Financial stability nets:
Complementing and reinforcing
micro and macro perspectives
Mario Bergara
Gerardo Licandro
Jorge Ponce
002 - 2012
1688-7565
Financial stability nets: Complementing and
reinforcing micro and macro perspectives1
Mario Bergara
Gerardo Licandro
Jorge Ponce
1. Lessons from the crisis: What is new?
The aftermath of the 2008 global financial crisis witnessed a surge on the discussion of
financial stability issues. In some countries the focus of the debate is on the role of the
shadow financial system, its relationship with banks, and the regulatory and
supervisory failure to address the problem of regulatory arbitrage. In Europe, the main
concerns lies on the lack of a European safety net, mainly due to the absence of a
European lender of last resort. In emerging countries, however, the discussion is
centered around the impact of the crisis on the volatility of capital flows and the
architecture of the international financial system. Though some of the phenomena
underlying the origins and depth of the financial crisis were either new or located in
new instruments and markets, most of the issues that were raised during this episode
can be traced back to the first financial crisis of the world. In the following lines, we
develop the argument that even though financial stability concerns are as old as
financial systems, and despite some of the main lessons of the recent crisis look pretty
much alike the lessons of several financial episodes of the past (to which many
jurisdictions have already reacted), there are good reasons to highten our concern with
financial stability.
Financial stability arises as a main concern, despite the fact that the concept is neither
new, nor the main explanation for the collapse the world experienced in 2008. The crisis
revealed the existence of regulatory failures at different levels, as well as problems in
the design of the financial safety nets both at the national and international level. In
what appears to be nearly a paradox, regulatory failure has remained in the background
overshadowed by the concentration of policy making bodies in financial stability.
Financial stability concerns have had an impact on the management of both macro and
micro policies regarding financial stability for a long time now. Uruguay can give
examples of that matter. To quote one, in 1998 when facing a bullish international
environment, Uruguay increased capital requirements on banks to tame the seemingly
bubling behaviour of domestic credit. For years now, Uruguay has worked on
increasing the maturity of domestic public debt to avoid liquidity pressures on fiscal
accounts that might in the end affect the health of the banking sector. Another example
is our country's concern with real exchange appretiations. In the graph below it is
possible to see that every financial crisis we had in the last 50 year was preceded by a
deep and gradual appretiation of the real exchange rate followed by a sudden and sharp
depreciation. That lesson has carved deep into the skins of the Uruguayan people, who
see the appretiation of the currency as a sign of trouble to come. As a reflection of that
concern, macroeconomic policy has always been keen to keep an eye on the exchange
rate market, trying to prevent the misalignement of the real exchange rate with respect
to fundamentals. Financial stability is then a long term concern in both macro en micro
economic policy design.
Despite their long standing tradition on caring about financial stability, emerging
countries like Uruguay are paying a renewed and closer attention to the matter because
the international environment has changed. The G20 solution to the financial crisis has
set clearly the boundaries of the international financial safety net, which were
previously unknown, and has left a legacy of medium term excess liquidity that has to
be dealt with in emerging economies. The sum of those two elements implies much
more volatile international capital flows, in an international financial architecture in
which each country is basically on its own.
As a result, even though financial stability is nothing new to us, we are paying a much
closer look at the ways to complementing and reinforcing efforts to enhance the
stability of our financial system and its contribution to the whole economy. In the next
lines we would go over the way we envisage financial stability in the new international
context.
2. Why is public intervention in financial markets necessary?
Public intervention in an industry is commonly justified by the existence of market
failures and externalities. Market failures and externalities are particularly pregnant in
financial markets. Financial markets operate in an environment of asymmetric
information where adverse selection, moral hazard and costly state verification
problems play a very important role. Moreover, the activities of the financial market
players pose important spill-overs and externalities over other players in the industry,
other industries, the domestic economy and even spread over other economies. Many
examples of contagion, externalities and other market failures may be identified on the
recent global financial crisis.
Some aspects that are specific to the financial industry provide a rationale for public
intervention in financial markets:
Representing and protecting small claimholders. Financial institutions (e.g. banks)
finance risky investments (e.g. loans) through retail deposits and other liabilities. Retail
depositors, as well as other claimholders, are relatively small (and maybe non-
sophisticated) agents. They do not have either the technical capabilities or the incentive
to monitor financial institutions. Hence, public intervention is justified in order to cope
with the potential moral hazard problem. In particular, a public entity assumes the
representation of small claimholders of financial institutions in order to protect them
(see Dewatripont and Tirole, 1994).
Controlling systemic risk, financial and macroeconomic stability. One of the main
functions of financial institutions is to manage risks. For this reason, financial
institutions are inherently fragile, to the point that some authors refer to them as "risk
machines" (see Bessis, 2010). Moreover, troubles in one institution may rapidly amplify
and spread to others through balance sheet interlinks and financial contagion, and
affect the payment systems and the real economy (see, for instance, Allen and Gale
2000, Diamond and Dybvig 1983, Freixas et al. 2000. Ponce and Tubio 2010 offer a
review of the literature). In addition to these externalities, amplification and spill-over
effects, a situation of financial instability may be the result of the materialization of a
macroeconomic risk which is common to all financial institutions (see Rochet, 2004).
Yet, financial institutions may face difficulties to coordinate actions in order to resolve
potentially damaging imbalances. Rochet and Vives (2004) demonstrate in a formal
model that such coordination failure may determine that solvent financial institutions
face severe liquidity shortfalls. Hence, these market failures and the need to preserve
public goods (e.g. the payment system and the financial and macroeconomic stability)
provide another rationale for public intervention.
Protecting taxpayer's money. Financial crises have demonstrated to impose large
cleaning burdens to fiscal authorities. Hence, the protection of fiscal revenues is
another rationale for prompt public intervention in order to reduce the frequency and
the impact of crises, and to quickly and efficiently resolve them once they have
materialized.
Public intervention in financial markets commonly implies a series of functions that
can be classified into the categories of prevention and resolution. Among the category of
prevention one can mention the activities of monitoring and assessing risks (two
crucial functions of financial supervision), and the application of a regulatory policy. A
regulatory policy implies the use of rules (i.e. regulations) but also of preventive action
(e.g. to enforce rules), and corrective action (e.g. to lean against imbalances). The
resolution policy involves the use of rules, which are important to guarantee prompt
and efficient resolution processes, the resolution and cleaning of institutions in trouble,
and the correction of imbalances. Many tools are used to fulfil the objectives of public
intervention in financial markets: prudential regulation, control and supervision (i.e.
preventive tools), and resolution mechanisms and emergency liquidity assistance (i.e.
resolution tools).
The set of all these functions and tools provides a financial safety net to the financial
system. In general, the functions and tools of the financial safety net are allocated to
different agencies. For example, it is generally the central bank which is responsible for
the provision of emergency liquidity assistance. Other responsibilities like prudential
regulation, supervision, and deposit insurance are allocated inside the central bank in
some jurisdictions and outside in others. In order to determine the most efficient
governance structure for the financial safety net policymakers should consider the
agencies explicit conflict of objectives, the potential conflict of opinions about key
issues (e.g. the intervention or the liquidation of a financial institution, the provision of
short term emergency assistance, the authorization of mergers and acquisitions), and
the need for coordination. In addition to this, policymakers should consider the pros
and cons of the unification versus the separation of financial safety net agencies on the
grounds of their relative expertise, capabilities, reputation, credibility and institutional
strength. Moreover, the financial safety net affects and is affected by other functions
like the conduction of monetary policy and fiscal policy. These effects should also be
considered when designing financial stability institutions. We come back to this point
in Section 5.
3. Micro- and macro-prudential perspectives
Sound risk management are needed not only at individual institutions but also at the
financial system as a whole. The severity of the recent global financial crisis can only be
explained by the systemic risk factors that propagated the problems in individual
institutions and markets to the entire global financial system. The close relationship
between individual and systemic risks provides a rationale for complementing the
traditional micro-prudential perspective (focusing on individual risks) with a macro-
prudential perspective (assessing systemic risks).
Most of the financial regulatory and supervisory apparatus focalizes on the micro-
prudential perspective. Some exceptions are the cases of Spain and Uruguay which
have been implementing mechanisms to control both the static and the dynamic
dimensions of systemic risk (e.g. dynamic provisioning and limit to currency
mismatches) during the last decade. The recent Basel III capital and liquidity accord
makes advances in the consideration of systemic risk. However, most of the current
financial regulation focuses on the stability of each financial institution and market
considered in insolation. Hence, it largely ignores the externalities that one institution
poses on the others, the systemic importance of individual institutions, and the risks
that are generated endogenously to the financial system. Moreover, the regulation
focusing on individual institutions may open possibilities for regulatory arbitrage, i.e.
the possibility that financial institutions avoid regulations of certain activities by
conducting them through other entities (or lines of business) which are subject to less
severe regulations.
The final objective of the macro-prudential perspective is to avoid the materialization of
large social and economic costs due to financial instabilities. Hence, this perspective to
financial stability considers the entire financial system and intends to protect their
infrastructures (e.g. the payment system, the interbank and the money markets). The
macro-prudential perspective oversights the aggregate risk of the entire financial
system by explicitly considering the exposition of individual institutions and market to
common sources of risk, and the dynamic of risks that are generated endogenously.
The micro- and the macro-prudential perspectives should be jointly considered in order
to avoid regulatory arbitrage and to ensure financial stability. Both perspectives should
complement and reinforce each other in order to protect small customers and the
stability of the entire financial system. Hence, their contribution should be transversal
to the financial safety net agencies rather than the responsibility of a specific, macro-
prudential authority. The following sections analyse the implications of jointly
considering the micro- and the macro-prudential perspectives on rules, institutions,
governance and the design of macroeconomic policy.
4. Micro- and macro prudential policies: A two-way road
The following lines we argue that the function of financial stability implies a more
articulated cooperation between institutions concerned with macro and
microeconomic policy making and regulation.
4.1. Implications of systemic risk on traditionally micro-prudential rules
and institutions
The consideration of systemic risks (e.g. exposure to common and correlated risks,
interconnectedness, financial and real sector conglomerates, cross border issues,
regulatory arbitrage, new kinds of risks and developments) have implications on
traditionally micro-prudential rules and institutions.
Risk-based regulation. Risk-based regulation implies that similar risks face similar
regulations regardless the financial institution and activity that generate them. This
kind of regulation is a direct way to provide safety and protection to claimholders of
financial institutions and other participants to the financial system. Other kind of
regulation (e.g. activity-based and institution-based) may imply that important sources
of risk remain unregulated and foster regulatory arbitrage. Moreover, they may ignore
the important synergies, interlinks and externalities among different activities and
financial institutions (which are particularly relevant under financial conglomerates)
that contribute to systemic risk. To anticipate and control excessive risk taking is a
direct mechanism to mitigate the negative effects that the materialization of risks
impose to the stability of the financial system. A risk-based regulation acts directly over
the incentives to take risks, and reduces the possibility of regulatory gaps whereby
important activities that should be regulated scape regulation.
Dynamic regulatory perimeter. Financial institutions are special not only because they
are specialized on risk management but also because they have shown to be creative
and efficient on the development of new products. Financial innovation may contribute
to social welfare but it also may serve as a device to arbitrate regulation and thereby to
increase individual and aggregate risk. The capacity to innovate of financial
institutions, the potential for regulatory arbitrage, and their potentially dangerous
effects to the whole financial system provide a rationale for allowing the agencies on
the financial safety net to expand and contract the regulatory perimeter (i.e. to select
what institutions and activities should be regulated) in order to promptly react to new
kinds of risks as market develop.
The possibility to dynamically adjust the regulatory perimeter is also justified by the
trend of financial institutions to form groups and conglomerates where a stockholding
company (even a non-financial one) owns financial institutions. Moreover, state-owned
and privately-owned financial institutions managing similar risks should be in the same
side of the regulatory perimeter and then subject to the same kind of regulations and
controls.
Uruguay represents a particular case in Latin America where the Law gives powers to
the financial sector regulator and supervisor to adjust the regulatory perimeter in order
to fulfil its mandate of preserving the stability of the financial system.
Centralized regulation. The regulation of financial institutions should be centralized in a
unique regulator. The existence of many agencies regulating the same financial
institution (e.g. in an activity-based regulatory framework) may imply important
overlaps in regulatory requirements or important gaps where important activities that
should be regulated escape regulation. Moreover, financial markets are naturally
dynamic and financial institutions and markets (e.g. banks and other intermediaries,
pension funds, insurance and capital markets) show important interlinks which justify
the need for a large level of consistency thought different regulations.
More centralization of financial regulation may imply lower bureaucratic costs,
economies of scale and scope, the use of a conglomerates logic and lower regulatory
arbitrage. These advantages from concentrating financial regulation may be traded off
the potential advantages from a less concentrated financial regulation (e.g. efficiency
gains due to specialization).
The rules and tools used by the centralized regulator should consider micro- and macro-
prudential risks. Otherwise stated, the financial regulator should take both prudential
perspectives into consideration when writing rules and using regulatory tools and
instruments. Hence, the financial regulator should receive as a clear and explicit
mandate not only to ensure the stability of individual institutions and markets, but also
to guarantee the stability of the whole financial system. Other aspects that are related
to the governance of the financial regulator and its relationship with other agencies are
analysed in Section 5.
4.2. Implications of micro-prudential concerns on macroeconomic polices
Micro prudential policy has a direct impact on macroeconomic policy, but experience
shows that the reciprocal is also true.
Changes in regulation and supervision affect the power, reach and timing of macro
policies. Leaving aside the obvious effects in crisis times, it is well known the impact of
regulation and supervision on the development of financial markets and credit.
Changes on the development of financial markets have a direct effect on the power of
monetary policy. Changes in credit affect might affect consumption and therefore
fiscal revenues. The recent crisis has highlighted the potencial effect of failure in
regulation and supervision on the creation of asset price bubbles. If we add those
"normal time" effects to the ones generated during times of stress, we have a clear case
why both monetary and fiscal policy should be concerned with financial stability.
Nevertheless, since many financial crisis can be traced back to problems in policy at the
macro level, there is a clear case of a reciprocal concern on macro policy design coming
from the authorities of the financial safety net. Particularly in the case of emerging
economies, threats to financial stability come from the macro environment, and
depend largely on the way macroeconomic policy is conducted. Reinhardt and Rogoff
illustrate that financial crisis tend to cluster in history, and are related to the volatility
of capital inflows and commodity prices. The literature on early warning systems
suggest that the most basic features that currency and banking crisis seem to share are
unsustainable appretiations of the domestic currency and fiscal problems. In the case of
Uruguay, the three cases depicted in the figure portrayed in section I can be explained
by (or cannot be understood without) problems on the design of macroeconomic policy.
Since most financial crisis events have macroeconomic factors that either caused or
amplified them, financial stability concerns should affect the design of macroeconomic
policies.
The impact of macroeconomic policies on financial stability justifies the presence of
macro policy makers in the discussion of financial stability issues not only as the ones
that pay the bill once the crisis has started, but also as key actors in the prevention of
episodes of financial instability. A direct result of the line of reasoning that this paper
develops is that financial stability is a two way road, in which all the actors involved
have some milage to cover in order to ensure financial stability.
5. Financial stability committees: from safety to stability nets
The final outcome in terms of financial stability depends on the policies conducted by
several of the agencies that are involved on macroeconomic policy design and the
financial safety net: prudential regulation and supervision, emergency liquidity
assistance, deposit insurance, etc. All the agencies that may contribute to the stability
of a financial system "own" policy instruments and tools, and are responsible for their
use. The challenges are that all these agencies should internalize the effects of their
policies on financial stability; that all these agencies should complement each other on
the identification and the assessment of risks and vulnerabilities; and that policy
instruments and tools should be used and calibrated by considering both the micro- and
the macro-prudential perspectives to financial stability.
Operationally independent agencies should receive clear mandates and remain
accountable for the outcome of their policies. Hence, safety net agencies should receive
the mandate of contributing to the stability of the whole financial system in addition to
their specific mandates. Yet, agencies may have conflicting opinions on crucial
decisions which may end in situations of financial instability. Financial stability
committees appear as a response to align incentives, coordinate efforts, and contribute
for all agencies to comply with their respective mandates. Financial stability
committees also add to the financial safety net by helping the micro- and the macro-
prudential perspectives to complement and to reinforce each other. Financial stability
committees are a step toward financial stability nets. Uruguay, like other Latin
American countries, has recently created a committee with the objectives of sharing
information and coordinating actions among the financial safety net agencies.
Financial stability committees serve as a framework to share information and to
coordinate actions. They also help to improve the identification and the assessment of
risks, and the accountability of the stability net agencies. Hence, they help safety net
agencies to comply with their mandates. The specific mandates of safety net agencies
and the operational constraints that they face imply that each of them specializes on
the oversight of specific dimensions of financial risks. To share, combine and analyse
the different pieces of information under the leadership of a financial stability
committee improves the efficiency of risk assessment not only by profiting from the
specialization of safety nets agencies on assessing specific risks, but also by having a
more comprehensive approach to risks, by considering the interlinks between them,
and by anticipating new risks. To get information from different safety net agencies
also has the benefit for the financial stability committee (and the social welfare) of
reducing the potential that the industry "captures" safety net agencies (see Boyer and
Ponce, 2011). Moreover, the sharing of information, the insights provided by different
safety net agencies, and the explicit consideration of different point of view on crucial
decisions imply the generation of observable (and verifiable) information which may
improve the accountability of the agencies.
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