exclusively to those banks previously identified as capable of
destabilising the system if they run into financial problems. The greater aggregate risks
associated with these institutions warrant demanding of them some extra protection against
shocks.6
Systemic institutions are identified following standardised methods both globally and
locally. Specifically, the FSB and the BCBS globally coordinate the exercise involving the
definition of global systemically important institutions. This exercise uses a methodology
based on weighted metrics of various bank variables, such as size, complexity,
interconnectedness, ability to replace their activities and volume of cross-border activity.
The Banco de España, meanwhile, annually conducts an exercise to identify systemically
important institutions at the national level, using a standardised European methodology very
similar to that used at the global level.
The second tool to mitigate the cross-sectional dimension of systemic risk is the so-called
"systemic risk buffer" (SRB), intended to tackle those risks not covered by the other
buffers. The SRB can be applied to the banking system as a whole, to a sub-set of credit
institutions or to one or several sectors of economic activity. Its main characteristics are the
extensive range of risks for which it can be used, and the discretionality and flexibility its
use allows.
Macroprudential tools falling on borrowers
Secondly, macroprudential instruments consist of establishing restrictions on one or several
of the characteristics of loans granted to debtors. For example, the percentage that a loan
represents relative to the collateral backing it or to the borrower's income can be limited,
and the maturity of the loan can be time-limited.
The evidence we have shows that lending standards have a very significant impact on the
risk of ex-post default by borrowers, in the sense that looser standards (e.g. a higher
percentage of the loan relative to the collateral backing it) increase that risk [see Galán and
Lamas (2019)]. These restrictions thus operate by strengthening the borrower's solvency
and, thereby, limiting the potential losses that banks would subsequently have to bear.
These restrictions are solely applicable to banks' new lending business; hence, immediately,
their introduction causes banks to restrict the supply of credit. And this prompts an
immediate effect on households' and firms' consumption and investment decisions. These
agents will presumably reduce their level of spending and, consequently, their demand for
credit. Also, financial and real asset prices will be adversely affected by the lower level of
spending and by the expectations channel, reducing the collateral available. These effects
feed into each other, further reducing credit supply and demand.
Selecting the specific characteristic of loans that will be subject to limits at each point in
time will depend on the situation we are in; in particular, on the level of and developments
in loans already granted. This is without ruling out the possibility that limits will have to be
set on several characteristics simultaneously, since the evidence available shows that, when
easy conditions are observed in several of these characteristics, there is usually a more than
proportionate increase in the probability of default. Moreover, when only one of the
characteristics is limited, it is usual for another characteristic to become looser, lessening
the impact of the limit imposed [see, for example, Tzur-Ilan (2017)].
This type of tool is not harmonised at the international level or in the EU, and some countries
use them mainly on mortgage loans to households. The Banco de España is shortly to
approve a circular in which it will make these tools operational, following the mandate
granted by the legislators. In our case, these tools may also be applied to loans to firms, in
line with best international practices.
Macroprudential policy and monetary policy
This description of how macroprudential tools operate highlights the fact that, although
monetary and macroprudential policy do not, a priori, share the same objectives, they do
share certain transmission mechanisms, such as the bank lending channel. In this respect,
monetary and macroprudential policy decisions generate interconnected effects, which may
boost or counter one another.
Specifically, monetary policy can promote financial stability through different channels. For
example, at times of credit exuberance, a restrictive monetary policy would reduce the
demand for credit and the level of risk assumed by agents [see, for example, Borio and
Lowe (2002)]. It might also tighten financing conditions on markets and temper the prices of
financial and real assets, many of which comprise the main collateral for credit transactions.
Logically, given the nature of monetary policy, its effects would be aggregated, without
being able to discriminate between agents or markets. When risks materialise, in recessions,
an expansionary monetary policy would help debtors to meet their financial obligations, it
would improve banks' financing conditions and it would reduce the downward pressure on
financial and real asset prices.
Effectiveness in the transmission of monetary policy, i.e. central banks' capacity to influence
the private sector's financing conditions, largely depends on financial stability. For example,
if banks do not have sufficient solvency levels, they may not be capable of passing changes
in money market interest rates through to their customers, or may pass them through
excessively. In this respect, financial stability may be said to be a de facto pre-requisite for
ensuring price stability.
Macroprudential policy can also increase an expansionary monetary policy's room for
manoeuvre if the latter is beginning to induce excessive risk-taking by certain agents or
markets. In this case, the activation of macroprudential instruments, which are more
selective and can affect certain agents alone, may enable the expansionary monetary policy
stance to be maintained, by smothering the increases in risks in specific sectors. This is
particularly important in the euro area, where monetary policy is determined at the
supranational level by the ECB taking into consideration the area as a whole, whereas
macroprudential policy remains under the national remit.
But nor must we exclude situations in which the objectives of the two policies may clash.
For example, in the expansion prior to the international financial crisis, the relatively
expansionary monetary policy stance contributed to the accumulation of macrofinancial
disequilibria. Had these macroprudential tools then been in place, they could have been
activated to counter some of the monetary policy effects on the risks to the financial
system's stability.
In short, we cannot ignore the interaction between these two policies. Thus, while each
policy must act on the basis of its individual objectives, the consequences each has for the
other should be taken into account.
Macroprudential policy in practice
identification and monitoring of systemic risk
Timely activation of macroprudential tools calls for indicators that enable the risks arising in
the financial system to be monitored and which, in parallel, allow the use of the instruments
and their effects to be calibrated.
In particular, these indicators should be capable of capturing the financial cycle. The
literature has identified various indicators that can play this role. For example, Terrones et
al. (2011) consider three main variables on the basis of which these indicators can be
calculated: credit to the non-financial private sector, house prices and stock market prices.
Thus, in the case of the CCyB, current regulations give a special role to the credit-to-GDP
gap (also known as the "Basel gap"). This indicator measures the difference between
financing received by the non-financial private sector as a percentage of GDP and its
longrun equilibrium trend, estimated using statistical procedures. Positive credit-to-GDP gap
values would indicate that we are in the expansionary phase of the financial cycle, since the
volume of credit, once the economy's level of income is taken into account, stands above
its equilibrium level. Consequently, activating the CCyB or increasing it might be considered.
Negative values would denote a contractionary phase in the financial cycle, whereby the
CCyB should be deactivated under normal conditions.
Along with purely statistical procedures, the estimation of the long-term equilibrium level of
the non-financial private sector's long-term financing that the calculation of these indicators
requires can be done using models that include the determinants of the demand for credit
[Galán y Mencía (2021)].
In any event, the decision to activate the CCyB, which is reviewed quarterly, should not
follow an automatic rule based on the trend of this indicator; rather, the regulations in force
emphasise the need to take other complementary indicators into account. The Banco de
España also tracks potential imbalances in house prices, and in the current account
balance, among others. This latter variable reflects how in small, open economies, when the
financial cycle is in expansion, a portion of this financing is usually obtained abroad,
consequently materialising in a current account deficit. It is moreover crucial to analyse the
sectoral disaggregation of credit indicators to identify risks that may be originating in
specific sectors. Lastly, we pay particular attention to the output gap, which I will discuss in
greater detail later.
As to the cross-sectional dimension of systemic risk, the key indicators seek, inter alia, to
measure the relative size of a bank, its centrality in the national banking network, its
interconnectedness to the rest of the financial system and to other countries' financial
systems, and the complexity of the activities it pursues.
As I mentioned, a composite indicator of all these metrics is what enables us to construct
systemic significance scores that are used as a reference to determine the calibration of the
percentage of the capital buffer required of each systemic institution. Some of these
indicators may also prove useful in determining the activation of the SRB.
The effectiveness of macroprudential tools
The degree of complexity entailed by any impact analysis of economic policy measures
increases in the case of macroprudential instruments. This is due to several factors. First,
experience of their use is still very limited. Further, given that their objective is
multidimensional, different metrics must be considered to evaluate them. Moreover, the
necessary cost-benefit analysis of the measures poses complications. While the costs of
activating the tools are immediate (e.g. in terms of reduction in the growth of credit and of
GDP), the benefits arise in the long term and are very difficult to verify (e.g. they are derived
from having avoided a systemic crisis).
In practice, the effectiveness of macroprudential instruments has been tested in many ways;
e.g. by analysing whether they significantly impact developments in credit, house prices,
banks' interconnectedness, the composition of their credit portfolio, etc. [see, for instance,
Jordá et al. (2021)]. That is to say, analysis is made of the impact on the indicators used to
measure developments in systemic risk. Their effectiveness has also been studied by
assessing whether they have helped reduce the likelihood of a systemic crisis [BCBS
(2010)], a bankruptcy of a bank or group of banks and debtor default [Galán y Lamas (2019)].
But only on limited occasions has there been a cost-benefit analysis of the application of
these measures in terms of their effects on GDP. More recently, researchers have begun to
assess the differential effects of activating as opposed to deactivating macroprudential
instruments, since their impact may be asymmetrical [Jiménez et al. (2017)].
A methodology has recently been developed which allows an integrated analysis of these
aspects to be performed. Specifically, Adrian et al. (2019) has developed the concept of
Growth at Risk, the aim of which is to analyse the impact of the instruments on the
distribution of expected GDP growth at different horizons. In that way, the impact not only
on a baseline scenario (the most likely, characterised by the 50th percenti