Erkki Liikanen: Macroprudential policy in Europe and the world -
challenges, experiences and institutional structures
Remarks by Mr Erkki Liikanen, Governor of the Bank of Finland, at the First annual ECB
macroprudential policy and research conference, jointly organised with the International
Monetary Fund, Frankfurt am Main, 27 April 2016.
* * *
Macroprudential policy - goals and definitions
Before the Global Financial Crisis, the term "macroprudential" was not commonly used even
among experts. Organisations such as the IMF, and notably BIS, may take credit for its early
projection.
The concept has now of course received much more attention among experts after the
financial crisis. In this conference, for example, we have been analysing macroprudential
issues from different angles. There have been many insightful presentations yesterday and
today. To mention one, my colleague Vitor Constâncio yesterday presented six guiding
principles of macroprudential policy in his interesting speech.
Still, "macroprudential policy" or its sister-term "systemic risk" are hardly "household names".
My recent experience with the editorial process of a book chapter that I wrote suggests that
these terms are not established. (The experienced language consultant used by the
publisher had marked the words "macroprudential policy" and asked: "Is it widely known what
it means? and the words "systemically important banks" in my text and asked: "What are
these?"). So I agree with Don Kohn about what he spoke about communication.
We must keep in mind that we have entered a new important area of policy, with its own
terminology, which is unfamiliar to the public. For legitimacy and accountability, we have to
make sure that we explain and talk about these new things to the public in a comprehensible
manner.
The experts are also still in search for the best definitions of macroprudential policy and
systemic risks. In general terms, macroprudential policy can be understood as measures to
control systemic risks which can threaten financial stability.
Judging by the recent literature, we can think of at least two concrete objectives of
macroprudential policy.
According to the first objective, the goal of macroprudential policy is to control the effects of a
credit crunch or, more generally, a large-scale balance-sheet contraction of financial
institutions on the society.1
According to the second and perhaps more ambitious objective, the goal of macroprudential
policy is to prevent an excessive build-up of risks in the financial sector as a whole. In other
words, it is about mitigating the financial cycle especially in booms.2
Below I will mainly focus on the second objective.
As we focus on the prevention of excessive build-up of risks in the financial sector, it is
essential to note that macroprudential policy complements microprudential policy. Both use
the same tools, especially capital requirements. But macroprudential policy also uses other
tools such as loan-to-value caps.
When defining the confines of macroprudential policy, it is also important to understand its
relationship with monetary policy. In the long term, financial stability is a prerequisite for price
stability. Hence the two policy areas are clearly intertwined.
However, in the short- and medium-term the economic cycle and the financial cycle can
behave quite differently. To deal with the latter, a separate set of macroprudential policy
instruments is needed. This way the two policy areas can best advance their common
longterm interests.
Next I will talk about
1. the challenges of macroprudential policy in the current juncture and especially in the
European context.
2. To illustrate the current challenges, I will also look back to history in Finland in the
late 1980's, few years prior to the dramatic banking and financial crisis of Finland in
the early 1990s, and
3. try to draw some macroprudential lessons of those experiences for today ́s
policymakers.
4. I will finish by discussing the emerging challenges from the growing shadow banking
activities, and draw some conclusions.
Challenges of macroprudential analysis, policy, and implementation
Successful macroprudential policy is a sum of three things: 1) good and timely analysis,
2) sufficient and effective policy instruments (tools), and 3) effective implementation.
We are on our way in Europe to get this done. Still a number of challenges can be identified
in each of the three elements.
The analytical challenges come in two parts.
First, this has been a timely conference. We must admit that academic research still has a lot
to do in terms of developing better models and establishing empirical facts. One contributing
factor to the global financial crisis may even have been the scarcity of systemic risk elements
in leading macroeconomic models used in policy work prior to the crisis. Promisingly, that
gap has now started to narrow.
Second, macroprudential analysis faces an imminent challenge in improving our
understanding of the potential risks to financial stability involved in the current low interest
rates environment and the use of unconventional monetary policy measures. For example,
there are again potential risks related to "searching for yield" and the related migration of
banking-like activities to the less regulated shadow banking sector. I will return to this below.
Concerning macroprudential policy instruments, the set of necessary tools for the banking
sector is already at the disposal of competent authorities. On the other hand, we may lack
sufficient tools to address potential systemic risks in the less regulated shadow banking
sector.3
High-quality analysis and a well-designed toolkit need to be complemented by the third
element of successful macroprudential policy: a timely and forceful implementation of the
appropriate policies. The implementation may be particularly challenging because of three
types of implementation lags.
First, there is often a lag between the build-up of systemic risks and the observation of those
risks, especially when the risks develop outside of the radar of supervision, as they have
often done.
Second, macroprudential policymakers may not have the necessary tools to address the
identified risks. In most countries, the available macroprudential tools and the limits on their
use are given by the national legislation. Usually, a lengthy legislative process is needed to
add any new tools into the toolbox.
Third, similar to many other policies, there is a lag between the point of time at which some
macroprudential measure is taken, and the time at which the measure will start to have an
impact.
A case study of macroprudential policy implementation: Finland in the 1980's
To illustrate the difficult challenges in macroprudential policy implementation, let me make a
brief digression to the financial history of Finland.
The deregulation of the Finnish financial markets took place in 1986 and even before. In the
spring of 1987 I became the Minister of Finance. In autumn 1987, the rate of growth of
lending rose above 15 %. By summer 1988, the growth rate had surpassed 25 %. At the end
of 1988, the growth rate was a stunning 31 %
In a hindsight, Finnish policymakers reacted much too slowly to this increase in lending.
Why?
1. The Bank of Finland was reluctant to return to the old days of administrative
regulations. In addition, the central bank had no statutory right in Finland to demand
cash reserve deposits from the banks.
2. The Ministry of Finance proposed to end the tax-deductibility of interest expenses.
This was heavily opposed by political parties. Some gradual progress was made,
but it was too modest.
3. And of course, the macroprudential tools of today - like the Countercyclical Capital
Buffer requirement or the loan-to-value cap - were not available then. And
obviously, there was no designated authority with the macroprudential mandate.
Finally, in late 1988, the Ministry of Finance proposed a solution in which a ceiling would be
imposed on the growth of lending and a progressive tax imposed on lending in excess of that
amount.
The Bank of Finland first regarded the proposed tax as a return to a repressive regulation.
But finally it used the proposed tax as a threat to pull the banks into a voluntary agreement
that gave the Bank of Finland a right to raise the cash reserve requirement of banks to a
maximum of 12 %. This would be an additional non-interest bearing deposit requirement,
which would be imposed on the whole banking sector on the basis of combined credit
growth.
Ultimately, this system of supplementary non-interest bearing cash deposits had the desired
cooling effect on bank lending. While the agreement was in force in 1989, lending grew at
less than a half the rate of 1988. But, as you know, it was too late.
The experience illustrates that macroprudential policymakers need to have the necessary
tools and mandates well in advance of any trouble. It is too late to build the tool-set in the
middle of the crisis.
Our experiences also demonstrate that policymakers need to be aware of the costs of
macroprudential inaction. A rapid rise in, say, house prices may serve both politicians and
house-owners in the short-term. But, in the longer term, everybody hurts from the
policymakers' failure to act.
The European framework for macroprudential policy
The macroprudential framework in Europe and in the euro area is specifically tailored to
reflect the European institutional features and financial architecture.
As elsewhere in the world, also in the European countries the national macroprudential
authorities play the key role in macroprudential analysis and policy-decisions: they are, or at
least should be, best informed of the cyclical and structural macroprudential risks and
vulnerabilities in their countries.
In the countries belonging to the banking union, the macroprudential powers are shared
between national designated macroprudential authorities and the European Central Bank.
More specifically, the ECB has a right to apply stricter requirements for certain
macroprudential tools than those proposed by the national macroprudential authorities.
The role of the European Systemic Risk Board (ESRB) is, in turn, to monitor cross-border
and cross-sectoral systemic risks in the whole EU area, and provide macroprudential
warnings and recommendations to national authorities and European bodies. Last but not
least, the European Capital Adequacy framework (CRD IV/CRR) provides a common
regulatory rulebook directing also the use of most macroprudential tools.
The European macroprudential set-up is generally appropriate for Europe's bank-based,
highly integrated and thereby potentially fragile financial system. Research suggests that
banking oriented financial systems - like that in Europe - may be particularly prone to
systemic risks and crises.4 In highly integrated markets these risks and crises can rapidly
spread across borders and markets.
One of the strengths of the euro area macroprudential policy, as I see it, is that the joint
responsibility between the ECB and national authorities is likely to reduce the inaction bias
inherent in taking unpopular and intrusive macroprudential actions. The ESRB, by closely
monitoring and evaluating national macroprudential frameworks and policies, plays a similar
role in the whole EU area.
There are also weaknesses in the European framework. Some EU-level regulatory rules and
procedures concerning the use of macroprudential tools are, as I see them, overly
complicated and bureaucratic. For example, the European capital adequacy framework does
not yet provide national authorities with fully satisfactory ways to increase residential
mortgage risk-weights for macroprudential reasons.
Given the inherent inaction bias in macroprudential policy-making, a too complex regulatory
rules may provide national macroprudential authorities a convenient excuse for deferring
necessary macroprudential actions.
The challenge of new players and new technologies
Finally, let me share a few thoughts on the potential changes in banking and financial
intermediation.
Recently, there has been a lot of discussion on the increasing role of new players and
technologies and the diminishing role of traditional deposit banks in financial intermediation.
And indeed, banking-like activities have increasingly shifted to the shadow banking sector.
The credit intermediation has also to some extent shifted away from the banking sector to the
debt securities market.
When evaluating these changes, it is useful to recall the history of major technological
breakthroughs. One of the lessons of history is that we tend to overestimate the impacts of
new players and technologies in the short term but underestimate these in the long term.5
In the light of this observation, we may end up exaggerating the short-term effects of the
much-discussed potential game-changers like shadow banks or digitalisation on the financial
system and financial stability. Still, we may underestimate their impact in the long term. To
illustrate, Nokia wanted to beat Motorola and Ericsson in the mobile terminal market and it
did. But the more dangerous competitors, Google and iPhone, came from a completely new
direction which did not exist before.
Another lesson in history is that changes always bring new risks (or old risks in new
disguise). The macroprudential policy-makers are well aware that we must, for example,
build sufficient information collection systems and tools for macroprudential policy to deal
with systemic risks building up in and migrating to the shadow banking sector.
One factor that keeps us on guard concerning financial stability is the prolonged low interest
rate environment. The current record-low global real interest rates reflects the weak global
economic growth and abundancy of global savings relative to profitable investment
opportunities.
It is clear that low interest rates may be generating search-for-yield and risk-taking incentives
in some asset markets. To counteract these pressures, the role of a well-functioning
macroprudential framework and policy will be quite central in the future.
Conclusions
Finally, let me conclude by commenting on the argument by some that we have already gone
too far in micro and macroprudential regulation. For instance, could it be that the
strengthened regulation is currently hampering the transmission of monetary policy in the
euro area?
Focusing on bank capital, there is ample evidence suggesting that a solid banking sector is a
key to unimpeded credit flows. Banks struggling with debt overhang or non-performing loans
lend less.
In accordance with this, experience strongly suggests that a swift recapitalisation of the
banking sector in response to crises is a key measure to restore economic growth.
So, the regulatory measures we have taken after the crisis, and their implementation must be
done properly.