Ignazio Visco: Key issues for the success of macroprudential policies
Speech by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, at the Bank of
Korea-Bank for International Settlements (BOK-BIS) Conference on Macroprudential
Regulation and Policy, Seoul, 18 January 2011.
* * *
I would like to thank Paolo Angelini and Sergio Nicoletti Altimari for highly useful discussions and assistance.
1. Macroprudential objectives and tools
While the objectives of monetary and fiscal policies are clearly defined, and often precisely
quantified, the situation is less clear in the case of financial stability. A broad consensus has
emerged on the idea that "macroprudential" policies directed to preserving financial stability
should limit systemic risk by addressing both the cross-sectional dimension of the financial
system, with the aim of strengthening its resilience to adverse real or financial shocks, and its
temporal dimension, to contain the accumulation of risk over the business or financial cycle.
The first dimension seems to me to be of paramount importance. The second dimension
emphasizes the need to contain the pro-cyclicality of the financial system, i.e. to "lean
against the financial cycle".1 Other authors argue that policy should be assigned more
specific objectives, such as combating fire sales and credit crunches.2
A key problem is that, whether a broad or a specific mandate is chosen, we are still far from
an operational definition of these objectives. We do have an ample array of indicators and
early warning signals, but we still lack a coherent framework to interpret them, to assess the
need for macroprudential intervention, and to measure the success of the policies adopted.
While the notion implicit in all definitions of macroprudential objectives is that what warrants a
macroprudential regulatory intervention is systemic risk (a negative externality), systemic risk
presents a number of challenges to the policymaker. First, it is hard to measure, because of
its various dimensions: pro-cyclicality; network or contagion risk - the spillover effects of a
single institution's distress on the rest of the financial system; correlation risk, which reflects
the common exposures of all financial institutions to the same risk factors; concentration risk,
due to the presence of a few dominant institutions in key financial markets and activities.
Second, systemic risk may be extremely difficult to spot ex ante. For instance, in the late
1990s the hedge fund industry was considered a main source of systemic risk, and a
candidate for regulation, but this risk did not materialize. By contrast, the recent crisis
provides several examples of triggers that did have systemic consequences but were not
seen as crucial ex ante: the behaviour of certain insurance companies; the supposedly safe
mortgage market of the world's financially most developed system; the European sovereign
debt market.3
These difficulties in measuring systemic risk have important implications for the practical
implementation of macroprudential policy and for the accountability of the macroprudential
authority. As the new authorities start working, they will have to base their decision-making
on operational arrangements. The year that has just begun will be very important in this
respect.
Similar difficulties emerge in the definition of the appropriate macroprudential tools. Financial
crises are often associated with wide fluctuations in credit and asset prices. Recent analyses
indicate that such tools as countercyclical capital requirements or loan-to-value ratios can
attenuate the volatility of credit and asset prices and dampen the pro-cyclicality of the
financial system, helping to reduce the likelihood of financial crises.4 At the same time,
because systemic financial risk can emerge from many sources, different instruments may
be required, to be chosen case by case. Furthermore, instruments may be under the control
of different authorities, for example those responsible for microprudential, fiscal or other
economic policies. This might significantly add to the complexity of the policy process,
reducing its timeliness and hence the likelihood of success.
In Europe, responsibility for macroprudential policies has been assigned to a new body, the
European Systemic Risk Board (ESRB), within the context of a comprehensive reform of the
European supervisory architecture approved by the European political authorities in the
autumn of 2009 following an in-depth analysis conducted by the De Larosière Committee
and the European Commission. The reform also introduces a European System of Financial
Supervision (ESFS) comprising, besides the macro-prudential authority, three new European
Supervisory Authorities (ESAs) for the banking, securities and insurance sectors. The new
authorities started operating on 1 January 2011.
Regulation No. 1092/2010 of the European Parliament and of the Council assigns a broad
mandate to the ESRB, charging it with macroprudential oversight of the financial system
within the European Union in order to contribute to the prevention or mitigation of systemic
risks to financial stability in the Union.5 To this end the ESRB is to conduct analyses of the
European financial system, issue risk warnings and, when called on, make
recommendations, which it will submit to one or more member states or national supervisory
authorities, the EU Council, the European Commission and the newly established ESAs. It
will decide, after consulting with the Council, whether to make its recommendations public
and will monitor follow-up, informing the Council and the ESAs where it finds the action taken
to be inadequate.
The ESRB itself does not have direct enforcement power; it will act mainly through other
(European or national) authorities, essentially via an "act or explain" mechanism. Its lack of
direct enforcement powers is a key difference with respect to the arrangement in the United
States, where the new macroprudential body, the Financial Stability Oversight Council
(FSOC), is assigned direct intervention tools, including at the micro level. As the new
authorities begin working, it will be important to monitor how this difference influences the
policy outcomes. A key challenge for the ESRB is to ensure that its recommendations have
teeth, that the "act or explain" mechanism produces a good balance between the "act" and
the "explain". A second important challenge for the ESRB will be to ensure that
countryspecific and/or sectoral warnings or recommendations, when required, are adopted in a
timely fashion. The European experience of the last three years suggests that
recommendations of this type would probably have been more effective than general
recommendations to counter developments that turned out to have implications for European
financial stability. The complexity of the ESRB's structure might make it difficult to reach a
consensus on national recommendations. A third challenge for the ESRB will be to ensure
effective cooperation with the authorities of the new European System of Financial
Supervision.
2. Interaction between macroprudential and monetary policies
The objectives of macroprudential policies should be kept separate from those of more
traditional policies. There is consensus that there is no need to change central banks' current
mandate of preserving price stability over the medium term. The benefits of a sound
monetary framework have become more - not less - evident during the crisis. Had central
banks failed to control inflation, and inflation expectations, monetary policy would have had
much less room for manoeuvre.
However, the increasing emphasis on financial stability and macroprudential policies poses
challenges to monetary policy. Central banks should not have to stand by idly until a crash
occurs before intervening. There is evidence that a loose monetary policy can stimulate
excess risk-taking and leverage, or liquidity transformation, thus increasing systemic fragility
and ultimately putting price stability itself at risk.6 Just how this should affect the conduct of
monetary policy is still unclear. At the very least, however, we have learned that monetary
policymakers should be aware of these channels and monitor a broad range of indicators,
such as buoyant credit growth, increasing leverage of financial institutions and, in general,
leading indicators of financial instability. Some authors argue that monetary policy should
react to financial variables and more generally to leading indicators of financial distress.7
Over longer horizons there is no evident trade-off between price stability and financial
stability objectives - indeed, there are probably synergies. We need to lengthen the horizon
of monetary policy by taking into account the interactions and feedbacks between the real
and the financial sectors and the non-linearities that emerge especially during crises. Many
of the effects associated with financial and asset prices imbalances are likely to be highly
non-linear and complex. The reaction of monetary policy should then also be non-linear and
respond to asset price misalignments and financial imbalances. When the probability of a
crisis becomes non-trivial, the interest rate path towards ensuring price stability might be
different than in normal circumstances. These aspects are not well captured in the empirical
models currently used to support monetary policy decisions, and, I would argue, in the
prevailing flexible inflation targeting framework.8 There is a great need for further research to
overcome these limitations.
Monetary policy and financial stability policy interact and influence one another. Monetary
policy affects asset prices and credit, whose developments are crucial for financial stability,
6
Borio and Zhu (2008) argue that such a channel exists. Altunbas, Gambacorta and Marques-Ibanez (2010),
Maddaloni and Peydró (2010) find empirical evidence consistent with this channel.
7
See Woodford (2010), Cúrdia and Woodford (2010), and Lambertini, Mendicino and Punzi (2011), among
others.
8
On the contrary, it is generally accepted that a flexible inflation targeting (FIT) approach, if sufficiently forward
looking, should (perhaps informally) take account of the fact that "significant financial instability invariably will
also have a significant impact on activity and inflation" (Bean, 2003, p. 18). In practice, however, in the design
of monetary policy actions it might be very difficult to take account of developments that are subject to
considerable uncertainty and may materialize with long lags due to cumulative and non-linear effects of
financial imbalances. Since "the real world is generally complex and non-linear, [even] within a well specified
FIT framework, the implicit monetary policy reaction function would then also be non-linear (and possibly very
complex, as it would not be possible to rely on certainty equivalence)" (Visco, 2003, p. 24), Indeed,
considering a Taylor rule as a description of the normal conduct of monetary policy, I argued that for some
purposes a linear rule with the interest rate expressed as a function also of asset price misalignments could be
a simple and linear approximation (a Taylor "approximation", after Brook Taylor the mathematician, within the
Taylor "rule" introduced by John Taylor the economist!) of how central banks would behave (or perhaps should
have behaved) in a non-linear and complex environment.
and the propensity to take risks. At the same time, macroprudential policies will likely react
to, and affect, credit growth and asset prices, influencing the monetary policy transmission
mechanism. These interactions need to be well understood and taken into account in
formulating the two policies.
Two research projects recently carried out at the Bank of Italy have focused on the
interaction between monetary policy and macroprudential policy. The first study concentrates
on the recent housing bubble in the United States.9 The results indicate that a tighter
monetary policy by the Fed between 2002 and 2006 would have not been sufficient to avoid
the bubble. However, by appropriately combining a tighter monetary policy with additional
credit restraint by means of an aggressive use of countercyclical macroprudential tools,
policymakers could have dampened the housing boom. The second study suggests the need
for coordination between monetary policy and countercyclical macroprudential policy, to
avoid conflicts in the use of their respective instruments (e.g., interest rates and bank capital
ratios).10 While the benefits of such coordination are small in "normal" times, they can
become substantial when the economy is hit by financial shocks that severely impair the
ability of the banking sector to provide credit to the economy. In this case, it may be optimal
for the central bank to "lend a hand" to macroprudential policy, partly deviating from its
primary objective of price stability in order to improve the overall stability of the economy.
To what extent do countercyclical macroprudential policy and monetary policy have the
potential to affect the economy independently of each other? Answering this question
requires the development of new analytical frameworks. The ideal framework should be
simple enough to allow a proper understanding of the basic underlying mechanisms; at the
same time, it should be sufficiently realistic to permit the two policies to usefully coexist, at
least in principle. Clearly, this would be impossible in a very simple framework. For instance,
in a standard AS-AD New Keynesian model, the two policies would be perfectly linearly
dependent, as they both end up influencing the only control available to the policymaker, the
interest rate, either through open market operations or via the macroprudential instrument.
In one possible modelling of the two channels, suggested by Angelini, Neri and Panetta in
the above-mentioned Bank of Italy paper, monetary policy would set the level of the nominal
interest rate, as in standard models, while countercyclical macroprudential policy would
influence the differential between the interest rate on bank loans and the rate on deposits by
setting a capital ratio. Is this channel powerful enough to make a difference? Are there other
possible channels? In my view, these issues will require a substantial research effort.
In Europe, consistency between monetary and macroprudential policies should be ensured
by the structure of the ESRB, characterized by its close relationship with the European
System of Central Banks, which represents the backbone of the new institution.11 In practice,
29 of the 37 voting members are central bankers, so central bankers alone can ensure the
9
Catte, Cova, Pagano and Visco (2010).
10
Angelini, Neri and Panetta (2010).
11
The ESRB General Board is composed of the president and the vice president of the ECB, the governors of
the 27 central banks of the European Union, a representative of the European Commission, the chairs of the
three ESAs, the chair of the Advisory Technical Committee (an advisory body made up of the representatives
of all institutions participating in the ESRB) and three external members (the chair and the two vice-chairs of
the Advisory Scientific Committee, a new advisory body made up of experts), all with voting rights. In addition,
the representatives of the national supervisory authorities and the chair of the EU Economic and Financial
Committee (EFC) will participate to the meetings without the right to vote. The chair of the ESRB is assigned
to the president of the ECB for the first five years (for subsequent mandates possible amendments to this
provision will be assessed by the European Parliament and the Council by December 2013). A Steering
Committee is in charge of preparing meetings and ensuring efficient ESRB operations. The Steering
Committee consists of the ESRB chair and vice-chair, five central bank members of the ESRB, the chairs of
the ESAs, the chair of the EFC and the Commission member.
simple majority required for General Board approval, as well as the qualified majority of two
thirds required to adopt a recommendation or to make a warning or recommendation public.
The scope for potential conflicts between policies should also be limited to the extent that the
tools and actions of macroprudential policies are normally more selective, sectoral and
geographically defined. For example, dealing with house price booms in a region or country
in the currency union will be an issue for macroprudential policy; a generalized credit boom,
on the other hand, will likely be a matter of concern for monetary policy as well.
3. Interaction between macroprudential and microprudential policymakers
A number of practical examples show that microprudential tools (capital and liquidity
requirements, loan-to-value ratios, etc.) may be appropriately calibrated to serve
macroprudential goals as well. If the tools are broadly the same but must serve two purposes
and be used by two different authorities, the potential for conflict arises. It is not hard to
imagine a scenario of economic downturn in which the macroprudential regulator would want
to run down the equity buffers built up during good times in order to avoid a credit crunch,
while the microprudential regulator, concerned with preserving the safety and soundness of
individual institutions, might be reluctant to let that happen.
Overall, there are both strong complementarities between macro and microprudential policies
- it is hard to imagine the success of one policy without the success of the other - and
potential short-term conflicts and overlaps. Whatever the institutional arrangements, it is
crucial to ensure a continuous exchange of information and to set up well-defined
mechanisms to resolve any conflicts between the two functions.
From this viewpoint, the US system appears well-designed. In Europe, the interaction
between macroprudential and microprudential authorities may be relatively complicated: the
latter include the Basel Committee, the European Banking Authority, the other European
supervisory authorities and the national supervisors. Cross-participation in the governing
bodies of the different authorities should limit coordination problems, but it is clear that the
European regulators will be called upon to make efforts in this direction. Indeed, a proposal
for a Memorandum of Understanding among the ESRB and the ESAs on the division of
responsibilities between micro and macrosupervisors is now being discussed.
Access to micro data may be problematic for the ESRB. Successful analysis will probably
require the ESRB and its Secretariat to act as a hub, devising meaningful projects,
decentralizing much of the analytical work to national authorities, and ensuring harmonization
of the research protocols.
4. Coordination among macroprudential bodies
The new macroprudential regulatory framework will feature a primary role at the global level
for four "global" players - the IMF, the Financial Stability Board (FSB), the ESRB and the
FSOC - and for a number of national macroprudential authorities. Effective action will require
a stepped-up interaction and cooperation among these authorities.
The IMF and the FSB are developing a monitoring process (the so-called Early Warning
Exercise) that permits a more integrated and comprehensive view of emerging global
developments and the corresponding risks. Using an integrated macro-financial and
regulatory perspective, the process should provide a first example of an organized, structural
attempt to identify and prioritize systemic macro-financial risks at global level and to propose
policy responses. The ESRB will also conduct a regular assessment of systemic risk and,
when necessary, translate it into recommendations for the adoption of mitigating policies.
The potential for overlap seems ample. Given the global mandates of the FSB and the IMF,
effective collaboration could have these two organisations focussing on the analysis of
linkages and contagion channels across the main macro areas and on developing policy
options to contain spillover risk. The ESRB, the FSOC and analogous national and regional
institutions elsewhere could focus on sources of risk arising within their jurisdictions and
devise policy measures to address domestic developments. The coming years will be crucial
to assess the functioning of the new framework and to minimize potential inefficiencies.
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